The Company is headquartered in Los Angeles, California and writes primarily personal automobile lines of business selling policies through a network of independent agents, 100% owned insurance agents and direct channels, in 11 states: Arizona, California, Florida, Georgia, Illinois, Nevada, New Jersey, New York, Oklahoma, Texas, and Virginia. The Company also offers homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. Private passenger automobile lines of insurance business accounted for approximately 75% of the $3.8 billion of the Company’s direct premiums written in 2019, and approximately 88% of the private passenger automobile premiums were written in California.
The Company’s net income for the year ended December 31, 2019 was $320.1 million, or $5.78 per diluted share, compared to net (loss) of $(5.7) million, or $(0.10) per diluted share, for the same period in 2018. Included in net income (loss) was $141.3 million of pre-tax net investment income that was generated during 2019 on a portfolio of $4.3 billion, at fair value, at December 31,
During 2019, 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 its insurance products competitive in California and in other states.
Cost Uncertainty-Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned. Consequently, significant assumptions are made when establishing insurance rates and loss reserves. While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analyses indicate that they are needed.
Economic Conditions-The Company’s financial condition, results of operations, and liquidity may be negatively impacted by global, national and local economic conditions, such as recessions, increased levels of unemployment, inflation, and large fluctuations in interest rates. Further, volatility in global capital markets could adversely affect the Company’s investment portfolio. The Company is not able to predict the timing and effect of these factors, or their duration and severity.
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 automobile insurance industry is exiting a hard market with carriers generally raising rates at a slower pace than in 2017 and 2018, although this also depends on individual state profitability and the carriers’ growth appetite.
The Company started an insurance platform modernization initiative in 2010 to migrate to Guidewire’s InsuranceSuite for its lines of business and states. Guidewire InsuranceSuite is a widely adopted industry-leading software for property and casualty insurance. The Company has completed the migration to InsuranceSuite for all of its claims processing, and for most of the states and lines of business in which the Company operates for its underwriting processing. Throughout 2019, the Company has made numerous enhancements to its information technology platforms to further improve agent experience and to promote cross selling
using our more modern and intuitive AgentCenter Portal. In addition, the Company implemented a new product offering for landlord insurance as well as new paperless eDelivery and customer portal capabilities and leveraged robotic process automation and automated rules engine for straight-through processing in 2019. The Company intends to continue to invest in modernization of its technology platforms, technologies for cross selling and new product offerings, and technology initiatives to enhance customer experience in 2020.
During 2019, the Company implemented rate changes in eleven states. In California, the following rate increases were approved by the California DOI for lines of business that exceeded 5% of the Company's total net premiums earned in 2019:
In May 2019, the California DOI approved a 6.99% rate increase on the California homeowners line of insurance business, which represented approximately 12% of the Company's total net premiums earned in 2019. The Company implemented this rate increase in August 2019.
In March 2019, the California DOI approved a 6.90% rate increase on MIC's private passenger automobile line of insurance business, which represented approximately 54% of the Company's total net premiums earned in 2019. The Company implemented this rate increase in May 2019.
In January 2019, the California DOI approved a 6.90% rate increase on CAIC's private passenger automobile line of insurance business, which represented approximately 12% of the Company's total net premiums earned in 2019. The Company implemented this rate increase in March 2019.
On October 1, 2019, the Company and the California DOI entered into a settlement agreement resolving the case involving the 2004 NNC, along with the related false advertising action that had been stayed pending the outcome of that case. Pursuant to the settlement agreement, the Company paid an additional amount of approximately $6 million to the California DOI on October 2, 2019, bringing the total settlement amount to approximately $41.2 million, in full settlement of the entire case including the false advertising action. The Company has not admitted to any allegations raised in the case. As a result of the settlement, the Company recognized approximately $6 million of incremental expense in its consolidated statements of operations in the third quarter of 2019 relating to the settlement.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see Note 18. Commitments and Contingencies-Litigation of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
reporting and settlement patterns, changes in the regulatory and legal environments, 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 loss reserve by looking at historical patterns and trends and projecting these out to current loss reserves. The underlying factors and assumptions that serve as the basis for preparing the loss reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company generally determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on loss reserves established by adjusters and average losses on previous similar catastrophes. For catastrophe losses on individual properties that are expected to be total losses, the Company typically establishes reserves at the policy limits.
There are many factors that can cause variability between the ultimate expected loss and the actual developed loss. While there are certainly other factors, the Company believes that the following three items tend to create the most variability between expected losses and actual losses.
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 expense 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 $5,000 to $6,000 on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $12,000 to $17,000. 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 emerges a higher degree of certainty for the loss reserves established for that accident year. At December 31, 2019, the accident years that are most likely to develop are the 2017 through 2019 accident years; however, it is possible that older accident years could develop as well.
The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 10%, 8%, and 6% for 2019, 2018, and 2017 accident years, respectively; however, the variation could be more or less than these amounts.
During the years 2015 through 2019, the changes in the loss severity amounts for the three preceding accident years from the prior year amounts (BI severity variance from prior year) have ranged as follows:
During 2016, the Company implemented a claims strategy that reduced the number of small dollar settlements offered shortly after the claims were reported. This strategy reduced the total number of claims expected, which had the effect of increasing the actual recorded severity across the total claims population. There were fewer small dollar claims in the calculation of actual recorded severity for the 2016 through 2019 accident years compared to prior accident years. Consequently, the implied inflation rate recorded for these years are skewed upward due to this strategy change.
Unexpected losses are generally not provided for in the current loss reserve because they are not known or expected and
Discussion of Losses and Loss Reserves and Prior Period Loss Development
of equity holdings, including non-redeemable preferred stocks, are actively traded on national exchanges or trading markets, and are valued at the last transaction price on the balance sheet date.
The Company’s effective income tax rate can be affected by several factors. These generally include large changes in fully-taxable income including net realized investment gains or losses, tax-exempt investment income, nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate was 15.3% for 2019, compared to 81.3% for 2018. Tax-exempt investment income of approximately $82 million coupled with relatively large pre-tax income of approximately $378 million lowered the effective tax rate for 2019 to a rate moderately below the statutory tax rate of 21%, while tax-exempt investment income of approximately $86 million coupled with relatively small pre-tax loss of approximately $31 million increased the effective tax rate for 2018 to a rate much higher than the statutory tax rate of 21%.
As a result of enactment of the Tax Cuts and Jobs Act (the "Act") on December 22, 2017 that was effective for tax years beginning January 1, 2018, the Company made certain tax adjustments. For the years ended December 31, 2018 and 2019, the Company computed its current and deferred income taxes at the new corporate tax rate of 21%, compared to computing only deferred income taxes at 21% and current income taxes at the pre-enactment rate of 35% for the year ended December 31, 2017. The alternative minimum tax (“AMT”) credit, previously classified as deferred tax asset that was included in deferred income taxes in the Company’s consolidated balance sheets, was reclassified during 2017 to current income taxes receivable as a result of the Act. The Company expects to use the current income taxes receivable balance of approximately $24 million associated with the AMT credit as an offset against its federal tax obligations for tax year 2019.
The Company continues to assess other impacts that the Act may have on business and investment strategies as well as financial results in future years. There are complex factors at play, including the effect of insurance regulation, which will likely require the tax benefits to be passed on to consumers, and changing dynamics in the capital markets, which may result in a shift in the Company’s allocation between taxable and tax-exempt investments.
The Company, which predominantly offers six-month personal automobile insurance policies, reintroduced twelve-month personal automobile policies for new business in MIC, its largest insurance subsidiary, in March 2018. Twelve-month policies are generally sold for twice the price of six-month policies. MIC's net premiums written from twelve-month policies in 2019 and 2018 was approximately $354 million and $205 million, respectively.
Net premiums earned included ceded premiums earned of $56.7 million and $48.9 million in 2019 and 2018, respectively. Net premiums written included ceded premiums written of $43.8 million and $56.0 million in 2019 and 2018, respectively. The increase in ceded premiums earned resulted mostly from an increase in reinsurance coverage and rates, growth in the covered book of business, and an increase in reinstatement premiums following the Camp and Woolsey Fires in the fourth quarter of 2018 that caused higher losses than the wildfires in the fourth quarter of 2017. The decrease in ceded premiums written resulted mostly from an increase in ceded reinstatement premiums in the second half of 2018 following the major wildfires in Northern and Southern California, coupled with reductions in ceded reinstatement premiums in the first quarter of 2019 as a result of a decrease in estimated total losses and reinsurance benefits for the Camp and Woolsey Fires, as described further in Note 12. Loss and Loss Adjustment Expense Reserves of the Notes to Consolidated Financial Statements, partially offset by an increase in ceded premiums written due to higher reinsurance coverage and rates as well as growth in the covered book of business.
Expense ratio is calculated by dividing the sum of policy acquisition costs and other operating expenses by net premiums earned. The expense ratio for the year ended December 31, 2019 compared to the year ended December 31, 2018 was affected by a decrease in average policy acquisition cost as a result of a decrease in average commission rate, which was offset by costs related to the NNC and other operating expenses in 2019. For a discussion of the NNC, see Note 18. Commitments and Contingencies of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
Income tax expense (benefit) was $58.0 million and $(24.9) million for the years ended December 31, 2019 and 2018, respectively. The $82.9 million increase in income tax expense was mainly due to a significant increase in pre-tax income of $408.7 million. Tax-exempt investment income, a component of total pre-tax income (loss), did not change significantly compared to the same period in 2018.
The following tables present the components of net realized investment gains (losses) included in net income:
The increases in fair value of fixed maturity securities during 2019 were primarily due to decreases in market interest rates. The decreases in fair value of fixed maturity securities during 2018 were primarily due to increases in market interest rates.
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 $151 million in 2020 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of $114 million during 2019. As of December 31, 2019, Mercury General had approximately $184 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. The Company does not attempt to match the duration and timing of asset maturities with those of liabilities; rather, it 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 $788.5 million at December 31, 2019 as well as a $50 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.
Net cash provided by operating activities for the year ended December 31, 2019 was $519.7 million, an increase of $136.2 million compared to the year ended December 31, 2018. The increase was primarily due to an increase in premium collections, partially offset by an increase in payments for losses and loss adjustment expenses and operating expenses. The Company utilized the cash provided by operating activities during the year ended December 31, 2019 primarily for the payment of dividends to its shareholders and net purchases of investment securities.
At December 31, 2019, 57.0% of the Company’s total investment portfolio at fair value and 79.4% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 50% corporate dividend received deduction, and private equity funds. At December 31, 2019, 93.3% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of A+, at fair value at December 31, 2019, consistent with the average rating at December 31, 2018. The Company’s municipal bond holdings, of which 96.2% were tax exempt, represented 82.6% of its fixed maturity portfolio at December 31, 2019, at fair value, and were broadly diversified geographically.
Taxable holdings consist principally of investment grade issues. At December 31, 2019, fixed maturity holdings rated below investment grade and non-rated bonds totaled $19.2 million and $37.8 million, respectively, at fair value, and represented 0.6% and 1.2%, respectively, of total fixed maturity securities. The majority of non-rated issues are a result of municipalities pre-funding and collateralizing those issues with U.S. government securities with an implicit AAA equivalent credit risk. At December 31, 2018, fixed maturity holdings rated below investment grade and non-rated bonds totaled $36.0 million and $76.4 million, respectively, at fair value, and represented 1.2% and 2.6%, respectively, of total fixed maturity securities.
The Company had $22.6 million and $25.0 million, or 0.7% and 0.8% of its fixed maturity portfolio, at fair value, in U.S. government bonds at December 31, 2019 and 2018, respectively. At December 31, 2019, Moody's and Fitch ratings for U.S. government issued debt were Aaa and AAA, respectively, although a significant increase in government deficits and debt could lead to a downgrade. The Company understands that market participants continue to use rates of return on U.S. government debt
The Company had $2.55 billion and $2.62 billion, or 82.6% and 87.8% of its fixed maturity securities portfolio, at fair value, in municipal securities at December 31, 2019 and 2018, respectively, of which $344.7 million and $404.8 million, respectively, were insured by bond insurers. The underlying ratings for insured municipal bonds have been factored into the average rating of the securities by the rating agencies with no significant disparity between the absolute bond ratings and the underlying credit ratings as of December 31, 2019 and 2018.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities was BBB- and BB at December 31, 2019 and December 31, 2018, respectively. The weighted-average rating of the entire mortgage backed securities portfolio was AA at December 31, 2019, compared to A+ at December 31, 2018. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 3.1 years and 4.0 years at December 31, 2019 and 2018, respectively.
The Company had collateralized loan obligations of $199.2 million and $165.8 million, which represented 6.4% and 5.6% of its fixed maturity securities portfolio, at fair value, at December 31, 2019 and 2018, respectively. The weighted-average rating was A+ at December 31, 2019 and 2018. The modified duration reflecting anticipated early calls was 5.2 years and 5.5 years at December 31, 2019 and 2018, respectively.
its fixed maturity securities portfolio, at fair value, at December 31, 2019 and 2018, respectively. The weighted-average rating was A and A+ at December 31, 2019 and 2018, respectively. The modified duration reflecting anticipated early calls was 1.8 years and 2.1 years at December 31, 2019 and 2018, respectively.
Equity holdings of $724.8 million and $529.6 million, at fair value, as of December 31, 2019 and 2018, respectively, consisted of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 50% corporate dividend received deduction, and private equity funds. The net gains (losses) due to changes in fair value of the Company’s equity portfolio were $90.9 million and $(77.5) million in 2019 and 2018, respectively. The primary cause for the increase in the fair value of the Company's equity securities was the overall improvement in equity markets in 2019.
The following table presents the equity security portfolio by industry sector at December 31, 2019 and 2018:
notes were issued at a slight discount of 99.847% of par, resulting in the effective annualized interest rate, including debt issuance costs, of approximately 4.45%.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and RBC ratio under the unsecured credit facility at December 31, 2019.
Among other considerations, industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to statutory policyholders’ surplus should not exceed 3.0 to 1. Based on the combined surplus of all the Insurance Companies of $1.54 billion at December 31, 2019 and net premiums written in 2019 of $3.7 billion, the ratio of premiums written to surplus was 2.42 to 1.
Insurance companies are required to file an Own Risk and Solvency Assessment ("ORSA") with the insurance regulators in their domiciliary states. The ORSA is required to cover, among many items, a company’s risk management policies, the material risks to which the company is exposed, how the company measures, monitors, manages and mitigates material risks, and how much economic and regulatory capital is needed to continue to operate in a strong and healthy manner. The ORSA is intended to be used by state insurance regulators to evaluate the risk exposure and quality of the risk management processes within insurance companies to assist in conducting risk-focused financial examinations and for determining the overall financial condition of insurance companies. The Company filed its most recent ORSA Summary Report with the California DOI in November 2019. Compliance with the ORSA requirements did not have a material impact on the Company's consolidated financial statements.
Loss and loss adjustment expense reserves represents an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2019. The Company has estimated the timing of these payments based on its historical experience and expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above. The ultimate cost of losses may vary materially from recorded amounts which are the Company’s best estimates. The Company believes that cash flows from operations and existing cash and investments are sufficient to meet these obligations despite the uncertainty in payment patterns. For more detailed information on the Company's liquidity and cash flows, see "Liquidity and Capital Resources-B. Cash Flows" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 12, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s loss reserve process, including controls over the selection of methods and assumptions used in the estimate of loss reserves. We also involved actuarial professionals with specialized skills and knowledge who assisted in:
Evaluating the results of the Company’s estimates for the remaining lines of business in comparison to the internal experience and related industry trends;
Developing a range of reserves based on actuarial methodologies in order to evaluate the Company’s total recorded loss reserves; and
Evaluating the year-over-year movements of the Company’s recorded loss reserves within the developed range.
We have audited Mercury General Corporation and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019, and the related notes and financial statement schedules I, II, and IV (collectively, the consolidated financial statements), and our report dated February 12, 2020 expressed an unqualified opinion on those consolidated financial statements.
The Company did not have other comprehensive income (loss) in 2019, 2018 and 2017.
The Company forms special purpose investment vehicles to facilitate its investment activities involving derivative instruments such as total return swaps, or limited partnerships or limited liability companies such as private equity funds. These special purpose investment vehicles are consolidated VIEs as the Company has determined it is the primary beneficiary of such VIEs. Creditors have no recourse against the Company in the event of default by these VIEs. The Company had no implied or unfunded commitments to these VIEs at December 31, 2019 and 2018. The Company's financial or other support provided to these VIEs and its loss exposure are limited to its collateral and original investment.
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 $16 million and $15 million at December 31, 2019 and 2018, respectively.
The table below presents a summary of deferred policy acquisition cost amortization and net advertising expense:
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 2019, 2018, and 2017.
Goodwill and other intangible assets arise as a result of business acquisitions and consist of the excess of the cost of the acquisitions over the tangible and intangible assets acquired and liabilities assumed and identifiable intangible assets acquired. Identifiable intangible assets consist of the value of customer relationships, trade names, software and technology, and favorable leases, which are all subject to amortization, and an insurance license which is not subject to amortization.
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, 2019 and 2018, goodwill and other intangible impairment assessments indicated that there was no impairment.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company generally determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on loss reserves established by adjusters and average losses on previous similar
At December 31, 2019, the Company’s deferred income taxes were in a net liability position, which included a combination of ordinary and capital deferred tax benefits and expenses. 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.
The Company recognized ceded premiums earned of approximately $57 million, $49 million, and $27 million in 2019, 2018, and 2017, respectively, which are included in net premiums earned in its consolidated statements of operations, and ceded losses and loss adjustment expenses of approximately $(71) million, $257 million, and $90 million in 2019, 2018, and 2017, respectively, which are included in losses and loss adjustment expenses in its consolidated statements of operations. The negative ceded losses and loss adjustment expenses in 2019 primarily resulted from the re-estimation of the catastrophe loss reserves, including estimated subrogation, on the 2018 Camp and Woolsey Fires and the 2017 Southern California wildfires, which have previously been ceded to reinsurers under the Treaty, in conjunction with the sale of the Company's subrogation rights during the
Share-based compensation expenses for all stock options granted or modified are based on their estimated grant-date fair values. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of four years. The Company estimates forfeitures expected to occur in determining the amount of compensation cost to be recognized in each period. The fair value of stock option awards is estimated using the Black-Scholes option pricing model with the grant-date assumptions and weighted-average fair values.
The Company's revenue from contracts with customers that are in scope of Topic 606 represents the commission income that the Company's 100% owned insurance agencies, Auto Insurance Specialists LLC ("AIS") and PoliSeek AIS Insurance Solutions, Inc. ("Poliseek"), earned from third-party insurers. The Company's commission income from third-party insurers was approximately $16.3 million and $16.0 million representing approximately 0.4% and 0.5% of the consolidated total revenue, for the years ended December 31, 2019 and 2018, respectively, with related expenses of approximately $10.5 million for each of the years ended December 31, 2019 and 2018. Due to the immateriality of the Company's commission income and its related expenses to the overall consolidated financial statements, the commission income, net of related expenses, is included in other revenues in the Company's consolidated statements of operations, and in other income of the Property and Casualty business segment in the Company's segment reporting in accordance with Topic 280, Segment Reporting (see Note 20. Segment Information).
As of December 31, 2019 and 2018, the Company had no contract assets, contract liabilities, capitalized costs to obtain or fulfill a contract, or remaining performance obligations associated with unrecognized revenues.
to expense the capitalized implementation costs of a hosting arrangement that is a service contract over the term of the hosting arrangement and present such expense in the same line item in the statement of income as the fees associated with the hosting element (service) of the arrangement and classify payments for capitalized implementation costs in the statement of cash flows in the same manner as payments made for fees associated with the hosting element. The entity is also required to present the capitalized implementation costs in the statement of financial position in the same line item that a prepayment for the fees of the associated hosting arrangement would be presented. ASU 2018-15 became effective for the Company on January 1, 2020 and did not have any material impact on its consolidated financial statements and related disclosures.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326)." The amendments in this ASU replace the "incurred loss" methodology for recognizing credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of information including past events, current conditions and reasonable and supportable forecasts that affect the collectibility of reported amounts of financial assets that are not accounted for at fair value through net income, such as loans, certain debt securities, trade receivables, net investment in leases, off-balance sheet credit exposures and reinsurance recoverables. Under the current GAAP incurred loss methodology, recognition of the full amount of credit losses is generally delayed until the loss is probable of occurring. Current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the probability threshold. Subsequently, the FASB has issued an additional ASUs on Topic 326 that do not change the core principle of the guidance in ASU 2016-13 but clarify or certain aspects of it. ASU 2016-13 and the additional ASUs on Topic 326 became effective for the Company on January 1, 2020. The Company adopted this ASU using a modified retrospective transition method by recognizing the cumulative-effect adjustment of approximately $2 million to retained earnings at January 1, 2020. The cumulative-effect adjustment primarily resulted from reestimating credit losses on the outstanding balances of the Company's reinsurance recoverables and premiums receivables at the adoption date of the new standard. The Company will make the required disclosures under Topic 326, starting with its consolidated financial statements that include the initial adoption date.
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 gains (losses) in the Company's consolidated statements of operations. See Note 3. Investments for additional information.
The Company writes covered call options through listed and over-the-counter exchanges. When the Company writes an option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company as realized gains from investments on the expiration date. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security in determining whether the Company has realized a gain or loss. The Company, as writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option. Liabilities for covered call options are included in other liabilities in the Company's consolidated balance sheets.
The fair values of the total return swaps reflect the estimated amounts that, upon termination of the contracts, would be received for selling an asset or paid to transfer a liability in an orderly transaction, based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract.
The fair value of the Company’s publicly traded $375 million unsecured notes at December 31, 2019 and 2018 was obtained from a third party pricing service.
The following table presents the estimated fair values of the Company's fixed maturity securities at December 31, 2019 by contractual maturity. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Level 1 measurements-Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure that reasonable fair values are used in pricing the investment portfolio.
U.S. government bonds/Short-term bonds: Valued using unadjusted quoted market prices for identical 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 $18.9 million and $24.8 million in commercial mortgage-backed securities at December 31, 2019 and 2018, respectively.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair values:
The Company adopted ASU 2016-02, "Leases (Topic 842)," which supersedes the guidance in Accounting Standards Codification ("ASC") 840, "Leases," on January 1, 2019, using a modified retrospective transition, with the cumulative-effect adjustment to the opening balance of retained earnings as of the effective date (the "effective date method"). Under the effective date method, financial results reported in periods prior to 2019 are unchanged. In addition, the Company elected the package of practical expedients permitted under the transition guidance within the new standard, which allowed the Company not to reassess (a) whether arrangements contain leases, (b) lease classification and (c) initial direct costs. Adoption of the new standard resulted in the recognition of operating lease right-of-use ("ROU") assets and operating lease liabilities of approximately $41 million and $43 million, respectively, at the adoption date for the Company's operating leases. The difference of approximately $2 million between the operating lease ROU assets and operating lease liabilities represents reclassification of deferred rent liability (the difference between the straight-line rent expenses and paid rent amounts under the leases) to operating lease ROU assets from other liabilities at the adoption date. The Company did not have any cumulative-effect adjustment as a result of the adoption.
Maturities of lease liabilities as of December 31, 2019 were as follows:
approximately $2 million with each lease term ranging from approximately 1 year to 3 years. These operating leases will commence in 2020.
Total rent expense recognized under the Company's various lease agreements was $14.9 million and $14.8 million for 2018 and 2017, respectively. The following table presents future minimum commitments for operating leases as of December 31, 2018:
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and risk based capital ("RBC") ratio under the unsecured credit facility at December 31, 2019.
Debt maturities for each of the next five years and thereafter as of December 31, 2019 are as follows:
On August 9, 2013, Animas Funding LLC ("AFL"), a special purpose investment vehicle, formed and consolidated by the Company, entered into a three-year total return swap agreement with Citibank, which was renewed through February 17, 2018. During June and July 2017, the underlying obligations were liquidated and the total return swap agreement between AFL and Citibank was terminated on. Under the agreement, AFL received the income equivalent on underlying obligations due to Citibank and paid to Citibank interest on the outstanding notional amount of the underlying obligations. The total return swap was secured by approximately $40 million of U.S. Treasuries as collateral, which were included in short-term investments on the consolidated balance sheets. The Company paid interest equal to LIBOR plus 135 basis points prior to the amendment of the agreement in January 2017 and LIBOR plus 128 basis points subsequent to the amendment until July 2017, on approximately $152 million of underlying obligations as of December 31, 2016.
There were no changes in the carrying amount of goodwill during 2019 and 2018. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2019 and 2018. All of the Company's goodwill is associated with the Property and Casualty business segment (See Note 20. Segment Information for additional information on the reportable business segment).
The following table presents the estimated future amortization expense related to other intangible assets as of December 31, 2019:
As a result of the Tax Cuts and Jobs Act of 2017 (the "Act"), the Company’s deferred tax assets and liabilities were measured using the new corporate tax rate of 21% at December 31, 2019, 2018 and 2017. For the years ended December 31, 2019 and 2018, the Company measured its current income taxes using the new corporate tax rate of 21%, rather than the pre-enactment corporate tax rate of 35%. Additionally in 2018, as a result of a determination made by the Office of Management and Budget, the Company reversed the previously recorded provisional 6.6% sequestration reduction to its alternative minimum tax (“AMT”) credit that originally resulted from repeal of the corporate AMT and reclassification of AMT credit carryforwards to current taxes receivable as a refundable credit.
In computing taxable income, property and casualty insurers reduce underwriting income by losses and loss adjustment expenses incurred. The amount of the deduction for losses incurred associated with unpaid losses is discounted at the interest rates and for the loss payment patterns prescribed by the U.S. Treasury. The Act changes the prescribed interest rates to rates based on corporate bond yield curves and extends the applicable time periods for the loss payment pattern. These changes are effective for tax years beginning after 2017 and are subject to a transition rule that spreads the additional tax payments from the amount determined by applying these changes versus the previous calculated amount over the subsequent eight years beginning in 2018. The Company recorded a total deferred tax liability adjustment of approximately $8.6 million at December 31, 2018 related to the changes in discounting of unpaid losses included in the Act based on the guidance published in 2018 by the Internal Revenue Service. As of December 31, 2019, the balance of the deferred tax liability related to changes in discounting of unpaid losses was $6.7 million.
The following table presents the significant components of the Company’s net deferred tax assets and liabilities:
There was a $4.6 million decrease to the total amount of unrecognized tax benefits related to tax uncertainties during 2019. The decrease was the result of tax positions taken regarding research and development federal tax credits and state tax apportionment issues based on management’s judgment and latest information available. The Company does not expect any changes in unrecognized tax benefits to have a material impact on its consolidated financial statements within the next 12 months.
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 2016 through 2018 for federal taxes and 2011 through 2018 for California state taxes. For tax years 2003 through 2010, the Company achieved a resolution with the California Franchise Tax Board (“FTB”) in December 2017 and paid a $4.6 million negotiated settlement amount in accordance with the settlement agreement provided by the FTB and signed by the Company. The settlement agreement was approved by the California attorney general in 2018. The Company believes that resolution of tax years 2003 through 2010 has the potential to establish guidance for future audit assessments proposed by the FTB for future tax years.
The following table presents the activity in loss and loss adjustment expense reserves:
The following is unaudited supplementary information about average historical claims duration as of December 31, 2019.
The Insurance Companies prepare their statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance departments of their domiciliary states. Prescribed statutory accounting practices primarily include those published as statements of statutory accounting principles by the National Association of Insurance Commissioners
(the "NAIC"), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2019, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
The following table presents a summary of the stock option activity for the year ended December 31, 2019:
The following table presents information regarding stock options outstanding at December 31, 2019:
Under the 2015 Plan and 2005 Plan, the Compensation Committee of the Company’s Board of Directors granted performance-based vesting RSU awards to the Company’s senior management and key employees prior to 2017. No RSUs were awarded in 2019, 2018, and 2017 under the 2015 Plan.
The RSU awards vested 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 achieved the threshold established by the Compensation Committee of the Company’s Board of Directors. Performance thresholds were based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. Shares were forfeited or canceled when employees were no longer employed by the Company. Expired shares represent shares that did not meet the vesting requirements.
In February 2019, based on certification by the Compensation Committee of the Company's Board of Directors of the results of the three-year performance period ended December 31, 2018, all of the outstanding RSUs granted in 2016 expired unvested because the Company did not meet the minimum three-year performance threshold.
At December 31, 2016, the Company determined that it was probable that the Company's Board of Directors would modify the payment method for the vested 2014 grant awards and pay for the vested awards in cash in lieu of shares of the Company's common stock. As a result, the 2014 grants were reclassified from equity to liability awards at December 31, 2016. $3.4 million of the amount previously recognized in additional paid-in capital for the 2014 grant awards was reclassified to other liabilities in
the consolidated balance sheets at December 31, 2016. Additional $0.2 million was reclassified from additional paid-in capital to other liabilities at the vesting date of February 28, 2017 for the 2014 grant awards, based on the additional amount of awards vested from December 31, 2016 to the vesting date.
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 2028. See Note 7. Leases for additional information on leases and future lease payments for operating leases as of December 31, 2019.
and accusation, and (b) the California DOI’s notice of noncompliance (the “NNC”), in which the California DOI asserts the unlawful rate allegations. In February 2012, the administrative law judge (“ALJ”) submitted a proposed decision dismissing the NNC, but the Commissioner rejected the ALJ’s proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, and the Commissioner responded with a demurrer. Following a hearing, the Superior Court sustained the Commissioner’s demurrer, based on the Company’s failure to exhaust its administrative remedies, and the Company appealed. The Court of Appeal affirmed the Superior Court's ruling that the Company was required to exhaust its administrative remedies, but expressly preserved for later appeal the legal basis for the ALJ’s dismissal: violation of the Company’s due process rights. 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, the proposed decision was not submitted until December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ’s proposed decision, which became the Commissioner’s adopted order (the "Order"). 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, and assessed a civil penalty in the amount of $27.6 million against the Company. 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 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.
On August 12, 2016, the Superior Court issued its ruling on the Writ, for the most part granting the relief sought by the Company. The Superior Court found that the Commissioner and the California DOI did commit due process violations, but declined to dismiss the case on those grounds. The Superior Court also agreed with the Company that the broker fees at issue were not premium, and that the penalties imposed by the Commissioner were improper, and therefore vacated the Order imposing the penalty. The Superior Court entered final judgment on November 17, 2016, issuing a writ requiring the Commissioner to refund the entire penalty amount within 120 days, plus prejudgment interest at the statutory rate of 7%. On January 12, 2017, the California DOI filed a notice of appeal of the Superior Court's judgment. While the appeal was pending, the California DOI returned the entire penalty amount plus accrued interest, a total of $30.9 million, to the Company in June 2017 in order to avoid accruing further interest. Because the matter had not been settled or otherwise finally resolved at the time, the Company did not recognize the $30.9 million as a gain in the consolidated statements of operations; instead, it recorded the $30.9 million plus interest earned in other liabilities in the consolidated balance sheets. The Company had filed a motion to dismiss the false advertising portion of the case based on the Superior Court's findings, but the ALJ denied that motion after the appeal was filed. The ALJ did, however, grant the Company's alternative request to stay further proceedings pending the final determination of the appeal. On May 7, 2019, the California Court of Appeal issued its decision reversing the Superior Court’s original judgment and directing the Superior Court to enter a new judgment in favor of the California DOI. The Company filed a petition for rehearing, which was denied, and subsequently filed a petition for review in the Supreme Court of California. Based on the decision of the California Court of Appeal, the Company accrued approximately $3 million in the second quarter of 2019, which represented an estimated amount of statutory interest the Company might be ordered to pay beyond the actual interest it had earned on the $30.9 million. The California Supreme Court denied the Company's petition for review on August 14, 2019, and the Commissioner's Order became final. On August 30, 2019, the Company paid approximately $35 million to the California DOI, which consisted of the $30.9 million received from the California DOI in June 2017 plus statutory interest.
On October 1, 2019, the Company and the California DOI entered into a settlement agreement resolving the case involving the 2004 NNC, along with the related false advertising action that had been stayed pending the outcome of that case. Pursuant to the settlement agreement, the Company paid an additional amount of approximately $6 million to the California DOI on October 2, 2019, bringing the total settlement amount to approximately $41.2 million, in full settlement of the entire case including the false advertising action; the Company has not admitted to any allegations raised in the case. As a result of the settlement, the Company recognized approximately $6 million of incremental expense in its consolidated statements of operations in the third quarter of 2019 relating to the settlement.
The Company is also involved in proceedings relating to assessments and rulings made by the FTB. See Note 11. Income Taxes.
The following table presents summarized quarterly financial data for 2019 and 2018: