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 70% of the $3.7 billion of the Company’s direct premiums written in 2020, and approximately 88% of the private passenger automobile premiums were written in California.
In 2021, the Company intends to cease accepting new business and renewing existing policies for the commercial automobile line of insurance business in Arizona, Georgia, Illinois and Nevada. The commercial automobile line of insurance business in those states has been volatile and challenged the Company’s objective of growing the business profitably. The Company plans to focus resources on the states and lines of insurance business with better opportunities for sustainable growth. The combined net premiums written in 2020 for the commercial automobile line of insurance business in those states was approximately $20 million.
This section discusses some of the relevant factors that management considers in evaluating the Company’s
performance, prospects, and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of management’s discussion and analysis, the Company’s consolidated financial statements and notes thereto, and all other items contained within this Annual Report on Form 10-K.
The Company’s net income for the year ended December 31, 2020 was $374.6 million, or $6.77 per diluted share, compared to $320.1 million, or $5.78 per diluted share, for the same period in 2019. Included in net income was $134.9 million of pre-tax net investment income that was generated during 2020 on a portfolio of $4.7 billion, at fair value, at December 31, 2020, compared to $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, 2019. Also included in net income were pre-tax net realized investment gains of $85.7 million and $222.8 million in 2020 and 2019, respectively, and pre-tax catastrophe losses, net of reinsurance benefits and related reinstatement premiums earned, of approximately $60.9 million and $65.3 million in 2020 and 2019, respectively.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $606 million and $520 million in 2020 and 2019, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
•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.
•Inflation-The largest cost component for automobile insurers is losses, which include medical, replacement automobile parts, and labor costs. There can be significant variation in the overall increases in medical cost inflation, and it is often years after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
•Loss Frequency-Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. Loss frequency trends are affected by many factors such as fuel prices, the economy, the prevalence of distracted driving, collision avoidance and other technology in vehicles, and stay-at-home orders issued by state and local governments due to the pandemic.
•Underwriting Cycle and Competition-The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company believes that the automobile insurance industry in 2020
In 2020, the Company continued its insurance platform modernization initiative to migrate its lines of insurance business to Guidewire’s InsuranceSuite, 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 many of the states and lines of insurance business in which the Company operates for its underwriting processing. The Company expects to complete the migration for the remaining states and lines of insurance business, including the policy and billing centers of the California private passenger automobile line of insurance business, over the next few years. In addition, the Company implemented a new product offering for Commercial Multi-Peril insurance, and improved paperless eDelivery as well as customer portal and billing self-service capabilities in 2020.
In 2021, the Company intends to continue to invest in modernization of its technology platforms, and deploy advanced technologies for enhanced digital customer experience, cross selling and customer relationship management, which will improve its customer acquisition process based on direct-to-consumer and agent distribution models.
Many businesses have been required by state and local governments to cease or substantially reduce operations, and have
suffered severe financial losses as a result. Many of these businesses have submitted claims to their insurers under the business interruption coverage of their commercial property policies, resulting in coverage disputes in many states. While the Company does insure a modest number of businesses with this business interruption coverage, these pandemic-related losses are not covered under the Company's policy terms and conditions. The Company’s business interruption, or “business income” coverage, requires a “direct physical loss” to the property that results in suspension of operations, such as a fire or water loss. The coverage is not triggered under the present circumstances. Most of the Company’s policies also contain an exclusion for losses caused directly or indirectly by “virus or bacteria.” This exclusion was adopted by many insurers after the SARS outbreak of 2003-2004, upon recognition that such a pandemic could result in losses far exceeding the capacity of individual insurers and the private insurance market as a whole. The Company does not believe it has any material exposure to business interruption claims.
Due to disruptions in the equity and fixed maturity securities markets following the outbreak of the COVID-19 pandemic, the Company's investment portfolio substantially declined in value during the quarter ended March 31, 2020. Such decline in the fair value of the Company's investment portfolio has recovered during the subsequent quarters of 2020. In March 2020, the Federal Open Market Committee (“FOMC”) unveiled a set of aggressive measures to cushion the economic impact of the global COVID-19 crisis, including, among others, cutting the federal funds rate by 100 basis points to a range of 0.00% to 0.25% and establishing a series of emergency credit facilities in an effort to support the flow of credit in the economy, easing liquidity pressure and calming market turmoil. While volatility in the financial markets remains elevated, overall market liquidity concerns have eased following the actions taken by the FOMC. The Company believes that it will continue to have sufficient liquidity to support its business operations during the COVID-19 crisis and beyond without the forced sale of investments, based on its existing cash and short-term investments, future cash flows from operations, and $50 million of undrawn credit in its revolving credit facility.
The process for implementing rate changes varies by state. For more detailed information related to insurance rate approval, see "Item 1. Business-Regulation."
On April 13, 2020, the California Insurance Commissioner issued Bulletin 2020-3 ordering insurers to make an initial premium adjustment within 120 days from the date of the Bulletin 2020-3 to adversely impacted California policyholders for the months of March and April 2020. The Commissioner granted insurers flexibility in determining how to quickly and fairly process the premium refunds. On May 15, 2020, the California Insurance Commissioner issued Bulletin 2020-4 extending the directives in Bulletin 2020-3 through May 31, 2020. The Bulletin 2020-8, originally issued on June 25, 2020 and amended on December 3, 2020, extended the previous directives of Bulletin 2020-3 and Bulletin 2020-4 through June 30, 2020, as well as any months subsequent to June 2020 because the COVID-19 pandemic continued to result in projected loss exposures remaining overstated or misclassified. The total amount of premiums returned to the Company's policyholders through refunds
The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 12%, 8%, and 6% for 2020, 2019, and 2018 accident years, respectively; however, the variation could be more or less than these amounts.
During the years 2016 through 2020, 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:
(1) Implied inflation rate is calculated by dividing the difference between the current and prior year actual recorded severity by the prior year actual recorded severity. The Company believes that severity increases are caused by litigation, medical costs, inflation, and increased utilization of medical procedures.
The Company recorded catastrophe losses net of reinsurance of approximately $64 million in 2020. Catastrophe losses due to the catastrophe events that occurred during 2020 totaled approximately $69 million, with no reinsurance benefits used for these losses. The majority of the 2020 catastrophe losses resulted from wildfires and windstorms in California and extreme weather events outside of California. These losses were partially offset by favorable development of approximately $5 million on prior years' catastrophe losses.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, accounts payable, options sold, and notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried on the consolidated balance sheets at fair value, as described in Note 2. Financial Instruments, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
The Company may hold or acquire financial instruments that lack observable market prices or pricing parameters because they are less actively traded currently or in future periods. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted financial instruments may be reduced during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise are not actively quoted. For a further discussion, see Note 4. Fair Value Measurements, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
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. Tax-exempt investment income of approximately $78 million coupled with pre-tax income of approximately $459 million resulted in an effective tax rate of 18.3%, below the statutory tax rate of 21%, in 2020, and tax-exempt investment income of approximately $82 million coupled with pre-tax income of approximately $378 million resulted in an effective tax rate of 15.3% in 2019.
Net premiums earned and net premiums written in 2020 decreased 1.2% and 3.2%, respectively, from 2019. The Company's net premiums earned and written in 2020 were each reduced by approximately $128 million due to premium refunds and credits to its eligible policyholders associated with the "Mercury Giveback" program for reduced driving and business activities following the outbreak of the COVID-19 pandemic. The decrease in net premiums earned and net premiums written was primarily due to these premium refunds and credits and to a decline in the number of private passenger automobile policies written in California, partially offset by higher average premiums per policy arising from rate increases in the California homeowners line of insurance business and growth in the number of homeowners policies written in California.
Net premiums earned included ceded premiums earned of $56.2 million and $56.7 million in 2020 and 2019, respectively. Net premiums written included ceded premiums written of $50.6 million and $43.8 million in 2020 and 2019, respectively. The increase in ceded premiums written resulted mostly from higher reinsurance coverage, higher rates, and growth in the covered book of business.
Income tax expense was $83.9 million and $58.0 million for the years ended December 31, 2020 and 2019, respectively. The $25.9 million increase in income tax expense was mainly due to a significant increase in pre-tax income of $80.4 million.
(1)Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each period.
(2)Net investment income before and after income taxes decreased primarily due to a lower average yield on investments, partially offset by higher average invested assets. Average annual yield on investments before and after income taxes decreased primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher with lower yielding investments, as a result of decreasing market interest rates.
(3)The increases in fair value of equity securities in 2020 and 2019 were primarily due to the overall improvement in equity markets.
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Form 10-K for the year ended December 31, 2019 for a discussion of changes in its results of operations from the year ended December 31, 2018 to the year ended December 31, 2019.
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 $222 million in 2021 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of $121 million during 2020. As of December 31, 2020, Mercury General had approximately $140 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The following table presents the estimated fair value of fixed maturity securities at December 31, 2020 by contractual maturity in the next five years.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2020:
(1)Fixed maturities and short-term bonds at amortized cost and equities and other short-term investments at cost.
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, 2020, consistent with the average rating at December 31, 2019. The Company’s municipal bond holdings, of which 93.4% were tax exempt, represented 78.6% of its fixed maturity portfolio at December 31, 2020, at fair value, and were broadly diversified geographically.
Taxable holdings consist principally of investment grade issues. At December 31, 2020, fixed maturity holdings rated below investment grade and non-rated bonds totaled $25.5 million and $38.4 million, respectively, at fair value, and represented 0.7% and 1.1%, 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, 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 Company had $13.8 million and $22.6 million, or 0.4% and 0.7% of its fixed maturity portfolio, at fair value, in U.S. government bonds at December 31, 2020 and 2019, respectively. At December 31, 2020, 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
The Company had $2.79 billion and $2.55 billion, or 78.6% and 82.6% of its fixed maturity securities portfolio, at fair value, in municipal securities at December 31, 2020 and 2019, respectively, of which $377.0 million and $344.7 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, 2020 and 2019.
At December 31, 2020 and 2019, respectively, the mortgage-backed securities portfolio of $93.3 million and $63.0 million, or 2.6% and 2.0% of the Company's fixed maturity securities portfolio, at fair value, was categorized as loans to "prime" borrowers, except for $2.0 million and $2.4 million, at fair value, of Alt-A mortgages. Alt-A mortgage backed securities are at fixed or variable rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with credit profiles stronger than those of sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. The Company had holdings of $17.6 million and $18.9 million, at fair value, in commercial mortgage-backed securities at December 31, 2020 and 2019, respectively.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities was BBB- at December 31, 2020 and 2019. The weighted-average rating of the entire mortgage backed securities portfolio was AA at December 31, 2020 and 2019. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 6.4 years and 3.1 years at December 31, 2020 and 2019, respectively.
The Company had other asset-backed securities of $153.3 million and $18.6 million, which represented 4.3% and 0.6% of its fixed maturity securities portfolio, at fair value, at December 31, 2020 and 2019, respectively. The weighted-average rating was AA+ and A at December 31, 2020 and 2019, respectively. The modified duration reflecting anticipated early calls was 1.6 years and 1.8 years at December 31, 2020 and 2019, respectively.
Equity holdings of $803.9 million and $724.8 million, at fair value, as of December 31, 2020 and 2019, 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 due to changes in fair value of the Company’s equity portfolio were $32.2 million and $90.9 million in 2020 and 2019, respectively. The primary cause for the increase in fair value of the Company's equity securities in 2020 and 2019 was the overall improvement in equity markets.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2020, 17.0% of the total investment portfolio, at fair value, was held in equity securities, compared to 16.8% at December 31, 2019.
(1) On March 8, 2017, the Company completed a public debt offering issuing $375 million of senior notes. The notes are unsecured senior obligations of the Company, with a 4.4% annual coupon payable on March 15 and September 15 of each year commencing September 15, 2017. These notes mature on March 15, 2027. The Company used the proceeds
(2) On March 29, 2017, the Company entered into an unsecured credit agreement that provides for revolving loans of up to $50 million and matures on March 29, 2022. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is greater than or equal to 25%. Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to total capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to total capital ratio was 15.6% at December 31, 2020, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of February 16, 2021, there have been no borrowings under this facility.
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 $1.77 billion at December 31, 2020 and net premiums written in 2020 of $3.6 billion, the ratio of premiums written to surplus was 2.04 to 1.
During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company. On October 30, 2020, the Company received notice from the DOI that the market conduct examination report mentioned above was being reviewed for potential further action in connection with some of the findings in the report. Subsequently, the DOI gave the Company notice of its intent to proceed with an enforcement action for the alleged violations in the report. The Company will have the opportunity to resolve the alleged violations before a Notice of Noncompliance is formally filed with the DOI.
As of December 31, 2020, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
(1)The Company’s debt contains various terms, conditions and covenants which, if violated by the Company, would result in a default and could result in the acceleration of the Company’s payment obligations. Amounts differ from the balances presented on the consolidated balance sheets as of December 31, 2020 because the debt amounts above include interest, calculated at the stated 4.4% coupon rate, and exclude the discount and issuance costs of the debt.
(2)The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, office equipment, and electronic data processing equipment that expire at various dates through the year 2028.
As discussed in Notes 1 and 12 to the consolidated financial statements, the Company estimates loss and loss adjustment expense reserves (loss reserves) to cover incurred losses and loss adjustment expenses. Specifically, loss reserves are established based on the Company’s assessment of claims pending and the development of prior years’ loss liabilities. As of December 31, 2020, the loss and loss adjustment expense reserves balance was $1.99 billion, which included catastrophe losses of $64 million.
The following are the primary procedures we performed to address this critical audit matter. We evaluated the design and tested the operating effectiveness of certain internal controls related to the Company’s reserving process. This
included controls related to 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 Company’s estimates for certain lines of business by performing independent analyses of loss reserves using the Company’s underlying historical claims data
• evaluating the Company’s estimates for the remaining lines of business in comparison to internal experience and related industry trends
We have audited Mercury General Corporation and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2020, 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, 2020, 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, 2020 and 2019, the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes and financial statement schedules I, II, and IV (collectively, the consolidated financial statements), and our report dated February 16, 2021 expressed an unqualified opinion on those consolidated financial statements.
Mercury General Corporation ("Mercury General") and its subsidiaries (referred to herein collectively as the "Company") are primarily engaged in writing personal automobile insurance through 14 Insurance Companies in 11 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. The private passenger automobile line of insurance business was more than 70% of the Company’s direct premiums written in 2020, 2019, and 2018, and approximately 88%, 88%, and 87% of the private passenger automobile premiums were written in California in 2020, 2019, and 2018, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
The Company did not have other comprehensive income (loss) in 2020, 2019 and 2018.
Fixed maturity securities include debt securities, 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. Premiums and discounts on fixed maturities are amortized using first call date and are adjusted for anticipated prepayments. Premiums and discounts on mortgage-backed securities are adjusted for anticipated prepayment using the retrospective method, with the exception of some beneficial interests in securitized financial assets, which are accounted for using the prospective method.
Short-term investments include money market accounts, options, and short-term bonds that are highly rated short duration securities and redeemable within one year.
From time to time, 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, 2020 and 2019. 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 $15 million and $16 million at December 31, 2020 and 2019, respectively.
The Company periodically assesses long-lived assets or asset groups including building and equipment, for recoverability when events or changes in circumstances indicate that their carrying amounts may not be recoverable. If the Company identifies an indicator of impairment, the Company assesses recoverability by comparing the carrying amount of the asset to the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset. An impairment loss is recognized when the carrying amount is not recoverable and is measured as the excess of carrying value over fair value. There were no impairment charges during 2020, 2019, and 2018.
Premium revenue is recognized on a pro-rata basis over the terms of the policies in proportion to the amount of insurance protection provided. Premium revenue includes installment and other fees for services which are recognized in the periods in which the services are rendered. Unearned premiums represent the portion of the written premium related to the unexpired
policy term. Unearned premiums are predominantly computed monthly on a pro-rata basis and are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs, partially offset by investment income, to related unearned premiums. To the extent that any of the Company’s lines of insurance business become unprofitable, a premium deficiency reserve may be required. Net premiums written, a statutory measure designed to determine production levels, were $3.61 billion, $3.73 billion, and $3.50 billion in 2020, 2019, and 2018, respectively. The Company's net premiums written in 2020 were reduced by approximately $128 million due to premium refunds and credits to its eligible policyholders associated with the "Mercury Giveback" program for reduced driving and business activities following the outbreak of the COVID-19 pandemic.
be paid. The GLM utilizes operational time, determined as a percentile of claims closed rather than a finite calendar period, which neutralizes the effect of changes in the timing of claims handling.
The Company accounts for all derivative instruments, other than those that meet the normal purchases and sales exception, as either an asset or liability, measured at fair value, which is based on information obtained from independent parties. In addition, changes in fair value are recognized in earnings unless specific hedge accounting criteria are met. See Note 9. Derivative Financial Instruments.
Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the periods presented. Diluted earnings per share is based on the weighted average shares of common stock and potential dilutive securities outstanding during the periods presented. At December 31, 2020 and 2019, potential dilutive securities consisted of outstanding stock options. See Note 17. Earnings Per Share, for the required disclosures relating to the calculation of basic and diluted earnings per share.
At December 31, 2020, 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 effect of reinsurance on property and casualty premiums written and earned was as follows:
The Company recognized ceded premiums earned of approximately $56 million, $57 million, and $49 million in 2020, 2019, and 2018, respectively, which are included in net premiums earned in its consolidated statements of operations, and ceded losses and loss adjustment expenses of approximately $(28) million, $(71) million, and $257 million in 2020, 2019, and 2018, 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 2020 were mainly due to the reimbursements from Pacific Gas and Electric Corporation ("PG&E") Subrogation Trust Fund to the Company for certain claims paid to its policyholders related to wildfires in recent past years, in accordance with PG&E's Plan of Reorganization approved by the United States Bankruptcy Court. These loss recoveries from PG&E were ceded to the Company's reinsurers as the original losses had previously been ceded to its reinsurers under the Treaty. 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 had previously been ceded to reinsurers under the Treaty, in conjunction with the sale of the Company's subrogation rights during the first quarter of 2019. The re-estimation primarily benefited the Company's reinsurers. See Note 12. Loss and Loss Adjustment Expense Reserves for additional information.
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 $18.0 million, $16.3 million and $16.0 million, with related expenses of approximately $11.8 million, $10.5 million and $10.5 million, for the years ended December 31, 2020, 2019 and 2018, respectively. 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).
AIS and PoliSeek are primarily engaged in the marketing and sales of insurance policies in private passenger automobile, commercial automobile and homeowners lines of business. Their revenues primarily consist of commission income received from property and casualty insurers. The primary performance obligation of AIS and Poliseek in return for the commission income from the insurers is to complete the sale of the policy and deliver the control of the policy to the insurer prior to the policy effective date. The total revenue from the sale of a policy is recognized when the sale is complete and the policy is effective as all the material aspects of the performance obligation are satisfied and the insurer is deemed to obtain control of the insurance policy at that time. The commission income is constrained such that the revenue is recognized only to the extent that the commission income received is not likely to be returned to the insurers due to policy cancellations. Any commission income not received when the sale is complete is recognized as commission income receivable, which is included in other receivables in the Company's consolidated balance sheets. Commission income receivable at December 31, 2020 and 2019 was approximately $1.2 million.
On January 1, 2020, the Company adopted Accounting Standards Update ("ASU") 2018-15, "Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract," on a prospective basis, which provides guidance that requires capitalizing and amortizing certain of the implementation costs. The majority of the Company's cloud computing arrangements relate to service contracts with third parties that host the Company's data and computing infrastructure that are used in providing services to and supporting transactions with its existing or potential policyholders and insurance agents.
The majority of the Company's premiums receivable are short-term in nature and are due within a year, consistent with the policy term of its insurance policies sold. Generally, premiums are collected prior to providing risk coverage, minimizing the Company's exposure to credit risk. The Company monitors the credit risk associated with premiums receivable, taking into consideration the fact that credit risk is reduced by the Company's right to offset loss payments and unearned premiums against premiums receivable. The Company has established an allowance for uncollectible premiums receivable related to credit risk, and the estimated allowance is reviewed quarterly and adjusted as appropriate based on evaluations of balances due from insureds, management’s experience, historical data, current economic conditions, and reasonable and supportable forecasts of future economic conditions that affect the collectibility of the reported amounts. In estimating an allowance for uncollectible premiums receivable, the Company assesses customer balances and write-offs by state, line of business, and the year the premiums were written, leveraging its current process for analyzing uncollectibility of premiums receivable. This allowance is based on historical write-off percentages adjusted for the effects of current trends and reasonable and supportable forecasts, as well as expected recoveries of amounts written off.
Evaluating the current trends or economic conditions that impact the Company's ability to collect premiums receivable and projecting those into the remaining life of premiums receivable in order to develop a reasonable and supportable forecast of the ultimate collectibility involve significant judgment and assumptions about future economic conditions. The Company believes that the sustained high unemployment rate resulting from the outbreak of a novel strain of coronavirus (“COVID-19”) will lead to significant uncollectible amounts over the life of the premiums receivable balances outstanding at December 31, 2020. In addition, the Company has offered payment grace periods upon request from customers, which adds an element of uncertainty to the collectibility. Actual uncollectible amounts could be considerably more or less than the estimate. The Company monitors the overall credit risk of premiums receivable by regularly reviewing macroeconomic indicators such as unemployment and interest rates, regulatory developments such as restrictions on cancellation of policies for nonpayment of premiums, and insurance policy specific indicators such as trends in policy cancellations.
Reinsurance recoverables are balances due to the Company from its reinsurers for paid and unpaid losses and loss adjustment expenses. A credit exposure exists with respect to these balances to the extent that any reinsurer is unable to meet its obligations. The Company has established an allowance for uncollectible reinsurance recoverables related to credit risk, and changes in the allowance are presented as a component of losses and loss adjustment expenses in the Company's consolidated statements of operations. The Company reviews the allowance quarterly and adjusts it as necessary to reflect changes in estimates of uncollectible balances. The Company evaluates the financial condition of its reinsurers and monitors concentration risk to minimize its exposure to significant losses from individual reinsurers. The Company attempts to mitigate its credit risk related to reinsurance by entering into reinsurance arrangements with reinsurers that have high credit ratings and by obtaining collateral as necessary. The primary method of obtaining collateral is through letters of credit.
At December 31, 2020, fixed maturity holdings rated below investment grade and non-rated comprised 1.3% of total investments at fair value. Additionally, the Company owns securities that are credit enhanced by financial guarantors that are subject to uncertainty related to market perception of the guarantors’ ability to perform. Determining the estimated fair value of municipal bonds could become more difficult should markets for these securities become illiquid.
The following table presents the estimated fair values of the Company's fixed maturity securities at December 31, 2020 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 3 Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.
The Company’s fair value measurements are based on the market approach, which utilizes market transaction data for the same or similar instruments.
Money market instruments: Valued based on unadjusted quoted prices for identical assets in active markets.
Fair value measurement using NAV practical expedient - The fair values of private equity funds measured at net asset value are determined using NAV as advised by the external fund managers and the third party administrators. The NAV of the Company's limited partnership or limited liability company interest in such a fund is based on the manager's and the administrator's valuation of the underlying holdings in accordance with the fund's governing documents and GAAP. In accordance with applicable accounting guidance, private equity funds measured at fair value using the NAV practical expedient are not classified in the fair value hierarchy. The strategy of two of the three such funds with a fair value of approximately $78.2 million at December 31, 2020 is to provide current income to investors by investing mainly in secured loans, CLOs or CLO issuers, and equity interests in vehicles established to purchase and warehouse loans; the strategy of the other such fund with a fair value of approximately $1.2 million at December 31, 2020 is to achieve favorable long-term financial returns and measurable positive social and environmental returns by investing in privately held technology, healthcare, specialty consumer goods and service companies. The Company has made all of its capital contributions in such funds and had no outstanding
unfunded commitments at December 31, 2020 with respect to the funds. The underlying assets of the funds are expected to be liquidated over the period of approximately one year to nine years from December 31, 2020. In addition, the Company does not have the ability to redeem or withdraw from the funds, or to sell, assign, pledge or transfer its investment, without the consent from the General Partner or Managers of each fund, but will receive distributions based on the liquidation of the underlying assets and the interest proceeds from the underlying assets.
The fair value of the Company’s publicly traded $375 million unsecured notes at December 31, 2020 and 2019 was based on the spreads above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. See Note 8. Notes Payable for additional information on unsecured notes.
In August 2017, the Company completed the sale of approximately six acres of land located in Brea, California (the "Property"), for a total sale price of approximately $12.2 million. Approximately $5.7 million of the total sale price was received in the form of a promissory note (the "Note") and the remainder in cash. The Note is secured by a first trust deed and an assignment of rents on the Property, and bears interest at an annual rate of 3.5%, payable in monthly installments. The Note was originally set to mature on August 31, 2020. Effective August 1, 2020, the maturity date was extended to August 31, 2021,
with no change in the annual interest rate. The fair value of the Note is included in other assets in the Company's consolidated balance sheets, and interest earned on the Note is recognized in other revenues in the Company's consolidated statements of operations.
The Company adopted ASU 2016-02, "Leases (Topic 842)," on January 1, 2019, using a modified retrospective transition method. Under this transition method, its financial results reported in periods prior to 2019 were unchanged.
The Company determines if an arrangement is a lease at inception. Right-of-use ("ROU") assets represent the Company's right to use an underlying asset for the lease term and lease liabilities represent its obligation to make lease payments arising from the lease. Lease assets and liabilities are recognized at the lease commencement date based on the estimated present value of lease payments over the lease term.
The Company uses its estimated incremental borrowing rate for leases for office space, office equipment and EDP equipment, which is derived from information available at the lease commencement date, in determining the present value of lease payments, as the rate implicit in the lease is not readily available for such leases. The Company gives consideration to its recent debt issuances as well as publicly available data for instruments with similar characteristics when calculating its incremental borrowing rates. For automobile leases, the Company uses the rate implicit in the lease at the lease commencement date in determining the present value of lease payments, as the readily-determinable implicit rate is provided in such leases.
The Company's lease terms include options to extend or terminate the lease when it is reasonably certain that it will exercise that option. The Company does not use the short-term lease exemption practical expedient and records all leases on the balance sheets, including leases with a term of twelve months or less. The Company accounts for the lease and non-lease components as a single lease component for leases for office space, automobiles, and office equipment, while it accounts for the lease components separately from the non-lease components for EDP equipment leases.
Total rent expense recognized under the Company's various operating lease agreements was $14.9 million for the year ended December 31, 2018.
The components of lease assets and liabilities along with their classification on the Company's consolidated balance sheets were as follows:
underwriters' fees. The 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%.
(2)On March 29, 2017, the Company entered into an unsecured credit agreement that provides for revolving loans of up to $50 million and matures on March 29, 2022. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is greater than or equal to 25%. Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to total capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to total capital ratio was 15.6% at December 31, 2020, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of February 16, 2021, there have been no borrowings under this facility.
On February 13, 2014, Fannette Funding LLC ("FFL"), a special purpose investment vehicle, formed by and consolidated into the Company, entered into a total return swap agreement with Citibank. The agreement had an initial term of one year, subject to periodic renewal. In July 2018, the agreement was renewed through January 24, 2020. During the fourth quarter of 2019, the underlying obligations were liquidated and the total return swap agreement between FFL and Citibank was terminated. Under the agreement, FFL 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 Company paid interest equal to LIBOR plus 128 basis points prior to the renewal of the agreement in January 2018, LIBOR plus 120 basis points subsequent to the January 2018 renewal through July 2018, and LIBOR plus105 basis points subsequent to the July 2018 renewal until December 2019, on approximately $100 million of underlying obligations as of December 31, 2018.
There were no changes in the carrying amount of goodwill during 2020 and 2019. No accumulated goodwill impairment losses existed at December 31, 2020 and 2019. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2020 and 2019. The Company considered the potential impact of the COVID-19 pandemic on the market factors affecting the fair values of the reporting units in its annual impairment review in 2020 and determined such factors did not indicate a goodwill impairment for any of the reporting units with goodwill. 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, 2020:
The Company recognizes tax benefits related to positions taken, or expected to be taken, on its tax returns, only if the positions are "more-likely-than-not" sustainable. Once this threshold has been met, the Company’s measurement of its expected tax benefits is recognized in its financial statements.
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 2017 through 2019 for federal taxes, and 2011 through 2013 and 2017 through 2019 for California state taxes. For tax years 2014 through 2016, the Company received Notices of Proposed Assessments (“NPAs”) related to the Company’s California apportionment factor and paid the total assessment with interest to the FTB in the third quarter of 2020. For tax years 2011 through 2013, the Company received NPAs and submitted a formal protest to the FTB in 2018. For tax years 2017 through 2019, the FTB initiated its examination in the fourth quarter of 2020.
If unrecognized tax benefits were recognized, $6.2 million and $7.2 million, including accrued interest, penalties and federal tax benefit related to unrecognized tax benefits, would impact the Company’s effective tax rate at December 31, 2020 and 2019, respectively.
The increase in the provision for insured events of prior years in 2020 of approximately $23.0 million primarily resulted from higher than estimated losses and loss adjustment expenses in the homeowners and commercial automobile lines of insurance business, partially offset by favorable development in the private passenger automobile line of insurance business.
The Company recorded catastrophe losses net of reinsurance of approximately $64 million, $53 million, and $67 million in 2020, 2019, and 2018, respectively. Catastrophe losses due to the catastrophe events that occurred in 2020 totaled approximately $69 million, with no reinsurance benefits used for these losses, resulting primarily from wildfires and windstorms in California and extreme weather events outside of California. These losses were partially offset by favorable development of approximately $5 million on prior years' catastrophe losses. Catastrophe losses before reinsurance benefits totaled approximately $57 million in 2019, resulting primarily from wildfires and winter storms in California, a hurricane in Texas, and tornadoes and wind and hail storms in the Midwest. These losses were partially offset by favorable development of approximately $4 million on prior years' catastrophe losses. Catastrophe losses before reinsurance benefits totaled approximately $289 million in 2018, resulting primarily from wildfires in Northern and Southern California and weather-related catastrophes across several states.
During the first quarter of 2019, the Company completed the sale of its subrogation rights related to the 2018 Camp and Woolsey Fires and the 2017 Thomas Fire (which was a component of the "2017 Southern California fires") to a third party. The Company’s reinsurers were the primary beneficiaries of this transaction, as they had absorbed most of the losses under the terms of the Treaty. The Company re-estimated its gross and net losses from the 2018 Camp and Woolsey Fires and the 2017 Southern California fires in conjunction with this sale, and its total gross losses from these catastrophes, after accounting for the assignment of subrogation rights and adjustments made to claims reserves as part of normal reserving procedures, were approximately $208 million, and its total net losses, after reinsurance benefits, were approximately $40 million at March 31, 2019. The Company benefited by approximately $10 million, before taxes, in the first quarter of 2019 from the sale of the subrogation rights, including adjustments made to the associated claims as a result of normal reserving procedures, reductions in the Company's retained portion of losses on the Camp and Woolsey Fires, and reduced reinstatement premiums recognized.
The following is information about incurred and paid claims development as of December 31, 2020, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities plus expected development on reported claims included within the net incurred claims amounts for our two major product lines: automobile and homeowners lines of business. As the information presented is for these two major product lines only, the total incurred and paid claims development shown below does not correspond to the aggregate development presented in the table above, which is for all product lines and includes unallocated claims adjustment expenses. The cumulative number of reported claims represents open claims, claims closed with payment, and claims closed without payment. It does not include an estimated amount for unreported claims. The number of claims is measured by claim event (such as a car accident or storm damage) and an individual claim event may result in more than one reported claim. The Company considers a claim that does not result in a liability as a claim closed without payment.
The following table presents the statutory net income, and statutory capital and surplus of the Insurance Companies, as reported to regulatory authorities:
(1)Statutory net income reflects differences from GAAP net income, including changes in the fair value of the investment portfolio as a result of the application of the fair value option.
The following table presents information regarding stock options outstanding at December 31, 2020:
As of December 31, 2020, the Company had $0.2 million of unrecognized compensation expense related to stock options awarded under the 2015 Plan, which will be recognized ratably over the remaining vesting period of approximately 1.1 years.
The fair value of each RSU grant was determined based on the closing price of the Company's common stock on the grant date for awards classified as equity and on each reporting date for awards classified as a liability. Compensation cost was recognized based on management’s best estimate of the performance goals that would be achieved at the end of the performance period, taking into account expected forfeitures. If the minimum performance goals were not met, no compensation cost was recognized and any recognized compensation cost was reversed.
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 directly with the CEA. The Company receives a small fee for placing business with the CEA, which is recorded as other income in the consolidated statements of operations. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 28, 2020, the most recent date at which information was available, was approximately $78.0 million. There was no assessment made in 2020.
In November and December 2020, the California Insurance Commissioner issued a mandatory moratorium on
cancellations and non-renewals of policies of residential property insurance after the declaration of a state of emergency through Bulletins 2020-11, 2020-12 and 2020-13. These Bulletins list declarations of a state of emergency issued by the California Governor in August, September and November 2020, along with the ZIP Codes within and adjacent to the fire perimeters in counties subject to each state of emergency. The mandatory moratorium prohibits insurers from canceling or refusing to renew a policy of residential property insurance for a property located in any ZIP Code listed in these Bulletins for one year after the declaration of a state of emergency and in effect at the time of the declared emergency, based solely on the fact that the insured structure is located in an area in which a fire has occurred. The Company will comply with these Bulletins and does not believe that these Bulletins will have a material adverse impact on its financial condition or cash flows.
The Company is also involved in proceedings relating to assessments made by the FTB. See Note 11. Income Taxes.
Net income for 2019 was primarily attributable to net premiums earned, net realized investment gains, and net investment income, partially offset by operating expenses and losses and loss adjustment expenses, including catastrophe losses and unfavorable development on prior accident years' loss and loss adjustment expense reserves. Main factors contributing to net income for the fourth quarter of 2019 were the increases in the fair values of the Company’s fixed maturity and equity securities due to decreases in market interest rates and the overall improvement in equity markets.
The Other business segment represents net premiums written and earned from an operating segment that does not meet the quantitative thresholds required to be considered a reportable segment. This operating segment offers automobile mechanical protection warranties which are primarily sold through automobile dealerships and credit unions.