The Company’s net income for the year ended December 31, 2014 increased to $177.9 million, or $3.23 per diluted share, from $112.1 million, or $2.04 per diluted share, for the same period in 2013. Included in net income is $125.7 million of pre-tax investment income that was generated during 2014 on a portfolio of $3.4 billion at fair value at December 31, 2014, compared to $124.5 million pre-tax investment income during 2013 on a portfolio of $3.2 billion at fair value at December 31, 2013. Included in net income are net realized investment gains of $81.2 million and losses of $11.4 million in 2014 and 2013, respectively.
During 2014, the Company continued its marketing efforts to enhance name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation, make the Company very competitive in California and in other states.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $247 million and $210 million in 2014 and 2013, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
Economic Conditions-Many businesses are still experiencing the effects of uncertain conditions in the global economy and capital markets, reduced consumer spending and confidence, and continued volatility, which could adversely impact the Company’s financial condition, results of operations, and liquidity. Further, the volatility and disruptions in global capital markets could adversely affect the Company’s investment portfolio. Although the disruption in the global financial markets has moderated, not all global financial markets are functioning normally. The Company is unable to predict the impact of current and future global economic conditions on the United States, and California, where the majority of the Company’s business is produced.
Inflation-The largest cost component for automobile insurers is losses, which include medical costs, replacement automobile parts, and labor costs. There can be significant variation in the overall increases in medical cost inflation,
and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
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 markets. The Company believes that the market is mixed with carriers both raising and decreasing rates depending on individual state profitability and the carriers’ growth appetite.
In 2014, the Company continued to invest in its web-based agency systems by adding new capabilities and enhanced features such as improved motor vehicle and accident matching and reconciliation. Many agents use comparative raters to evaluate products and prices from several insurance carriers, and the Company has completed integrations with the most popular raters for the private passenger automobile and homeowner lines of business.
Guidewire, a commercially available software solution, was launched in 2010 to replace legacy platforms. As of December 31, 2014, Guidewire for both homeowners and commercial automobile has been deployed in ten states including California. For private passenger automobile, Guidewire has been deployed in eight states, with four additional states scheduled for launch in 2015. California private passenger automobile is expected be implemented in phases over the next two years beginning with claims processing in 2015.
The process for implementing rate changes varies by state. For more detailed information related to insurance rates approval, see “Item 1. Business-Regulation.”
In January, a 6.0% rate increase on its preferred private passenger automobile line of business, which represents approximately 51% of the total Company net premiums earned.
In October, a 6.9% rate increase on its standard private passenger automobile line of business, which represents approximately 15% of the total Company net premiums earned.
The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with loss reserves estimates. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them
The Company also engages independent actuarial consultants to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultants for GAAP reporting or periodic disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count development, and average severity methods described below. The Company also uses the paid loss development method as part of its reserve analysis. When deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $3,000 to $3,500, on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $9,000 to $10,500. The Company creates incurred and paid loss triangles to estimate ultimate losses utilizing historical payment and reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity. As a larger proportion of claims from an accident year are settled, there becomes a higher degree of certainty for the reserves established for that accident year. Consequently, there is a decreasing likelihood of reserve development on any particular accident year, as those periods age. At December 31, 2014, the Company believes that the accident years that are most likely to develop are the 2012 through 2014 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%, 5%, and 3% for 2014, 2013, and 2012, respectively. For example, at December 31, 2014, the loss severity for the amounts recorded at December 31, 2013 changed by (3.1)%, (1.3)%, and 0.4% for the 2013, 2012, and 2011 accident years, respectively. Comparatively, at December 31, 2013, the loss severity for the amounts recorded at December 31, 2012 changed by (2.2)%, 2.1%, and 1.4% for the 2012, 2011, and 2010 accident years, respectively. The following table presents the effects on the 2014, 2013, and 2012 accident year California BI loss reserves based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.
Implied inflation rate is calculated by dividing the difference between current and prior year actual recorded severity by the prior year actual recorded severity.
At December 31, 2014 and 2013, the Company recorded its point estimate of approximately $1.1 billion and $1.0 billion, respectively, in losses and loss adjustment expense liabilities, which include approximately $440.8 million and $409.2 million, respectively, of IBNR. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2014 and 2013 and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company may hold or acquire financial instruments that lack observable market prices or market parameters because they are less actively traded currently or in future periods. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, 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 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 3 of Notes to Consolidated Financial Statements.
At December 31, 2014, the Company’s deferred income taxes were in a net liability position mainly due to deferred tax liabilities generated by deferred acquisition costs and unrealized gains on securities held. These deferred tax liabilities were substantially offset by deferred tax assets resulting from unearned premiums, expense accruals, loss reserve discounting, and alternative minimum tax credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established. Management’s recoverability assessment of the Company’s deferred tax assets, which are ordinary in character, takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities that represent sources of future ordinary taxable income.
The Company’s effective income tax rate can be affected by several factors. These generally include 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 28.1% for 2014, compared to 15.1% for 2013. The increase in the effective tax rate is mainly due to an increase in taxable income relative to tax exempt investment income and an increase in nondeductible expenses. The Company’s effective tax rate for the year ended December 31, 2014 was lower than the statutory tax rate primarily as a result of tax exempt investment income earned.
The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them and/or discloses them in the notes to the consolidated financial statements where required. The Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows. See also “Regulatory and Legal Matters” and Note 16 of Notes to Consolidated Financial Statements.
The Company’s insurance premiums are recognized as income ratably over the term of the policies and in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the consolidated balance sheets and are computed monthly on a pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs partially offset by investment income to related unearned premiums. To the extent that any of the Company’s lines of business become unprofitable, a premium deficiency reserve may be required.
Net premiums written and net premiums earned in 2014 increased 4.1% and 3.6%, respectively, from 2013. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile and homeowners lines of business.
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by favorable development of approximately $3 million and unfavorable development of approximately $3 million on prior accident years’ losses and loss adjustment expense reserves for the years ended December 31, 2014 and 2013, respectively. The favorable development in 2014 was primarily from California personal auto lines of business partially offset by adverse development in other states. The unfavorable development in 2013 was primarily from the Florida private passenger automobile line of business. The 2014 loss ratio was also negatively impacted by a total of $11 million of catastrophe losses mostly due to winter freeze events on the East Coast and homeowners losses in California from severe rainstorms during 2014. The 2013 loss ratio was also negatively impacted by a total of $17 million of catastrophe losses mostly due to tornadoes in Oklahoma and severe storms in the Midwest and Southeast regions during 2013. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 70.7% and 72.0% for the years ended December 31, 2014 and 2013, respectively. The Company attributes the improved accident year loss ratio to the impact of rate increases which exceeded underlying loss cost trends in 2014.
Combined ratio is equal to loss ratio plus expense ratio and is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results.
The following tables present the changes of the investment portfolio included in net income of the Company:
For 2013, the increases in fair value were primarily caused by the overall improvement in the equity markets.
The expense ratio did not materially change in 2013 compared to 2012. The 2013 expense ratio was affected by the consolidation of claims and underwriting operations located outside of California into hub locations, which resulted in
approximately $10 million of pre-tax office closure costs and severance related expense during the first quarter of 2013. The charges added 0.1 point to the expense ratio and 0.3 point to the loss adjustment expense portion of the loss ratio.
$662.4 million at December 31, 2014 as well as $100 million of credit available on a $250 million revolving credit facility, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs or for future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The nominal average maturities of the overall bond portfolio were 12.6 years and 13.3 years (11.4 years and 12.1 years when including short-term instruments) at December 31, 2014 and 2013, respectively. The portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturities of the overall bond portfolio were 3.4 years and 5.2 years (3.1 years and 4.7 years when including short-term instruments) at December 31, 2014 and 2013, respectively, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio reflecting anticipated early calls were 2.8 years and 3.9 years, (2.6 years and 3.6 years when including short-term instruments) at December 31, 2014 and 2013, respectively, including collateralized mortgage obligations with a modified duration of 1.8 years and 2.3 years at December 31, 2014 and 2013, respectively, and short-term bonds that carry no duration. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield, and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a better indicator of price volatility than simple maturity alone.
The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at December 31, 2014 at fair value. Credit ratings for the Company’s fixed maturity portfolio were stable as compared to the prior year, with 82.0% of fixed maturity securities at fair value experiencing no change in their overall rating. 15.4% of fixed maturity securities at fair value experienced upgrades, partially offset by 2.6% in credit downgrades. A majority of the downgrades were slight and still within the investment grade portfolio, except for $5.5 million at fair value that were downgraded to below investment grade during 2014.
Intermediate ratings are offered at each level (e.g., AA includes AA+, AA and AA-).
The Company had $2.3 billion at fair value ($2.2 billion at amortized cost) in municipal bonds at December 31, 2014, of which $995.3 million were insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was A+ at December 31, 2014.
The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for $6.2 million and $7.0 million ($5.5 million and $6.3 million at amortized cost) of Alt-A mortgages at December 31, 2014 and 2013, respectively. 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 $32.5 million and $21.9 million ($32.3 million and $21.8 million at amortized cost) in commercial mortgage-backed securities at December 31, 2014 and 2013, respectively.
Equity holdings consist of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. The net losses in 2014 due to changes in fair value of the Company’s equity portfolio were $32.9 million. Prior to the fourth quarter of 2014, the Company realized gains by selling equity securities. During the 4th quarter of 2014, decreases in the fair value of equity securities were primarily due to holdings in energy stocks.
Effective December 3, 2014, the Company extended the maturity date from July 31, 2016 to December 3, 2017.
Effective December 3, 2014, the Company extended the maturity date from June 30, 2018 to December 3, 2019, and expanded the borrowing capacity from $200 million to $250 million.
The bank loan and credit facilities contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and RBC ratio. The Company was in compliance with all of its loan covenants at December 31, 2014, except that CAIC's RBC ratio as of December 31, 2014 was below the loan covenant required level. The Company received a waiver of the non-compliance and contributed $10 million to the statutory surplus of CAIC to comply with the covenant. The Company will continue to monitor
In 2014, the Company made capital expenditures, including capitalized software, of approximately $26 million primarily related to Information Technology.
The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations. The RBC formula is used by insurance regulators to monitor capital and surplus levels. It was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements, and a number of other factors. The Company periodically monitors the RBC level of each of the Insurance Companies. As of December 31, 2014, 2013, and 2012 each of the Insurance Companies exceeded the minimum required RBC levels, as determined by the NAIC and adopted by the state insurance regulators. Except for CAIC, at 386% and 520% at December 31, 2014 and 2013, respectively, none of the Insurance Companies’ RBC ratio was less than 800% of the authorized control level RBC as of December 31, 2014, 2013, and 2012. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
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 $1.4 billion at December 31, 2014, and net premiums written of $2.8 billion, the ratio of premiums written to surplus was 2.0 to 1.
Beginning in 2015, insurance companies will be required to file an ORSA with the insurance regulators in their state of domicile. 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 the state insurance regulator 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 will comply with the ORSA requirements and does not expect these requirements to have a material impact on the Company's consolidated financial statements.
The DOI in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies in their states. Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing, and other practices. The following table presents a summary of current financial and market conduct examinations:
As of December 31, 2014, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
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 balance presented on the consolidated balance sheets as of December 31, 2014 because the debt amounts above include interest, calculated at the most recent LIBOR rate and bank margin in effect.
The table excludes liabilities of $11.1 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercury General Corporation’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 9, 2015 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Mercury General Corporation (“Mercury General”) and its subsidiaries (referred to herein collectively as the “Company”) are primarily engaged in writing personal automobile insurance through 13 Insurance Companies in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. The private passenger automobile lines of insurance were more than 77% of the Company’s direct premiums written in 2014, 2013, and 2012, of which approximately 83%, 81%, and 78% of the private passenger automobile premiums were written in California during 2014, 2013, and 2012, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
Short-term investments include money market accounts, options, short-term bonds that are highly rated short duration securities and redeemable within one year, and total return swaps.
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 on the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security or currency 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 of $0.2 million and $0.1 million were included in other liabilities at December 31, 2014 and 2013, respectively.
In 2014, the Company formed and consolidated FFL, a special purpose investment vehicle. The Company is the sole managing member of FFL. On February 13, 2014, FFL entered into a total return swap agreement with Citibank, N.A. (“Citibank”) subject to annual renewals. Under the total return swap agreement, FFL receives the income equivalent on underlying obligations and pays to Citibank interest equal to LIBOR plus 140 basis points on the outstanding notional amount of the underlying obligations, which was approximately $114 million as of December 31, 2014. The total return swap agreement is secured by approximately $30 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets. In the event of significant erosion in market value, FFL’s position in the loan portfolio will be reduced and the Company has the option of adding additional capital or terminating the total return swap agreement. The Company extended the agreement for one year.
Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses, and the servicing costs that will be incurred as premiums are earned. The Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. Deferred policy acquisition cost amortization was $526.2 million, $505.5 million, and $477.8 million during the years ended December 31, 2014, 2013, and 2012, respectively. The Company does not defer advertising expenses but expenses them as incurred. The Company recorded net advertising expenses of approximately $23 million, $20 million, and $19 million during the years ended December 31, 2014, 2013, and 2012, respectively.
Fixed assets are stated at historical cost less accumulated depreciation and amortization. The useful life for buildings is 30 to 40 years. Furniture, equipment, and purchased software are depreciated on a combination of straight-line and accelerated methods over 3 to 7 years. The Company has capitalized certain consulting costs, payroll, and payroll-related costs for employees related to computer software developed for internal use, which are amortized on a straight-line method over the estimated useful life of the software, generally not exceeding 7 years . In accordance with applicable accounting standards, capitalization ceases no later
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 amount 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 the three years ended December 31, 2014.
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.
The Company evaluates goodwill for impairment annually or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill may exceed its implied fair value. 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, 2014 and 2013, goodwill and other intangible impairment assessments indicated that there was no impairment.
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. The Company’s derivative instruments include a total return swaps and interest rate swaps. See Note 7.
Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the period presented. Diluted earnings per share is based on the weighted average shares of common stock and potential dilutive common stock outstanding during the period presented. At December 31, 2014 and 2013, potential dilutive common stocks consist of outstanding stock options. Note 15 contains the required disclosures relating to the calculation of basic and diluted earnings per share.
The Company's annual direct premiums written by lines of insurance were:
Share-based compensation expense for all share-based payment awards granted or modified is based on the estimated grant-date fair value. 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 or five years for options granted prior to 2008 and four years for options granted subsequent to January 1, 2008, for only those shares expected to vest. 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 fair value of each restricted share grant was determined based on the market price on the grant date. Compensation cost is recognized based on management’s best estimate that performance goals will be achieved. If such goals are not met, no compensation cost is recognized and any recognized compensation cost would be reversed. See Note 14 for additional disclosures.
In May 2014, the FASB issued a new standard that requires entities to apply a five-step model to determine the amount and timing of revenue recognition. The model specifies, among other criteria, that revenue should be recognized when an entity transfers control of goods or services to a customer at the amount at which the entity expects to be entitled. The new standard will be effective for fiscal years and interim periods within those years that begin after December 15, 2016. Early adoption is not permitted. The Company is in the process of evaluating the impact on the consolidated financial statements.
In July 2013, the FASB issued a new standard that requires entities to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when the uncertain tax position would reduce the net operating loss or other carryforward under the tax law of the applicable jurisdiction and when the entity intends to use the deferred tax asset for that purpose. The Company adopted the new standard which became effective for the interim period ended March 31, 2014. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
At December 31, 2014, fixed maturity holdings rated below investment grade and non-rated comprised 1.4% 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 estimated fair values at December 31, 2014 by contractual maturity are shown below. 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.
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 uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3. The Company recognizes transfers between levels at either the actual date of the event or a change in circumstances that caused the transfer.
Equity contracts: Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.
Corporate securities/Short-term bonds: Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2014 and 2013, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
The following table presents a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at December 31:
There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy in 2014 and 2013.
The following tables present the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains in the consolidated statements of operations:
Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy that is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset diversification throughout various industries. For additional disclosures regarding equity contracts, see Note 3.
The decrease in the provision for insured events of prior years in 2014 of approximately $3 million primarily resulted from lower than expected loss severity on California personal auto lines of business partially offset by adverse development in other states.
The Insurance Companies are subject to the financial capacity guidelines established by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For 2015, the insurance subsidiaries of the Company are permitted to pay approximately $177 million in dividends to Mercury General without the prior approval of the DOI of domiciliary states. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2014, 2013, and 2012, the Insurance Companies paid the Company ordinary dividends of $225 million, $120 million, and $145 million, respectively.
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, 2014, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
as of December 31, 2014, 2013 and 2012. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. The matching contributions, at a rate set by the Board of Directors, totaled $8.0 million, $8.1 million, and $7.2 million for 2014, 2013, and 2012, respectively.
In May 2005, the Company adopted the 2005 Incentive Award Plan (the “2005 Plan”), which succeeded a prior plan. A maximum of 4,920,750 shares of common stock under the 2005 Plan are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. As of December 31, 2014, only options and restricted stock awards have been granted under these plans. Beginning January 1, 2008, options granted, for which the Company has recognized share-based compensation expense become exercisable at a rate of 25% per year beginning one year from the date granted, are granted at the market price on the date of grant, and expire after 10 years. Prior to January 1, 2008, shares became exercisable at a rate of 20% per year.
The following table presents information regarding stock options outstanding at December 31, 2014:
As of December 31, 2014, $344,000 of total unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of 2.4 years.
The restricted stock unit activity as of December 31, 2014, 2013, and 2012 and changes during the years then ended is as follows:
Incremental shares of 273,000, 421,000, and 415,000 for 2014, 2013, and 2012, respectively, were excluded from the computation of the diluted earnings per common shares due to their anti-dilutive effect. Potentially dilutive securities representing approximately 21,000, 63,000, and 80,000 shares of common stock for 2014, 2013, and 2012, respectively, were also excluded from the computation of diluted earnings per common share because their effect would have been anti-dilutive.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. The California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee and a penalty for each policy on which the Company allegedly used a misleading advertisement and to suspend certificates of authority for a period of one year. In January 2012, an Administrative Law Judge (“ALJ”) bifurcated the 2004 NNC between (a) the California DOI’s order to show cause, in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. Following an evidentiary hearing on the noncompliance portion of the 2004 NNC in April 2013, post-hearing briefs and an unsuccessful mediation, the ALJ closed the evidentiary record on April 30, 2014. On December 8, 2014 the ALJ submitted a proposed decision to the California Insurance Commissioner and recommended that it be adopted as the decision of the California Insurance Commissioner. The decision states that from the period July 1, 1996 through 2006, Mercury’s "brokers" were actually operating as "de facto agents" and that the charging of "broker fees" by those producers constituted the charging of "premium" in excess of the Company’s approved rates and assesses a civil penalty in the amount of $27,593,550 against the Company. The California Insurance Commissioner adopted the ALJ's proposed decision on January 7, 2015, and the Company received notice of the California Department of Insurance decision on January 10, 2015.
The Company denies the allegations and/or findings in the 2004 and 2010 NNC matters, and believes that no monetary penalties are warranted, and the Company intends to vigorously defend itself against the allegations including the $27,593,550 assessed fine, unless a reasonable settlement can be reached. Although the Company intends to continue to defend the allegations in the 2004 NNC, it accrued a liability, and incurred a corresponding expense, for the full proposed penalty amount in the 2004 NNC matter in the three month and twelve month periods ended December 31, 2014. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the 2004 and 2010 NNC matters will be material to the Company’s financial position. The Company has also accrued a liability for the estimated cost to continue to defend itself in the notice of non-compliance matters.
Net income during 2014 was primarily affected by the $27.6 million penalty assessed by California DOI, higher net premiums earned and increases in the fair value of the Company’s investment portfolio offset by catastrophe related losses. See Note 16 of Notes to Consolidated Financial Statements for "2004 NNC" discussion. The primary causes of the net loss during the fourth quarter of 2014 were the $27.6 million penalty described above, the declines in the fair value of the Company’s equity securities due to the overall decline in the equity market, and the severe rainstorms in California.
WAIC is a Los Angeles-based non-standard, personal automobile lines insurance company that operates predominantly in California. The Company intends to use the WAIC non-standard automobile product to complement the Company’s preferred product offering.
The determination of purchase price and valuation of financial assets acquired and financial liabilities assumed are expected to be completed as soon as practicable. The final purchase price allocation is still under review, specifically related to the determination of the fair value of loss reserves, assets, liabilities, and identifiable intangible assets. The Company expects this review to be completed during the first quarter of 2015.