The space owned and not occupied by the Company is leased to independent third party tenants.
In addition, the Company owns a 4.25 acre parcel of land in Brea, California, for future expansion.
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 insurance, mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile and commercial property insurance. Private passenger automobile lines of insurance accounted for approximately 83.7% of the $2.8 billion of the Company’s direct premiums written in 2008. Approximately 79.9% 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).
• 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.
• Market Volatility - The prolonged and severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, bankruptcies and government intervention in a number of large financial institutions, have resulted in significant losses in the Company’s investment portfolio As a result, depending on market conditions, the Company may incur substantial additional losses in future periods, which could have a material adverse impact on its results of operations, equity, business and insurer financial strength and debt ratings.
• 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 premium growth in excess of 20% during hard markets. Premium growth rates in soft markets have been from slightly positive to negative and in 2008 they were negative 8%. In management’s view, 2004 through 2007 was a period of very profitable results for companies underwriting automobile insurance. Many in the industry began experiencing declining profitability in 2007 and 2008 and are now increasing rates. Rate increases generally indicate that the market is hardening.
The Company generates its revenues through the sale of insurance policies, primarily covering personal automobiles and homeowners. These policies are sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling and servicing policies.
• A sharp upward increase in market interest rates or a downturn in securities markets could cause a significant loss in the value of the Company’s investment portfolio.
In 2008, the Company launched its new internet agency portal, Mercury First, in New York. The Mercury First rollout is continuing to all states through 2009. Mercury First is a single entry point for agents and brokers that provides a broad suite of capabilities. One of its most powerful tools is a Point of Sale (POS) system that allows agents and brokers to easily obtain and compare quotes and write new business. The POS for Private Passenger Auto is already in use. POS solutions for Commercial Auto and Homeowner are planned to be in use by agents in 2009. 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 paying bills, reporting claims or updating their records. The system enables quick access to documents and forms as well as empowering the agents with several self-service capabilities.
As part of the Company’s commitment to service excellence, the Company launched an initiative in 2008 to improve its call center technologies. The initiative’s goal is to enhance telephony infrastructure using Voice over Internet Protocol, centralized call recording, quality monitoring and workforce management software. The technology has been integrated with the Company’s claim processing software and deployed to the centralized customer service call center. During 2009, this technology will be rolled out to other claims processing field offices.
The California DOI uses rating factor regulations requiring automobile insurance rates to be determined in decreasing order of importance by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) other factors as determined by the California DOI to have a substantial relationship to the risk of loss and adopted by regulation.
The Company is also involved in legal proceedings incidental to its insurance business. See Note 14 of Notes to Consolidated Financial Statements-Commitments and Contingencies-Litigation.
The preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”), and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates, among other factors, can 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 claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company calculates a point estimate rather than a range of loss reserve estimates. There is inherent uncertainty with estimates and this is particularly true with estimates for loss reserves. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over inflation rates and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its reserve by looking at historical patterns and trends and projecting these out to current reserves. The underlying factors and assumptions that serve as the basis for preparing the reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information.
• The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of business which have a long operating history.
• The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
• The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves.
In states with little operating history where there are insufficient claims data to prepare a reserve analysis relying solely on Company historical data, the Company generally projects ultimate losses using industry average loss data or expected loss ratios. As the Company develops an operating history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development methods. The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous similar catastrophes.
There are many factors that can cause variability between the ultimate expected loss and the actual developed loss. Because the actual loss for a particular accident period is unknown until all claims have settled for that period, the Company must estimate what it expects that loss to be. While there are certainly other factors, the Company believes that the following items tend to create the most variability between expected losses and actual losses:
• Variability in the number of claims reported subsequent to a period-end relating to that period - particularly on coverages that take longer to settle such as the California automobile bodily injury coverage.
• Variability between Company loss experience and industry averages for those lines of business that the Company is relying on industry averages to establish reserves.
In general, when establishing reserves, the Company expects that historical trends will continue. Furthermore, the Company believes that costs tend to increase, which is generally consistent with historical data, and therefore the Company believes that it is more reasonable to expect inflation than deflation. Many potential factors can affect the BI inflation rate, including: changes in statutes and regulations, an increase or reduction in litigated files, general economic factors, more timely handling of claims, safer vehicles, changes in weather patterns, and gasoline prices; however, whether these are the factors that actually impacted the BI losses, and the magnitude of that impact is unknown.
(a) The recent downward trend in the total number of claims reported is reflective of declining loss frequencies and a decline in the number of insurance policies issued.
During 2008, the Company experienced a large increase in the average cost paid on claims that closed within the 2008 accident period. Only between 35% and 40% of the claims close in the first year, however the averages are still an indicator that inflation is increasing at a higher rate than in previous recent accident periods. As a result, the Company adjusted inflation rate assumptions upwards for the 2008 accident year, as compared to 2007. The Company is uncertain as to what is driving the larger than normal inflation increases but, as shown in the table above, it is not unusual for the rate to vary from period to period.
3. Variability between the Company’s loss experience and industry averages for those lines of business where there is a heavy reliance on industry averages to establish reserves, primarily New Jersey bodily injury claims.
New Jersey is a no-fault state, which means that the majority of medical costs are paid directly by a policyholder’s insurance company rather than by the insurance company of the person who was at-fault in the accident. This coverage is known as personal injury protection (“PIP”) and in New Jersey the standard policy has a statutory limit of $250,000 per person. In New Jersey, the BI coverage provides compensation for “pain and suffering” and any out of pocket medical costs not provided by the PIP coverage. The PIP limits are very high in New Jersey and the BI cases are often more complicated and expensive than in other states, therefore they tend to take longer to settle. Consequently, establishing a reserve for these coverages in New Jersey is generally more difficult than in most of the states in which the Company operates. Adding to the reserving difficulty is the fact that the Company has a very short operating history in New Jersey, underwriting personal automobile insurance only since the fall of 2003.
As a result of the lack of sufficient operating history prior to 2008, the Company relied on industry loss data to determine the ultimate losses for the BI and PIP coverage’s in New Jersey. The reserve approach utilized for New Jersey in 2007 assumed that there would not be significantly more development on the 2004 accident year claims, due to the maturity of those claims, and that the relationship between Company loss data and industry loss data in accident years 2005, 2006 and 2007 will be similar to that experienced in accident year 2004.
4. Unexpected large individual losses or groups of losses arising from older accident periods typically caused by an event that is not reflected in the historical company data used to establish reserves.
At December 31, 2008 and 2007, the Company recorded its point estimate of approximately $1,134 million and $1,104 million, respectively, in loss and loss adjustment expense reserves which includes approximately $385 and $322 million, respectively, of incurred but not reported (“IBNR”) loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs which may differ from case estimates, unreported claims which occurred on or prior to December 31, 2008 and estimated future payments for reopened-claims reserves. Management believes that the liability established at December 31, 2008 for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company complies with SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” in recognizing revenue on insurance policies written. The Company’s insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums, net of investment income. To the extent that any of the Company’s lines of business become substantially unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business. At December 31, 2008, a premium deficiency reserve of $639,000 was established for New Jersey operations after anticipating 4% investment income.
For equity securities, the net loss due to changes in fair value in 2008 was approximately 52.6% of fair value at December 31, 2008. The primary cause of the losses in fair value of equity securities was the overall decline in the stock markets, which saw a decline of approximately 38.5% in the S&P 500 index in 2008. The underperformance of the Company’s equities was primarily due to the large allocation to energy related stocks, which experienced a decline in value more severe than that of the overall stock market. For fixed maturity securities, the net loss due to changes in fair value was approximately 9.9% of fair value in 2008. The Company believes that the primary causes of the majority of the losses in fair value of fixed maturity securities were ongoing downgrades of municipal bond insurers, widening credit spreads, and reduced market liquidity.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipalities, certain corporate and other debt securities, corporate equity securities, and exchange traded funds. Over 99% of the fair value of the financial instruments held at December 31, 2008 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 in a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
At December 31, 2008, the Company’s deferred income taxes were in a net asset position, compared to a net liability position at December 31, 2007. The movement to net asset position is due primarily to a decrease in the market value of investment securities. The Company assesses the likelihood that deferred tax assets will be realized and to the extent management believes realization is not likely, a valuation allowance is established. Management’s recoverability assessment is based on estimates of anticipated capital gains, available capital gains realized in prior years that could be utilized through carryback and tax-planning strategies available to generate future taxable capital gains, which are expected to be sufficient to offset recorded deferred tax assets.
Specifically, the Company has the ability and intention to generate realized capital gains, and minimize realized capital losses for which no tax benefit will be derived, by employing a combination of prudent planning strategies. 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 these debt securities, which represent a significant portion of the unrealized loss positions at year-end, are not due 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 has prior years’ realized capital gains available to offset realized capital losses, via the filing of carryback refund claims. 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 properties of its appreciated real estate holdings. Finally, the Company has an established history of generating capital gain premiums earned through its common stock call option program. Based on the continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and the Company's favorable track record in generating net capital gains from this program in both upward and downward markets, management believes it will be able to generate sufficient amounts of option premium capital gains (more than sufficient to offset any losses on the underlying stocks employed in the program) on a consistent, long term basis. 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.
The Company has known, and may have unknown, potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the notes to the consolidated financial statements if they meet the requirements stated in SFAS No. 5. 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; however, it is not expected to be material to the Company’s financial position. See also “Regulatory and Legal Matters” and Note 14 of Notes to Consolidated Financial Statements.
The expense ratio (GAAP basis) (policy acquisition costs and other operating expenses related to premiums earned) was 28.5% and 27.4% in 2008 and 2007, respectively. The increase in the expense ratio largely reflects costs such as payroll, benefits, and advertising that have not declined in proportion to the decline in premium volumes; an increase in technology-related expenses; the establishment of the product management function; and approximately $2 million of AIS acquisition-related expenses.
The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 101.8% and 95.4% in 2008 and 2007, respectively. The Company’s underwriting performance contributed $51.3 million of loss and $138.8 million of income to the Company’s results of operations before income tax benefit and expense for 2008 and 2007, respectively.
The income tax benefit of $208.7 million in 2008, compared to a tax expense of $77.2 million in 2007, resulted primarily from realized losses in the investment portfolio.
Operating income is a non-GAAP measure which represents net income excluding realized investment gains and losses, net of tax, and adjustments for other significant non-recurring, infrequent or unusual items. Net income is the GAAP measure that is most directly comparable to operating income. Operating income is meant as supplemental information and is not intended to replace net income. It should be read in conjunction with the GAAP financial results. The following is a reconciliation of operating income to the most directly comparable GAAP measure:
Net premiums earned and net premiums written in 2007 decreased approximately 0.1% and 2.1%, respectively, from 2006. The premium decreases were principally attributable to a decrease in the number of policies written by the Company’s non-California operations, mostly in New Jersey and Florida, which were experiencing significant competition. The decrease was partially offset by a slight increase in the average premium collected per policy. During 2007, the Company implemented no rate changes in California. In states outside of California, the Company implemented automobile rate increases in two states, automobile rate decreases in four states, and homeowners rate decreases in one state.
Net investment income was $158.9 million and $151.1 million in 2007 and 2006, respectively. The after-tax yield on average investments (fixed maturities, equities and short-term investments valued at cost) was 4.0% on average invested assets of $3.5 billion and 3.8% on average invested assets of $3.3 billion in 2007 and 2006, respectively. The effective tax rate on investment income was 13.3% and 15.5% in 2007 and 2006, respectively. The lower tax rate in 2007 reflected a shift in the mix of the Company’s portfolio from taxable to non-taxable securities. Proceeds from bonds which matured or were called totaled $311.7 million and $522.2 million in 2007 and 2006, respectively. The proceeds were mostly reinvested into securities meeting the Company’s investment profile.
The principal sources of funds for the Insurance Companies are premiums, sales and maturity of invested assets and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments.
The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $240.2 million at December 31, 2008, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
Net cash provided from operating activities in 2008 was $63.5 million, a decrease of $152.6 million over the same period in 2007. This decrease was primarily due to the slowdown in growth of premiums reflecting softening market conditions in personal automobile insurance coupled with an increase in loss and loss adjustment expenses paid in 2008 compared with the same period in 2007. The Company has utilized the cash provided from operating activities primarily for the purchase and development of information technology such as the NextGen and Mercury First computer systems and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $786.5 million, were primarily reinvested by the Company in high grade fixed maturity securities.
The following table shows estimated fair value of fixed maturity securities at December 31, 2008 by contractual maturity in the next five years.
The investment markets have experienced substantial volatility due to uncertainty in the credit markets and a global economic recession which began in late 2007. In the third and fourth quarters of 2008, asset values experienced severe declines which resulted from extreme volatility in the capital markets and a widening of credit spreads beyond historic norms. Consequently, during 2008, the Company recognized approximately $550.5 million in net realized investment losses, of which, approximately $274 million was related to fixed maturity securities and approximately $254 million was related to equity securities. Included in this loss is $531.1 million related to the change in fair value of the total investment portfolio. As a result of the adoption of SFAS No. 159 on January 1, 2008, the change in unrealized gains and losses on all investments are recorded as realized gains and losses on the consolidated statements of operations.
Fixed maturity securities include debt securities and redeemable preferred stocks. 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 resulted in a portfolio with a moderate duration. Fixed maturity investment made by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The modified duration of the fixed maturity securities is 7.2 years at December 31, 2008 compared to 4.4 years at December 31, 2007.
As reported for the year ended December 31, 2007, the Company had more than 85% of its fixed maturity assets invested in municipal securities with another 10% invested in AAA-rated mortgage-backed securities and U.S. government bonds. Less than 5% of its fixed maturity securities were invested in corporate securities at December 31, 2007. More than half of the Company’s municipal securities were insured by companies with AAA ratings. The majority of mortgage-backed securities were collateralized by prime borrowers and had AAA ratings. Uninsured municipal securities had an average credit rating of AA, while insured municipal securities had an underlying average credit rating of AA-. Due to the strong underlying credit ratings of the Company’s municipal securities, the government backing of most of mortgage-backed securities, and the relatively small corporate security exposure, the Company has been able to maintain a very strong overall credit rating of AA on the fixed maturity portfolio at December 31, 2008. The following table presents the credit quality rating of the Company’s fixed maturity portfolio by types of security at December 31, 2008 at fair value:
The Company had approximately $2.2 billion at fair value ($2.4 billion at amortized cost) in municipal bonds at December 31, 2008, which comprised approximately 45% of net losses held in the portfolio. Approximately 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, 2008.
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 principle amounts upon maturity, avoiding forced sales, prior to maturity, of bonds that have declined in market value due to the bond insurers’ rating downgrades.
At December 31, 2008, municipal securities include auction rate securities. The Company owned $3 million and $18.7 million at fair value of adjustable rate short-term securities, including auction rate securities, at December 31, 2008 and 2007, respectively.
The average rating of the Company’s Alt-A mortgages is AA and the average rating of the entire mortgage backed securities portfolio is AAA. The valuation of these securities is based on Level 2 inputs that can be observed in the market.
Equity holdings consist of non-redeemable preferred stocks and dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. The following table summarizes the equity security portfolio by sector for 2008 and 2007:
Effective January 1, 2009, the Company acquired AIS for $120 million. The acquisition was financed by a $120 million credit facility. The loan matures on January 2, 2012 with interest payable quarterly at an annual floating rate of LIBOR rate plus 125 basis points. In addition, the Company may be required to pay up to $34.7 million over the next two years as additional consideration for the AIS acquisition. The Company plans to fund that portion of the purchase price, if necessary, from cash on hand and cash flow from operations. On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate plus 125 basis points on the loan for a fixed rate of 3.18%. The swap is not designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change.
The interest included in the Company’s debt obligations was calculated using the fixed rates of 7.25% on $125 million of senior notes, 4.25% under an $18 million credit facility, and 3.18% under a $120 million credit facility. The Company is party to an interest rate swap of its fixed rate on $125 million of senior notes for a floating rate of six month LIBOR plus 107 basis points. Using the 2008 actual effective annual interest rate of 3.3% for the remaining term of $125 million of senior notes, the total contractual obligations would be approximately $13 million lower than the total debt contractual obligations stated above.
Unlike many other forms of contractual obligations, loss and loss adjustment expenses do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total loss and loss adjustment expense payments to be made by period, as shown above, are estimates.
The table excludes FIN No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN No. 48”) liabilities of $5 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing of related future payments.
Consolidated Statements of Operations for Each of the Years in the Three-Year Period
Consolidated Statements of Comprehensive (Loss) Income for Each of the Years in the Three-Year Period
Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive (loss) income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 2008, 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 27, 2009 expressed an unqualified opinion on the effectiveness of Mercury General Corporation and subsidiaries’ internal control over financial reporting.
As discussed in Note 1 to the consolidated financial statements, the Company has adopted the provisions of Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, as of January 1, 2008.
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, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive (loss) income, and cash flows for each of the years in the three-year period ended December 31, 2008, and our report dated February 27, 2009 expressed an unqualified opinion on those consolidated financial statements.
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. The most significant assumptions in the preparation of these consolidated financial statements relate to loss and loss adjustment expenses. Actual results could differ from those estimates.
Effective January 1, 2008, the Company adopted SFAS No. 159. SFAS No. 159 permits an entity to measure certain financial assets and financial liabilities at fair value. Entities that elect the fair value option report unrealized gains and losses in earnings at each subsequent reporting date. The Company elected to apply the fair value option of SFAS No. 159 to all short-term investments and all available-for-sale fixed maturity and equity securities existing at the time of adoption and similar securities acquired subsequently unless otherwise noted at the time when the eligible item is first recognized, including hybrid financial instruments with embedded derivatives that would otherwise need to be bifurcated.
Effective January 1, 2008, the losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option are included in net realized investment gains (losses) in the Company’s consolidated statements of operations. Interest and dividend income on the investment holdings is recognized on an accrual basis on each measurement date and is included in net investment income in the Company’s consolidated statements of operations.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). SFAS No. 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to irrevocably be accounted for at fair value, with changes in fair value recognized in the statement of operations. The Company adopted SFAS No. 155 on January 1, 2007. As SFAS No. 159 incorporates accounting and disclosure requirements that are similar to those of SFAS No. 155, effective January 1, 2008, SFAS No. 159 rather than SFAS No. 155 is applied to the Company’s fair value elections for hybrid financial instruments.
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. Fixed maturity securities are reported at fair value. Prior to the adoption of SFAS No. 159, these securities were carried at fair value with the corresponding unrealized gains (losses), net of deferred income taxes, reported in accumulated other comprehensive income. Premiums and discounts on fixed maturities are amortized using first call date and are adjusted for anticipated prepayments. Mortgage-backed securities at amortized cost are adjusted for anticipated prepayment using the prospective method. Equity holdings, including non-redeemable fund preferred stocks, are with minor exceptions, actively traded on national exchanges and are valued at the last transaction price on the balance sheet date.
Equity securities include common stocks, nonredeemable preferred stocks and other risk investments and are reported at quoted fair values. Prior to the adoption of SFAS No. 159, changes in fair value of these securities, net of deferred income taxes, were reflected as unrealized gains and losses in accumulated other comprehensive income.
Prior to the adoption of SFAS No. 159, when a decline in value of fixed maturities or equity securities was considered other than temporary, a loss was recognized in the consolidated statements of operations. Realized capital gains and losses were included in the consolidated statements of operations based upon the specific identification method.
The liability for losses and loss adjustment expenses is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period, plus estimates, based upon past experience, of ultimate developed costs which may differ from case estimates and estimates of unreported claims. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of reinsurance recoverable is included in other receivables.
• The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves.
• The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company primarily uses this method for loss adjustment expenses because specific case reserves are generally not established for loss adjustment expenses.
In states with little operating history where there is insufficient claims data to prepare a reserve analysis relying solely on Company historical data, the Company generally projects ultimate losses using industry average loss data or expected loss ratios. As the Company develops an operating history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development methods. The Company analyzes catastrophe losses separately from non-catastrophe losses. For these losses, the Company determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous storms.
Goodwill represents the excess of amounts paid for acquiring businesses over the fair value of the net assets acquired. 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. Goodwill impairment evaluations indicated no impairment at December 31, 2008.
• Fair value hedge: changes in fair value of the hedging instrument, as well as the hedged item, are recognized in income in the period of change.
• Fair value hedge: changes in fair value of the hedging instrument, as well as the hedged item, are recognized in earnings for the current period.
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for reporting information about a public business enterprise’s operating segments. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assessing performance. The Company does not have any operations that require separate disclosure as reportable operating segments for the periods presented.
The annual direct premiums written attributable to private passenger and commercial automobile, homeowners and other lines of insurance were as follows:
Effective January 1, 2008, the Company adopted SFAS No. 157 for financial assets and liabilities. In December 2007, the FASB provided a one-year deferral of SFAS No. 157 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value on a recurring basis, at least annually. SFAS No. 157 redefines fair values as 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, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. Specifically, SFAS No. 157 establishes a three-level hierarchy for fair value measurements based upon the nature of the inputs to the valuation of an asset or liability. SFAS No. 157 applies where other accounting pronouncements require or permit fair value measurements. In October 2008, the FASB issued FASB Staff Position No. 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP FAS 157-3”), which clarifies the application of SFAS No. 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. Such considerations include inputs to broker quotes, assumptions regarding future cash flows and use of risk-adjusted discount rates. The adoption of FSP FAS No. 157-3 did not have a material impact on the Company’s consolidated financial statements.
As discussed above, effective January 1, 2008, the Company adopted SFAS No. 159, which establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement alternatives for similar types of financial assets and liabilities. The standard also requires additional information to aid financial statement users’ understanding of the impacts of a reporting entity’s decision to use fair value on its earnings and requires entities to display, on the face of the statement of financial position, the fair value of those assets and liabilities which the reporting entity has chosen to measure at fair value. The Company elected to apply the fair value option of SFAS No. 159 to all short-term investments and all available-for-sale fixed maturity and equity securities existing at the time of adoption and similar securities acquired subsequently unless otherwise noted at the time when the eligible item is first recognized, including hybrid financial instruments with embedded derivatives that would otherwise need to be bifurcated. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as expansion of use of fair value measurement consistent with the long-term measurement objectives of the FASB for accounting for financial instruments.
Effective January 1, 2009, the Company adopted SFAS No. 141 (revised 2007), “Business Combinations” ("SFAS No. 141(R)"). While SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141, “Business Combinations” (“SFAS No. 141”), that the acquisition method (referred to as the purchase method in SFAS No. 141) be used for all business combinations and for an acquirer to be identified for each business combination, SFAS No. 141(R) significantly changes the accounting for business combinations in a number of areas including the treatment of contingent consideration, contingencies, and acquisition costs. SFAS No. 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. This replaces the cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. Additionally, SFAS No. 141(R) requires costs incurred to effect the acquisition to be recognized separately from the acquisition rather than included in the cost allocated to the assets acquired and liabilities assumed. SFAS No. 141(R) requires the acquirer to recognize goodwill as of the acquisition date, measured as a residual, which in most types of business combinations will result in measuring goodwill as the excess of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree at the acquisition date over the fair values of the identifiable net assets acquired. In addition, under SFAS No. 141(R), changes in deferred tax asset valuation allowances and acquired income tax uncertainties in a business combination after the measurement period impact income tax expense.
In April 2008, the FASB issued FASB Staff Position FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No.142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. The Company adopted FSP FAS 142-3 on January 1, 2009. The adoption of FSP FAS 142-3 did not have a material impact on the Company’s consolidated financial statements.
Effective January 1, 2008, the losses due to changes in fair value for items measured at fair value pursuant to the Company’s election of the fair value option are included in net realized investment gains and losses in the Company’s consolidated statements of operations.
Net realized gains and losses from investments included losses of $527.7 million related to trading securities which were still held at December 31, 2008.
Gross gains and losses realized on the sales of investments (excluding calls) are shown below:
The availability of observable inputs varies by instrument. In situations where fair value is based on internally developed pricing models or inputs that are unobservable in the market, the determination of fair value requires more judgment. The degree of judgment exercised by the Company in determining fair value is typically greatest for instruments categorized in Level 3. 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 considers factors specific to the asset or liability.
U.S. government bonds and agencies: U.S. treasuries and agencies are priced using unadjusted quoted market prices for identical assets in active markets.
Short-term investments: Comprised of actively traded short-term bonds and money market funds that have daily quoted net asset values for identical assets.
Derivative contracts: Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.
Derivative contracts; Notes payable: Comprised of interest rate swaps that are valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.
Municipal securities: Comprised of certain distressed municipal securities for which valuation is based on models that are widely accepted in the financial services industry and require projections of future cash flows that are not market observable. Included in this category are $3.0 million of auction rate securities (“ARS”). ARS are valued based on a discounted cash flow model with certain inputs that are significant to the valuation, but are not market observable.
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 and losses in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
As required by SFAS No. 157, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3).
Losses included in earnings are reported in net realized investment gains and losses.
The amortized cost and estimated fair value of investments in fixed maturities available-for-sale (excluding hybrid financial instruments with an estimated fair value of $31.8 million) as of December 31, 2007 were as follows:
Unrealized losses that had been in a continuous unrealized loss position over 12 months were mostly accounted for by unrealized losses of fixed maturity securities, and amounted to 0.3% of the total investment market value at December 31, 2007.
In October 2007, the Company completed the acquisition of a 4.25 acre parcel of land in Brea, California. In conjunction with the purchase, the Company entered into an 18-month lease agreement with the seller allowing the seller to use the property during the lease term. Also, as part of the acquisition, the Company issued a secured promissory note in the amount of $4,500,000 without interest. In December 2008, the note was paid in full and the lease agreement with the seller was terminated. The Company has taken possession of the property at December 31, 2008.
The Company and its subsidiaries file a consolidated federal income tax return. The provision for income tax (benefit) expense consists of the following components:
Realization of deferred tax assets is dependent on generating sufficient taxable income of an appropriate nature prior to their expiration. The Company has the ability and intent, through the use of prudent tax planning strategies and the generation of capital gains to generate income sufficient to avoid losing the benefits of its deferred tax assets. As a result, although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized.
On July 1, 2008, the California Superior Court ruled in favor of the Company in a case filed against the California FTB for tax years 1993 through 1996, entitling the Company to a tax refund of $24.5 million, including interest. The time period for appeal of the decision has passed and the Company received the full amount on August 15, 2008. After providing for federal taxes, the Company recognized a net tax benefit of $17.5 million in the third quarter 2008.
The Company adopted the provisions of FIN No. 48 on January 1, 2007. No adjustment to the Company's financial position was required as a result of the implementation of this Interpretation.
The statutory surplus of each of the Insurance Companies exceeded the highest level of minimum required capital.
The Company, at the option of the Board of Directors, may make annual contributions to an employee Profit Sharing Plan (the “Plan”). The contributions are not to exceed the greater of the Company’s net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed an amount equal to 15% of the compensation paid or accrued during the year to all participants under the Plan. No contributions were made by the Company during 2008 compared to $1,900,000 for each of 2007 and 2006.
In May 1995, the Company adopted the 1995 Equity Participation Plan (the “1995 Plan”) which succeeded a prior plan. In May 2005, the Company adopted the 2005 Equity Incentive Award Plan (the “2005 Plan”) which succeeded the 1995 Plan. Share-based compensation awards may only be granted under the 2005 Plan. A combined total of 5,400,000 shares of Common Stock under the 1995 Plan and the 2005 Plan are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. The maximum number of shares that may be issued under the 2005 Plan is 5,400,000. As of December 31, 2008, only options and restricted stock awards have been granted under these plans. Beginning January 1, 2008, options granted for which the Company has recognized share-based compensation expense generally become exercisable 25% per year beginning one year from the date granted, are granted at the market price on the date of grant, and expire after 10 years. Prior to January 1, 2008, shares became exercisable at a rate of 20% per year. The Company has no restricted stock outstanding as of December 31, 2008.
The aggregate intrinsic value in the table above represents the total pretax 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, 2008. The aggregate intrinsic value of stock options exercised was $442,000, $1,134,000 and $1,661,000 during 2008, 2007 and 2006, respectively. The total fair value of options vested was $652,000, $487,000 and $886,000 during 2008, 2007 and 2006, respectively.
The following table summarizes information regarding stock options outstanding at December 31, 2008:
As of December 31, 2008, $1,457,000 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.
The antidilutive impact of incremental shares is excluded from loss positions in 2008 in accordance with GAAP.
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 2014. 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 $1,426,000 and $1,153,000 at December 31, 2008 and 2007, respectively. Total rent expense under these lease agreements was $12,002,000, $9,469,000 and $8,292,000 for 2008, 2007 and 2006, respectively.
The CEA is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. The Company places all new and renewal earthquake coverage offered with its homeowners policies through the CEA. The Company receives a small fee for placing business with the CEA, which was recorded as other income in the consolidated statements of operations.
The economies of California, the United States and the world are experiencing a deepening recession. There has been a rise in the unemployment rate and significant disruption in the capital markets. While some economists have predicted an end to this recession by sometime in the second half of 2009, the actual length and depth of the recession and the disruption in the capital markets is currently unknown.
The impact on the Company from the recession would also affect the net income and surplus of the Insurance Companies which could impact the ability and capacity of the Company to pay shareholder dividends.
The total cost of the acquisition has been allocated to the assets acquired and the liabilities assumed based upon preliminary estimates of their fair values at the acquisition date. The following table summarizes the consideration paid for AIS and the preliminary allocation of the purchase price.
The fair value of the financial assets acquired includes cash, receivables from customers and other assets. The fair value of the liabilities assumed includes accounts payable and other accrued liabilities.