square foot office building in Los Angeles, California, owned by Mercury Casualty. The Company occupies approximately 95% of the building and leases the remaining office space to others.
In November 2001, the Company purchased twelve acres of land in Rancho Cucamonga, California. Construction of a 100,000 square foot office building to house Company personnel is planned to begin in 2002 with completion anticipated in early 2003. Any space in the building that is not occupied by the Company will be leased to outside parties.
During 2001, approximately 87.5% of the Company's net premiums written were derived from California.
In September 1996, the California Insurance Commissioner issued permanent rating factor regulations designed to implement the requirements that automobile insurance rates be determined by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further
The Company submitted a proposed rating plan in response to these regulations in March 1997. The Company's plan was approved by the California DOI and became effective October 1, 1997. Although the rate changes produced some minor dislocations, implementation of the plan has not materially changed the Company's overall competitive position or its profitability.
The preparation of the Company's financial statements requires judgments and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60 (SFAS No. 60), "Accounting and Reporting by Insurance Enterprises" and Statement of Financial Accounting Standards No. 5 (SFAS No. 5), "Accounting for Contingencies". Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. 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. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision.
The Company complies with the SFAS No. 60 definition of how insurance enterprises should recognize revenue on insurance policies written. The Company's insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums. To the extent that any of the Company's lines of business become substantially unprofitable then a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business.
Statement of Financial Accounting Standards No. 133 (SFAS NO. 133), "Accounting for Derivative Instruments and Hedging Activities" became effective for fiscal years beginning after June 15, 1999. Statement of Financial Accounting Standards No. 137 (SFAS No. 137), "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" defers the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. This standard, adopted by the Company on January 1, 2001 had no impact on the Consolidated Financial Statements.
Statement of Financial Accounting Standards SFAS No. 141 (SFAS No. 141), "Business Combinations" and Statement of Financial Accounting Standards SFAS No. 142 (SFAS No. 142), "Goodwill and Other Intangible Assets" became effective January 1, 2002. SFAS No. 141 requires companies to apply the purchase method of accounting for all business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interest method. SFAS No. 142 changes the method by which companies may recognize intangible assets in purchase business combinations and generally requires identifiable intangible assets to be recognized separately from goodwill. In addition, it eliminates the amortization of all existing and newly acquired goodwill on a prospective basis and requires companies to assess goodwill for impairment, at least annually, based on the fair value of the reporting unit.
As required by SFAS 142, the Company has assessed these assets and determined that they are not impaired. Furthermore, as required by SFAS 142, the Company will no longer amortize these assets after 2001. Total amortization expense in 2001 related to these assets was $1.9 million.
The California private passenger automobile insurance marketplace has entered a period of rising premium rates. Virtually all of the Company's competitors have recently filed for rate increases which helped spur the Company's premium growth during 2001. In August 2001 the Company received approval from the California Department of Insurance for a 6.9% rate increase in its non-standard line and in its non-good driver private passenger automobile line written
The GAAP expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 26.4% in 2001 and 26.3% in 2000. The expense ratio was relatively unchanged as total expenses increased at essentially the same rate as premium volume. The majority of expenses vary directly with premiums.
Total losses and expenses in 2001, excluding interest expense of $7.7 million, were $1,374.4 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $6.1 million, compared with an underwriting gain of $19.1 million in 2000.
Realized investment gains in 2001 were $6.5 million, compared with realized gains of $3.9 million in 2000.
The income tax provision of $19.5 million in 2001 represented an effective tax rate of 15.6%, compared with an effective rate of 14.9% in 2000. The higher rate in 2001 reflects a shift in a portion of the Company's investments from tax-exempt issues to taxable issues.
Investment income in 2000 was $106.5 million compared with $99.4 million in 1999. The after-tax yield on average investments of $1,710.2 million (cost basis) was 5.56%, compared with 5.62% on average investments of $1,595.5 million in 1999. The effective tax rate on investment income in 2000 was 10.6%, compared with 9.8% in 1999. The higher tax rate in 2000 reflects a modest shift in the Company's portfolio mix from non-taxable to taxable issues. Bonds matured and called in 2000 totaled $45.6 million compared with $49.2 million in 1999.
Realized investment gains in 2000 were $3.9 million compared with realized losses of $11.9 million in 1999. The gains realized in 2000 were designed to utilize capital loss tax benefits. Included in 1999 losses was a $6.0 million write-down of a preferred stock investment that became other than temporarily impaired during the third quarter.
Net income in 2000 was $109.4 million or $2.02 per share (diluted), compared with $133.7 million or $2.44 per share (diluted), in 1999. Diluted per share results are based on 54.3 million average shares in 2000 and 54.8 million shares in 1999. Basic per share results were $2.02 in 2000 and $2.45 in 1999.
Net cash provided from operating activities in 2001, was $199.5 million, while funds derived from the sale, redemption or maturity of investments was $323.2 million, of which approximately 58% was represented by the sale of fixed maturities. The amortized cost of fixed-maturity investments increased by $96.3 million during the year. Equity investments, including perpetual preferred stocks, increased by $27.3 million at cost, while short-term cash investments increased by $39.0 million. The amortized cost of fixed-maturities available for sale that were sold, called or matured during the year was $254.2 million.
The market value of all investments held at market as "Available for Sale" exceeded the amortized cost of $1,910.1 million at December 31, 2001 by $26.1 million. That unrealized gain, reflected in shareholders' equity, as Accumulated Other Comprehensive Income, net of applicable tax effects, was $17.0 million at December 31, 2001 compared with a gain of $30.9 million at December 31, 2000. The decrease in market values since December 31, 2000 were largely caused by widening spreads on many of the Company's corporate bonds. The widening spreads reflect the perceived increased credit risk by the market and by the major rating agencies in the wake of both the September 11 events and the industry-wide accounting concerns raised after the collapse of Enron.
Equity holdings of $277.8 million at market (cost $277.9 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 26% of total shareholders' equity.
As part of the Elm County Mutual transaction the Company agreed to make annual $1 million payments to Employers Reinsurance Corporation over 7 years beginning September 30, 2001. At December 31, 2001, the Company is carrying a note payable for $4.8 million, which represents the discounted value of the six remaining payments using a 7% rate.
The Company had outstanding debt at December 31, 2001 of $129.5 million. Prior to the $125 million senior note issuance, the Company had $75 million payable under a revolving credit facility due November 21, 2001 and $27 million payable under a $30 million revolving credit facility due October 26, 2001. The interest rate on these two loans was variable and through August 7, 2001 was priced off of the Eurodollar London Interbank Rate (LIBOR) making the effective interest rate 5.77% and 5.78%, respectively. On August 7, 2001, the Company repaid the entire balance of both the $75 million and $27 million borrowings with proceeds received from the $125 million senior note issuance. The Company also terminated the $75 million revolving credit facility. The $30 million facility that expired on October 26, 2001 was not renewed.
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
Net income ........................... $ 105,339 $ 109,366 $ 133,709 ========== ========== ==========
The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. In 2001 and 2000 over 87% of the net written premiums were from California.
The consolidated financial statements include the accounts of Mercury General Corporation (the Company or MGC) and its wholly-owned subsidiaries, Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Inc., Mercury Insurance Company of Georgia, Mercury Insurance Company of Illinois, Mercury Insurance Company of Florida, Mercury Indemnity Company of Georgia, Mercury Indemnity Company of Illinois, Mercury Indemnity Company of Florida, Mercury Insurance Services, LLC (MISLLC), American Mercury Insurance Company (AMIC), AFI Management Company, Inc. (AFIMC), American Mercury Lloyds Insurance Company (AML) and Mercury County Mutual Insurance Company (MCM). AML is not owned by MGC, but is controlled by MGC through its attorney-in-fact, AFIMC. MCM is not owned by the Company but is controlled through a management contract. American Mercury MGA, Inc. (AMMGA), is a wholly owned subsidiary of AMIC. Effective October 31, 1999 the financial statements also include Concord Insurance Services, Inc., (Concord) a Texas insurance agency owned by MGC. Concord is discussed further in Note 8. The results of MCM are included in the financial statements effective September 30, 2000. MCM is discussed further in Note 9. All of the subsidiaries as a group, including AML and MCM, but excluding AFIMC, AMMGA, MISLLC and Concord, are referred to as the Insurance Companies. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.
In most cases, the market valuations were drawn from standard trade data sources. In no case were any valuations made by the Company's management. Equity holdings, including non- sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date.
Temporary unrealized investment gains and losses on securities available for sale are credited or charged directly to shareholders' equity as accumulated other comprehensive income, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statements of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method. Included in realized losses for 1999 is a $6.0 million write-down of a preferred stock investment that became other than temporarily impaired during the third quarter of 1999. As the result of a liquidating dividend, the Company realized gains of $477,000 and $347,000 on the same equity security in 2001 and 2000, respectively.
Under Statement of Financial Accounting Standards No. 115 (SFAS No. 115), "Accounting for Certain Investments in Debt and Equity Securities", the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 and were drawn from standard trade data sources such as market and broker quotes. The carrying value of receivables, accounts payable and other liabilities is equivalent to the estimated fair value of those items. The notes payable are carried at their book value which is calculated as the principal less unamortized discount on the senior debt and the discounted value of future payments on the Employers Re note. The terms of the notes are discussed in Note 5.
Net premiums written during 2001, 2000 and 1999 were $1,442,886,000, $1,272,447,000 and $1,206,171,000, respectively.
Acquisition costs related to unearned premiums, which consist of commissions, premium taxes and certain other underwriting costs, which vary directly with and are directly related to the production of business, are deferred and amortized to income ratably over the terms of the policies. Deferred acquisition costs are limited to the amount which 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 the premiums are earned. The Company does not defer advertising expenses.
Statement of Financial Accounting Standards No. 141, (SFAS No. 141) "Business Combinations" and Statement of Financial Accounting Standards No. 142,(SFAS No. 142) "Goodwill and Other Intangible Assets" became effective January 1, 2002. SFAS No. 141 requires companies to apply the purchase method of accounting for all business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interest method. SFAS No. 142 changes the method by which companies may recognize intangible assets in purchase business combinations and generally requires identifiable intangible assets to be recognized separately from goodwill. In addition, it eliminates the amortization of all existing and newly acquired goodwill on a prospective basis and requires companies to assess goodwill for impairment, at least annually, based on the fair value of the reporting unit. See Notes 8 and 9.
The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities and expected benefits of utilizing net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled and reflected in the financial statements in the period enacted.
In 2001, debt issuance costs of $1,345,000 were paid in connection with the public debt offering of $125 million of senior notes payable.
In 2000, notes payable with a discounted value of $5,889,000 were issued as part of the consideration for the right to manage and control Elm County Mutual Insurance Company (ELM) (See Note 9).
The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by Statement of Financial Accounting Standards No. 123,(SFAS No. 123) "Accounting for Stock-Based Compensation". Disclosure of stock-based compensation determined in accordance with SFAS No. 123 is presented in Note 14.
Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 ------- ------- -------- Fixed maturities available for sale: Gross realized gains .................. $ 5,558 $ 1,740 $ 865 Gross realized losses ................. (1,608) (908) (259) ------- ------- -------- Net ............................. $ 3,950 $ 832 $ 606 ======= ======= ========
A summary of the net increase (decrease) in unrealized investment gains and losses less applicable income tax expense (benefit), is as follows:
Year ended December 31, (Amounts in thousands) ------------------------------- 2001 2000 1999 -------- -------- --------- Net increase (decrease) in net unrealized investment gains and losses: Fixed maturities available for sale ... $(19,324) $ 77,288 $(111,179) Income tax expense (benefit) .......... (6,763) 27,051 (38,912) -------- -------- --------- $(12,561) $ 50,237 $ (72,267) ======== ======== =========
Equity securities available for sale: Unrealized gains ...................... $ 15,898 $ 16,799 Unrealized losses ..................... (16,036) (14,882) Tax effect ............................ 48 (671) -------- -------- $ (90) $ 1,246 ======== ========
Net unrealized investment gains (classified as accumulated other comprehensive income on the balance sheet) ................ $ 16,975 $ 30,871 ======== ========
The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2000 are as follows:
Year ended December 31, (Amounts in thousands) --------------------------------- 2001 2000 1999 --------- --------- --------- Balance, beginning of year ........... $ 71,126 $ 63,975 $ 61,947 Costs deferred during the year ....... 313,984 275,808 269,427 Amortization charged to expense ...... (301,670) (268,657) (267,399) --------- --------- --------- Balance, end of year ................. $ 83,440 $ 71,126 $ 63,975 ========= ========= =========
approximately 7.44%. At December 31, 2001, the book value of the debt was $124.7 million and the fair market value was $125.4 million.
Prior to the issuance of the senior notes, the Company used short-term floating rate bank debt as part of its capital structure. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate of LIBOR plus 107 basis points. The Company believes that the swap will significantly reduce interest expense in 2002, but does expose it to higher interest expense in future periods, should LIBOR rates increase. The swap will be accounted for as a fair value hedge under SFAS No. 133.
Realization of the net deferred tax assets is dependent on generating sufficient taxable income prior to their expiration. Although realization is not assured, management believes it is more likely than not that the net deferred tax asset will be realized.
In December 1999, the Company acquired control of Concord Insurance Services, Inc. ("Concord"), a Texas insurance agency headquartered in Houston, Texas. The effective date of the transaction was October 31, 1999. Concords' results of operations are included in the Consolidated Financial Statements of the Company effective October 31, 1999.
The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include primarily those published as statements of Statutory Accounting Principles by the National Association of Insurance Commissioners (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, 2001, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
Rent Year Expense - ---- ------- 2002................................................................. $3,788 2003................................................................. $2,537 2004................................................................. $2,312 2005................................................................. $1,572 2006................................................................. $ 727 Thereafter........................................................... $2,322
2001 2000 ---- ---- Allocated shares 69,000 46,000 Shares committed-to-be released 23,000 23,000 Unreleased shares 23,000 46,000 ---------- ---------- Total ESOP shares 115,000 115,000 ========== ========== Market value of unreleased shares at December 31, $1,004,000 $2,018,000 ========== ==========
In May 1995 the Company adopted The 1995 Equity Participation Plan (the "1995 Plan") which succeeds the 1985 Plan. Under the 1995 Plan, 5,400,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. During 1995, the Company granted incentive stock options under both the 1995 Plan and the 1985 Plan. The options granted become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date of the grant. The options expire in 10 years. At December 31, 2001 no awards other than options have been granted.
The diluted weighted shares excludes incremental shares of 104,000, 126,000 and 94,000 for 2001, 2000 and 1999, respectively. These shares are excluded due to their antidilutive effect.