Since December 1986, Mercury General's executive offices are located in a 36,000 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 October 1992, the Company purchased a 158,000 square foot office building in Brea, California. The Company occupies approximately 77% of the facility and leases the remaining office space to others.
The Company leases all of its other office space. Office location is not material to the Company's operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.
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 new plan did not have a material effect on the Company's overall competitive position or its profitability.
Realized investment losses in 1998 were $3.9 million, compared with realized gains of $5.0 million in 1997. The gains and losses in both years were principally incurred to enhance investment income on both fixed maturities and equity securities, including perpetual preferred stocks. The losses realized in 1998 were designed to utilize expiring capital gains tax benefits.
The income tax provision of $57.8 million in 1998 represented an effective tax rate of 24.5%, compared with an effective rate of 25.5% in 1997. The 1997 rate is higher primarily because the Company had a large non tax-deductible charge for ESOP compensation expense in 1997 that did not occur in 1998. ESOP compensation expense is calculated based on the current market value for the Company's stock multiplied by shares allocated to employees, however, only the Company's cost basis is deductible for tax purposes. The increase in the Company's share price on the shares allocated in 1997, which had been purchased in 1994, caused the large non-deductible charge that resulted in increasing the Company's effective tax rate in 1997. This situation did not occur in 1998 as the shares allocated to employees during 1998 had a similar cost and market value.
The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 25.1% in 1997 and 24.5% in 1996. The increase in the expense ratio in 1997 reflects increased provisions for profit-related bonuses to both agents and employees and the inclusion of the operating results of AMI for a full year.
The income tax provision of $53.5 million in 1997 represented an effective tax rate of 25.5%, compared with an effective rate of 22.6% in 1996. The increase in the rate is largely attributable to the increased proportion of realized gains and the increase in underwriting gains, both of which are taxed at the full corporate rate of 35%, in contrast to investment income which consists primarily of tax-exempt interest and tax sheltered dividend income.
The market value of all investments held at market as "Available for Sale" exceeded the amortized cost of $1,511.9 million at December 31, 1998 by $78.8 million. That unrealized gain, reflected in shareholders' equity, as Accumulated Other Comprehensive Income, net of applicable tax effects, was $51.2 million at December 31, 1998 compared with an unrealized gain of $46.1 million at December 31, 1997. The increase in market values since December 31, 1997 reflects principally the substantial decline in intermediate and long term interest rates during 1998.
Traditionally, it has been the Company's policy not to invest in high yield
Holdings in the taxable sector consist largely of senior public utility issues. Fixed-maturity investments of $1,245.4 million (amortized cost), include $42.5 million (amortized cost) of sinking fund preferreds, principally utility issues. The market value of all fixed maturities exceeded cost by $79.5 million at December 31, 1998. The only securities held which may be considered derivatives are a small amount of adjustable rate preferred stocks.
Equity holdings of $219.7 million at market (cost $220.4 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 24.0% of total shareholders' equity.
The Company had outstanding debt at December 31, 1998 of $78 million. Of this amount, $75 million has been borrowed under a three year revolving credit bank loan. The loan agreement requires the Company to meet numerous affirmative and negative covenants. The proceeds of the loan were used to repay a prior loan and to acquire AMI, with the balance contributed to the Company's new insurance subsidiaries. The loan agreement may be extended annually for additional periods of one year each to maintain the three year maturity date. The interest rate is variable and is optionally related to the Federal Funds rate, Bank of New York rate (prime rate) or the Eurodollar London Interbank rate (LIBOR). Based on the rates effective through February 22, 1999, LIBOR plus .40, the net interest cost on the loan approximates 5.65%.
of credit may be used to fund the Company's stock repurchase program authorized by the Board of Directors in August 1998 as well as for general corporate purposes. The interest rate and loan covenants are the same as the Company's $75 million loan discussed above. The Company plans to extend the maturity date of this loan during 1999.
In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been 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 has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1998. Each of the companies' policyholders' surplus exceeded the highest level of minimum required capital.
The Year 2000 issue is the result of computer programs being written using two digits rather than four digits to define the applicable year. Computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, or as no date. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business operations.
In March of 1998, the Company completed the modifications necessary to its computer programs and systems for all of its "critical" systems for business written in California, Georgia, Illinois and Florida. Modifications were made to both hardware and software. The Company considers policy issuance, premium billing and collections and its claims systems as its critical systems. The modifications completed on the above critical systems represent approximately 94% of the Company's total premiums written.
The Company expensed approximately $475,000 in 1998 and $125,000 in 1997, primarily for internal labor costs, related to Year 2000 modifications. The Company expects to incur an amount less than what has previously been expensed for 1999. It is not possible to quantify the aggregate cost to the Company with respect to the Year 2000 problems, although the Company does not anticipate it will have a material adverse impact on its business.
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, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles.
The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. In 1998 and 1997 over 90% 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 Indemnity Company of Georgia and Mercury Indemnity Company of Illinois. Effective December 1, 1996 the financial statements also include newly acquired companies American Mercury Insurance Company (AMIC), Cimarron Insurance Company, Inc., AFI Management Company, Inc. (AFIMC), and American Mercury Lloyds Insurance Company (AML). AML is not owned by MGC, but is controlled by MGC through its attorney-in-fact, AFIMC. The acquisition is discussed further in Note 8. Effective for 1997 and 1998, the financial statements also include the newly formed company American Mercury MGA, Inc. (AMMGA), a wholly owned subsidiary of AMIC. The 1998 financial statements include the results of Cimarron Insurance Company through June 5, 1998, the date it was sold to an unrelated party. This sale is discussed further in Note 9. Collectively, the newly-acquired companies, including AML, are referred to as AMI. All of the subsidiaries as a group, including AML, but excluding AFIMC and AMMGA, are referred to as the Insurance Companies. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments", and Statement of Financial Accounting Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments", require disclosure of estimated fair value information about financial instruments, for which it is practicable to estimate that value. Under SFAS No. 115, 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 estimated fair value of notes payable equals their carrying value, which was based on borrowing rates currently available to the Company for bank loans with similar terms and maturities. The terms of the notes are discussed in Note 5.
Insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are computed on the monthly pro rata basis. Unearned premiums are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets.
Statement of Financial Accounting Standards No. 131 (SFAS No. 131), "Disclosures about Segments of an Enterprise and Related Information," became effective for fiscal years beginning after December 15, 1997. SFAS 131 establishes standards for the way information about operating segments is reported in financial statements. The Company does not have any operations that require disclosure as operating segments.
Statement of Position 98-1 (SOP 98-1), "Accounting For the Costs of Computer Software developed or obtained for Internal Use" is effective for financial statements beginning after December 15, 1998. SOP 98-1 requires that the cost of internally developed computer software be capitalized. The Company will implement this standard during the first quarter 1999 and is currently evaluating the impact that it will have on the Consolidated Financial Statements.
Interest paid during 1998, 1997, and 1996 was $4,494,000, $5,077,000, and $1,882,000, respectively. Income taxes paid were $65,984,000 in 1998, $52,611,000 in 1997, and $30,550,000 in 1996.
The subsidiary sold in 1998 consisted primarily of invested assets totaling $8,408,000 at the sale date.
The balance sheet of AMI at the acquisition date included the following assets: investments of $75,310,000, cash of $1,362,000, receivables of $44,418,000 and other assets of $31,124,000. Liabilities assumed in the acquisition included unearned premiums of $50,199,000, loss and loss adjustment expense reserves of $47,039,000 and other liabilities of $19,985,000.
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), which is effective for fiscal years beginning after December 15, 1995. The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by SFAS No. 123. Disclosure of stock-based compensation determined in accordance with SFAS No. 123 is presented in Footnote 14. The adoption of this pronouncement did not have a material effect on the financial statements of the Company.
Certain reclassifications have been made to the prior year balances to conform to the current year presentation.
A summary of net realized investment gains (losses) is as follows:
Accumulated unrealized gains and losses on securities available for sale follows:
Notes payable at December 31, 1998 consist of two revolving credit facilities with a consortium of banks. A November 21, 1996 credit facility provides for an aggregate commitment of $75 million, of which $75 million has been drawn and is outstanding. The $75 million notes are due November 21, 2001. This due date may be extended annually for additional periods of one year to maintain the three-year maturity date. The other outstanding debt consists of a 364 day $100 million line of credit dated October 31, 1998. The outstanding draw on this line of credit is $3 million and is due on October 31, 1999.
The $75 million and $100 million credit facilities are subject to a commitment fee on the undrawn balances of 0.15% and 0.12%, respectively. In addition, the $100 million credit facility imposes a utilization fee of 0.05% on the outstanding debt of both lines of credit if the aggregate principal outstanding balance of both lines of credit exceeds 66 2/3% of the sum of the aggregate commitments. For both debts, the interest rate is variable and is optionally related to the Federal Funds rate, Bank of New York prime rate or the Eurodollar London Interbank rate (LIBOR). Based on the rates effective through February 22, 1999, the net interest cost on the loans at December 31, 1998 is approximately 5.65%.
Increase in incurred losses in 1997 relating to prior years reflects increases in the Company's estimates for loss adjustment expenses.
AMI writes property and casualty insurance, primarily in Oklahoma and Texas, where the companies are domiciled. Its primary lines are automobile and mechanical breakdown insurance. The results of operations for the month of December 1996 and all of 1997 and 1998, with the exception of Cimarron, which is discussed in Note 9, are included in the consolidated financial statements of the Company.
Cimarron ceased writing new business in 1997 and all renewal business was underwritten and retained by American Mercury Insurance Company. The consolidated results for 1998 include $0.2 million of revenue and $0.1 million of net income from the operations of Cimarron up the sale date of June 5, 1998.
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 a variety of publications of 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, 1998, there were no material permitted statutory accounting practices utilized by the Insurance Companies. During 1998, the NAIC approved the codification of statutory accounting practices. Codification will become effective in the year 2001 if it is adopted by the states. If adopted, it will result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements.
The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1998 according to the formula issued by the NAIC. Each of the companies' policyholders' surplus exceeded the highest level of minimum required capital.
contributions, at a rate set by the Board of Directors, totaled $1,648,000, $1,349,000, and $955,000 for the plan years ended December 31, 1998, 1997 and 1996.
As explained in Note 1, the Company applies APB Opinion No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Statements of Income. Had compensation cost for the Company's Plans been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's net income would have been reduced by $454,000, $363,000 and $295,000 in 1998, 1997 and 1996, respectively, and earnings per share (basic and diluted) would have been reduced by .01 in 1998, would have remained the same in 1997, and been reduced by .01 (basic and diluted) in 1996. Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996: dividend yield of 2.0 percent for all years, expected volatility of 32.7 percent in 1998 and 30 percent for 1997 and 1996 and expected lives of 7 years for all years. The risk-free interest rates used were 5.4 percent for the options granted during 1998, 6.4 percent for the options granted during 1997 and 5.5 and 6.4 percent for the options granted during 1996.
A summary of the status of the Company's plans as of December 31, 1998, 1997 and 1996 and changes during the years ending on those dates is presented below: