The Company leases additional office space for operations. Office location is not crucial to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space. In addition, the Company owns 5.9 acres of land in Rancho Cucamonga, California.
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. Certain statements contained in this report are forward-looking statements based on the Company’s current expectations and beliefs concerning future developments and their potential effects on the Company. There can be no assurance that future developments affecting the Company will be those anticipated by the Company. Actual results may differ from those projected in the forward-looking statements. These forward-looking statements involve significant risks and uncertainties (some of which are beyond the control of the Company) and are subject to change based upon various factors, including but not limited to the following risks and uncertainties: changes in the demand for the Company’s insurance products, inflation and general economic conditions, including general market risks associated with the Company’s investment portfolio; the accuracy and adequacy of the Company’s pricing methodologies; catastrophes in the markets served by the Company; uncertainties related to estimates, assumptions and projections generally; the possibility that actual loss experience may vary adversely from the actuarial estimates made to determine the Company’s loss reserves in general; the Company’s ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in states where the Company operates; legislation adverse to the automobile insurance industry or business generally that may be enacted in the states where the Company operates; the Company’s success in managing its business in non-California states; the presence of competitors with greater financial resources and the impact of competitive pricing and marketing efforts; the ability of the Company to successfully manage its claims organization outside of California; the Company's ability to successfully allocate the resources used in the states with reduced or exited operations to its operations in other states; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions and trends in litigation and health care and auto repair costs and marketing efforts; and legal, cyber security, regulatory and litigation risks.
The Company is headquartered in Los Angeles, California and writes primarily personal automobile lines of business selling policies through a network of independent agents, 100% owned insurance agents and direct channels, in 11 states: Arizona, California, Florida, Georgia, Illinois, Nevada, New Jersey, New York, Oklahoma, Texas, and Virginia. The Company also offers homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. Private passenger automobile lines of insurance business accounted for 76.3% of the $3.2 billion of the Company’s direct premiums written in 2017, and 85% of the private passenger automobile premiums were written in California.
primarily in the Company's New Jersey and Florida branch offices. As a result, during the second quarter of 2016, the Company recorded a charge, primarily in loss and loss adjustment expenses, of approximately $2 million for employee termination costs.
During 2017, 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 competitive in California and in other states.
The Company believes its thorough underwriting process gives it an advantage over competitors. The Company’s agent relationships and underwriting and claims processes are its most important competitive advantages.
driving and collision avoidance and other technology in vehicles. Loss trends were generally flat or slightly down in 2017.
In January 2018, the California DOI approved a 5.0% rate increase on MIC's private passenger automobile line of insurance business, which represented approximately 51% of the total Company's net premiums earned in 2017. The Company expects to implement this rate increase in March 2018.
In March 2017, the California DOI approved a 6.9% rate increase on CAIC's private passenger automobile line of insurance business, which represented approximately 14% of the Company's total net premiums earned in 2017. This rate increase became effective in May 2017.
Commissioner’s interpretation of certain provisions of the California Insurance Code. Subsequent to the filing of the Writ, a consumer group petitioned and was granted the right to intervene in the Superior Court action. The Court did not order a stay, and the $27.6 million assessed penalty was paid in March 2015. The Company filed an amended Writ on September 11, 2015, adding an explicit request for a refund of the penalty, with interest.
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see "Critical Accounting Policies and Estimates" below and Note 1. Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
The Company establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. For material loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, 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.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see Note 17. Commitments and Contingencies-Litigation of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
and assumptions that serve as the basis for preparing the loss reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The GLM determines an average severity for each percentile of claims that have been closed as a percentage of estimated ultimate claims. The average severities are applied to open claims to estimate the amount of losses yet to be paid. The GLM utilizes operational time, determined as a percentile of claims closed rather than a finite calendar period, which neutralizes the effect of changes in the timing of claims handling.
For the Company’s California automobile lines of insurance business, total reserves are comprised of the following:
or underinsured motorist BI coverage, which covers damages to the insured for BI caused by uninsured or underinsured motorists. BI payments are primarily for medical costs and general damages.
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 2017, 2016, and 2015 accident years, respectively.
The following table presents the effects on the California automobile BI loss reserves for the 2017, 2016, and 2015 accident years based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.
The number of claims expected and the actual recorded severity for the 2014 and 2015 accident years are not comparable with the amounts previously reported on this table in prior filings. These amounts have been restated to be on a consistent reporting basis with the 2016 and 2017 accident years.
Implied inflation rate is calculated by dividing the difference between the current and prior year actual recorded severity by the prior year actual recorded severity.
During 2016, the Company implemented a claims strategy that reduced the number of small dollar settlements offered shortly after the claims were reported. This strategy reduced the total number of claims expected, which had the effect of increasing the actual recorded severity across the total claims population. There were fewer small dollar claims in the calculation of actual recorded severity for the 2016 and 2017 accident years compared to prior accident years. Consequently, the implied inflation rate recorded for these accident years is skewed upward due to this strategy change.
At December 31, 2017, there were 26,628 California automobile BI claims reported for the 2017 accident year and the Company estimates that these are expected to ultimately grow by approximately 4.7%. The Company believes that while actual development in recent years has ranged approximately from 3% to 5%, it is reasonable to expect that the range could be as great as between 0% and 10%. Actual development may be more or less than the expected range.
Discussion of losses and loss reserves and prior period loss development at December 31, 2017
The Company’s fixed maturity and equity investments are classified as "trading" and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-redeemable preferred stocks, are actively traded on national exchanges or trading markets, and are valued at the last transaction price on the balance sheet date.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, total return swaps, accounts payable, options sold, and secured and unsecured notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried on the consolidated balance sheets at fair value, as described in Note 2. Financial Instruments, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange traded funds. 98.0% of the fair value of these financial instruments held at December 31, 2017 is based on observable market prices, observable pricing parameters, or is derived from such prices or parameters. The availability of observable market prices
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 13.3% (17.7% excluding the effect of the Act) for 2017, compared to (3.3)% for 2016. The increase in the effective tax rate excluding the effect of the Act was mainly due to a significant increase in pretax income of $96.4 million. Excluding the effect of the Act, the Company’s effective tax rate for the years ended December 31, 2017 and 2016 was lower than the statutory tax rate primarily as a result of tax-exempt investment income earned.
As a result of enactment of the Act on December 22, 2017 that is effective for tax years beginning January 1, 2018, the Company made certain tax adjustments for the twelve months ended December 31, 2017. Adjustments were made to reflect the
At December 31, 2017, the Company’s AMT credit balance was $57.9 million. The AMT credit, previously classified as deferred tax asset that was included in deferred income taxes in the Company’s consolidated balance sheets, was reclassified to current income taxes receivable as a result of the Act. The AMT credit will be used to offset future federal tax obligations, and as tax refunds, until its benefits are fully realized by December 31, 2021. The Company is currently evaluating other impacts that the Act may have on business and investment strategies as well as financial results in future years, and has not yet determined the extent of such impacts. There are complex factors at play, including the effect of insurance regulation, which will likely require the tax benefits to be passed on to consumers, and changing dynamics in the capital markets, which may result in a shift in the Company’s allocation between taxable and tax-exempt investments.
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by unfavorable development of approximately $54 million and $85 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2017 and 2016, respectively. The unfavorable development in 2017 was primarily attributable to higher than estimated California automobile and property losses, while the unfavorable development in 2016 was primarily from the California and Florida automobile lines of business. The 2017 loss ratio was also negatively impacted by a total of approximately $79 million of catastrophe losses, net of reinsurance benefits, primarily due to wildfires in Northern and Southern California, severe rainstorms in California, and the impact of Hurricane Harvey in Texas and Hurricane Irma in Florida and Georgia. The 2016 loss ratio was also negatively impacted by a total of approximately $27 million of catastrophe losses, mostly due to severe storms outside of California and rainstorms in California. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 72.3% and 71.6% for the years ended December 31, 2017 and 2016, respectively. The increase in the adjusted loss ratio was primarily due to higher loss severity, partially offset by higher average premiums per policy.
Expense ratio is calculated by dividing the sum of policy acquisition costs and other operating expenses by net premiums earned. The lower expense ratio for the year ended December 31, 2017 was primarily attributable to lower policy acquisition costs and advertising expenses compared to the year ended December 31, 2016.
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; a combined ratio over 100% generally reflects unprofitable underwriting results.
Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each respective period.
Net investment income before and after income taxes increased due to higher average invested assets. Average annual yield on investments before and after income taxes decreased slightly, primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher, with lower yielding investments purchased during low interest rate environments.
The increases in fair value of equity securities during 2017 and 2016 were primarily due to an overall improvement in the equity markets.
Net premiums earned and net premiums written in 2016 increased 5.9% and 5.2%, respectively, from 2015. The increases in net premiums earned and net premiums written were primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile line of insurance business and growth in the number of homeowners and commercial automobile policies written in California.
The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio. The fair values in 2016 and 2015 were adversely affected by the increase in market interest rates.
The Company is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay ordinary dividends of approximately $167 million in 2018 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of $109 million during 2017. As of December 31, 2017, Mercury General had approximately $171 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
Net cash provided by operating activities for the year ended December 31, 2017 was $341.4 million, an increase of $49.7 million compared to the year ended December 31, 2016. The increase was primarily due to a decrease in operating expenses and policy acquisition costs paid and an increase in premiums collected, partially offset by higher income taxes and losses and loss adjustment expenses paid. The Company utilized the cash provided by operating activities during the year ended December 31, 2017 primarily for the payment of dividends to its shareholders and net purchases of investment securities.
An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well-diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company believes that this strategy enables the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a market risk and consistent asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2017:
The fair value is measured using the net asset value practical expedient. See Note 4. Fair Value Measurements of the Notes to Consolidated Financial Statements for additional information.
To calculate the weighted-average credit quality ratings as disclosed throughout this Annual Report on Form 10-K, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each security’s average of ratings assigned by nationally recognized securities rating organizations.
Taxable holdings consist principally of investment grade issues. At December 31, 2017, fixed maturity holdings rated below investment grade and non-rated bonds totaled $48.3 million and $78.6 million, respectively, at fair value, and represented 1.7% and 2.7%, respectively, of total fixed maturity securities. At December 31, 2016, fixed maturity holdings rated below investment grade and non-rated bonds totaled $51.6 million and $86.6 million, respectively, at fair value, and represented 1.8% and 3.1%, respectively, of total fixed maturity securities.
Credit ratings for the Company's fixed maturity portfolio were stable in 2017, with 80.7% of fixed maturity securities at fair value experiencing no change in their overall rating. 10.2% and 9.1% of fixed maturity securities at fair value experienced upgrades and downgrades, respectively, in 2017. The downgrades were slight and still within the investment grade portfolio in 2017.
The following table presents the credit quality ratings of the Company’s fixed maturity securities by security type at fair value:
The Company had $13.2 million and $12.3 million, or 0.5% and 0.4% of its fixed maturity portfolio, at fair value, in U.S. government bonds at December 31, 2017 and 2016, respectively. In April 2017, Moody's and Fitch affirmed their Aaa and AAA ratings, respectively, for U.S. government issued debt, although a significant increase in government deficits and debt could lead to a downgrade. The Company understands that market participants continue to use rates of return on U.S. government debt as a risk-free rate and have continued to invest in U.S. Treasury securities. The modified duration of the U.S. government bonds portfolio reflecting anticipated early calls was 2.1 years and 2.2 years at December 31, 2017 and 2016, respectively.
At December 31, 2017 and 2016, respectively, 62.9% and 60.6% of the insured municipal securities, at fair value, most of which were investment grade, were insured by bond insurers that provide credit enhancement in addition to the ratings reflected by the financial strength of the underlying issuers. At December 31, 2017 and 2016, the average rating of the Company’s insured municipal securities was A+, which corresponds to the average rating of the investment grade bond insurers. The remaining 37.1% and 39.4% of insured municipal securities at December 31, 2017 and 2016, respectively, were insured by non-rated or below investment grade bond insurers that the Company believes did not provide credit enhancement. The modified duration of the municipal securities portfolio reflecting anticipated early calls was 4.5 years and 4.3 years at December 31, 2017 and 2016, respectively.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities was B- at December 31, 2017 and 2016 . The weighted-average rating of the entire mortgage backed securities portfolio was A- at December 31, 2017, compared to A at December 31, 2016. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 4.9 years and 3.7 years at December 31, 2017 and 2016, respectively.
A and the modified duration reflecting anticipated early calls was 6.2 years and 4.4 years at December 31, 2017 and 2016, respectively.
The Company had other asset-backed securities of $53.1 million and $37.0 million, which represented 1.8% and 1.3% of its fixed maturity securities portfolio at December 31, 2017 and 2016, respectively. The weighted-average rating was A+ and A and the modified duration reflecting anticipated early calls was 1.1 years and 1.5 years as of December 31, 2017 and 2016, respectively.
Equity holdings of $537.2 million and $357.3 million, at fair value, as of December 31, 2017 and 2016, respectively, consisted of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and private equity funds. The net gains due to changes in fair value of the Company’s equity portfolio were $37.5 million and $23.7 million in 2017 and 2016, respectively. The primary cause of the increase in the value of the Company's equity securities was the overall improvement in the equity markets in 2017.
The following table presents the equity security portfolio by industry sector at December 31, 2017 and 2016:
On March 8, 2017, the loan and credit facility agreements were terminated and the Company repaid the total outstanding amounts with the proceeds from its public offering of $375 million of senior notes.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and RBC ratio under the unsecured credit facility at December 31, 2017.
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 business 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, 2017, 2016, and 2015, each of the Insurance Companies exceeded the minimum required RBC level, as determined by the NAIC and adopted by the state insurance regulators. None of the Insurance Companies’ RBC ratios were less than 400% of the authorized control level RBC as of December 31, 2017, 2016 and 2015. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
Insurance companies are required to file an Own Risk and Solvency Assessment ("ORSA") with the insurance regulators in their domiciliary states. The ORSA is required to cover, among many items, a company’s risk management policies, the material risks to which the company is exposed, how the company measures, monitors, manages and mitigates material risks, and how much economic and regulatory capital is needed to continue to operate in a strong and healthy manner. The ORSA is intended to be used by state insurance regulators to evaluate the risk exposure and quality of the risk management processes within insurance companies to assist in conducting risk-focused financial examinations and for determining the overall financial condition of insurance companies. The Company filed its most recent ORSA Summary Report with the California DOI in November 2017. Compliance with the ORSA requirements did not have a material impact on the Company's consolidated financial statements.
As of December 31, 2017, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
The table excludes liabilities of $10.1 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes and financial statement schedules I, II, and IV (collectively, the “consolidated financial statements”, and our report dated February 8, 2018 expressed an unqualified opinion on those consolidated financial statements.
consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates.
Equity securities consist of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and private equity funds.
As required by statute, the Company’s insurance subsidiaries have securities deposited with the departments of insurance or similar governmental agencies in the states in which they are licensed to operate with fair values totaling $17 million and $19 million at December 31, 2017 and 2016, respectively.
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting basis and the respective tax basis of the Company’s assets and liabilities, and expected benefits of utilizing net operating loss, capital loss, and 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. 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 effect on deferred tax assets and liabilities of a change in tax rates or laws is recognized in earnings in the period that includes the enactment date.
The fair value of each restricted stock unit grant was determined based on the market price on the grant date for awards classified as equity and on each reporting date for awards classified as a liability. Compensation cost is recognized based on management’s best estimate of the performance goals that will be achieved. If such goals are not met, no compensation cost is recognized and any recognized compensation cost would be reversed. See Note 15. Share-Based Compensation for additional disclosures.
In October 2016, the FASB issued ASU 2016-16, "Income Taxes (Topic 740), Intra-Entity Transfers of Assets Other Than Inventory." ASU 2016-16 requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Current GAAP prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. ASU 2016-16 is effective for the Company beginning January 1, 2018. The Company does not anticipate that ASU 2016-16 will have a material impact on its consolidated financial statements and related disclosures.
In August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments (Topic 230)." The new guidance is intended to reduce diversity in how certain transactions are classified in the consolidated statement of cash flows. ASU 2016-15 is effective for the Company beginning January 1, 2018. The Company does not anticipate that ASU 2016-15 will have a material impact on its consolidated financial statements and related disclosures.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326)." The amendments in this ASU replace the "incurred loss" methodology for recognizing credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of information including past events, current conditions and reasonable and supportable forecasts that affect the collectibility of reported amounts of financial assets that are not accounted for at fair value through net income, such as loans, certain debt securities, trade receivables, net investment in leases, off-balance sheet credit exposures and reinsurance receivables. Under the current GAAP incurred loss methodology, recognition of the full amount of credit losses is generally delayed until the loss is probable of occurring. Current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the probability threshold. ASU 2016-13 will be effective for the Company beginning with the first quarter ending March 31, 2020. While the Company is in the process of evaluating the impact of ASU 2016-13, it does not expect this ASU to have a material impact on its consolidated financial statements and related disclosures as most of its financial instruments with potential exposure to material credit losses are accounted for at fair value through net income.
In March 2016, the FASB issued ASU 2016-09, "Compensation - Stock Compensation (Topic 718)," which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The Company adopted ASU 2016-09 for the quarter ended March 31, 2017. As a result of the adoption, the Company recognizes excess tax benefits in its provision for income taxes rather than paid-in capital. Additional amendments to accounting for income taxes and minimum statutory withholding tax requirements had no impact to retained earnings as of January 1, 2017, where the cumulative effect of these changes are required to be recorded. The Company elected to continue to estimate forfeitures expected to occur to determine the amount of compensation cost to be recognized in each period. The Company also elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented, which resulted in an increase to both net cash provided by operating activities and net cash used in financing activities of approximately $913,000 and $27,000 for 2016 and 2015, respectively. The adoption of the presentation requirements for cash flows related to employee taxes paid with shares resulted in an increase to both net cash provided by operating activities and net cash used in financing activities of approximately $3,292,000 and $0 for 2016 and 2015, respectively.
a modified retrospective approach. While the Company is in the process of evaluating the impact of ASU 2016-02, it does not expect this ASU to have a material impact on its consolidated financial statements, except for recognizing lease assets and lease liabilities for its operating leases. The Company's lease obligations under various non-cancellable operating lease agreements amounted to approximately $32,000,000 at December 31, 2017.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, options sold, total return swaps, accounts payable, and secured and unsecured notes payable. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried at fair value in the consolidated balance sheets.
The fair values of the total return swaps reflect the estimated amounts that, upon termination of the contracts, would be received for selling an asset or paid to transfer a liability in an orderly transaction at December 31, 2017 and 2016 based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract.
The fair values of the Company's $120 million secured note and $20 million secured note at December 31, 2016 approximated their carrying values.
At December 31, 2017, fixed maturity holdings rated below investment grade and non-rated comprised 3.4% 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 Company obtained unadjusted fair values on 98.0% of its investment portfolio from an independent pricing service. For private equity funds that were classified as Level 3 and included in equity securities at December 31, 2017 and 2016, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value. The fair value of such private equity funds was $1.5 million and $9.1 million at December 31, 2017 and 2016, respectively.
Private equity funds: Private equity funds, excluding a private equity fund measured at net asset value ("NAV"), are valued based on underlying investments of the fund or assets similar to such investments in active markets, taking into consideration specific unadjusted broker quotes based on net fund value and unobservable inputs from at least one knowledgeable outside security broker related to liquidity assumptions.
The Company’s financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment gains or loses in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
There were no transfers between Levels 1, 2, and 3 of of the fair value hierarchy in 2017 and 2016.
At December 31, 2017 and 2016, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
The fair values of the Company’s $120 million secured note and $20 million secured note at December 31, 2016 were estimated based on assumptions and inputs, such as the market value of underlying collateral and reset rates, for similarly termed notes that are observable in the market. In addition, the fair values of these secured notes approximated their carrying values, as the interest rates on these securities were variable and approximated current market interest rates.
In August 2017, the Company completed the sale of approximately six acres of land located in Brea, California (the "Property"), for a total sale price of approximately $12.2 million. Approximately $5.7 million of the total sale price was received in the form of a promissory note (the "Note") and the remainder in cash. The Note is secured by a first trust deed and an assignment of rents on the Property, and bears interest at an annual rate of 3.5%, payable in monthly installments. The Note matures in August 2020, and its fair value is included in other assets in the Company's consolidated balance sheets. Only the cash portion of the total sale price of the Property, excluding the Note, is reported in the Company's consolidated statements of cash flows. Interest earned on the Note is recognized in other revenues in the Company's consolidated statements of operations. The Company recognized a gain of approximately $3.3 million on the sale transaction, which is included in other revenues in its consolidated statements of operations.
On March 29, 2017, the Company entered into an unsecured credit agreement that provides for revolving loans of up to $50 million and matures on March 29, 2022. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is greater than or equal to 25%. Commitment fees for the undrawn portions of the
credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to total capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to total capital ratio was 17.6% at December 31, 2017, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of February 2, 2018, there have been no borrowings under this facility.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and risk based capital ("RBC") ratio under the unsecured credit facility at December 31, 2017.
Debt maturities for each of the next five years and thereafter as of December 31, 2017 are as follows:
On February 13, 2014, Fannette Funding LLC ("FFL"), a special purpose investment vehicle, formed by and consolidated into the Company, entered into a total return swap agreement with Citibank. Under the agreement, FFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest on the outstanding notional amount of the underlying obligations. The total return swap is secured by approximately $30 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets. The Company paid interest equal to LIBOR plus 145 basis points prior to the renewal of the agreement in January 2017 and LIBOR plus 128 basis points subsequent to the January 2017 renewal, on approximately $108 million of underlying obligations as of December 31, 2017 and 2016. The agreement had an initial term of one year, subject to annual renewal. In January 2018, the agreement was renewed through August 15, 2018, and the interest rate was changed to LIBOR plus 120 basis points.
There were no changes in the carrying amount of goodwill during 2017 and 2016. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2017 and 2016. All of the Company's goodwill is associated with the Property and Casualty business segment (See Note 21. Segment Information for additional information on the reportable business segment).
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2017 and 2016.
Other intangible assets with definite useful lives are amortized on a straight-line basis over their useful lives. Other intangible assets amortization expense was $5.4 million, $6.1 million, and $6.0 million for the years ended December 31, 2017, 2016, and 2015, respectively. None of the intangible assets with definite useful lives are anticipated to have a residual value.
The following table presents the estimated future amortization expense related to other intangible assets as of December 31, 2017:
In computing taxable income, property and casualty insurers reduce underwriting income by losses and loss adjustment expenses incurred. The amount of the deduction for losses incurred associated with unpaid losses is discounted at the interest rates
and for the loss payment patterns prescribed by the U.S. Treasury. The Act changes the prescribed interest rates to rates based on corporate bond yield curves and extends the applicable time periods for the loss payment pattern. These changes are effective for tax years beginning after 2017 and are subject to a transition rule that spreads the additional tax payments from the amount determined by applying these changes versus the previous calculated amount over the subsequent eight years beginning in 2018. The changes included in the Act related to discounting of unpaid losses are broad and complex. The Securities Exchange Commission has issued rules that would allow for a measurement period of up to one year after the enactment date of the Act to finalize the recording of the related tax impacts. The transitional impact of the Act will be finalized and recorded by the measurement period.
In accordance with the Act, the Company’s deferred tax assets and liabilities were remeasured using the newly enacted corporate tax rate of 21%. Additionally, the Company’s alternative minimum tax credit carryforward balance of $57.9 million and $47.2 million at December 31, 2017 and 2016, respectively, was reclassified to current income taxes receivable as a refundable credit. The Company believes it will realize the full benefit of the AMT credit no later than the tax year ending December 31, 2021.
The Company is currently under examination for tax years 2011 through 2016. For tax years 2011 through 2013, the FTB issued Notices of Proposed Assessments ("NPAs") to the Company, which the Company intends to formally protest. If a reasonable settlement is not reached, the Company intends to pursue other options, including a formal hearing with the FTB, an appeal with the California Office of Tax Appeals, or litigation in Superior Court. For tax years 2014 through 2016, the FTB commenced its audit in December 2017.
The Company does not expect the total amount of unrecognized tax benefits to materially increase within the next 12 months.
The increase in the provision for insured events of prior years in 2017 of approximately $54.4 million primarily resulted from higher than estimated losses in California automobile and property lines, which experienced higher loss severity on liability coverages including Bodily Injury and Property Damage and higher loss adjustment expenses than originally estimated.
The information about incurred and paid claims development for the years ended December 31, 2008 to 2016 is presented as unaudited supplementary information.
The following is unaudited supplementary information about average historical claims duration as of December 31, 2017.
The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between the Company’s closing stock price and the stock option exercise price, multiplied by the number of in-the-money stock options) that would have been received by the stock option holders had all stock options been exercised on December 31, 2017. The aggregate intrinsic values of stock options exercised were $371,000, $591,000, and $303,000 for 2017, 2016, and 2015, respectively. The total fair value of stock options vested during each of 2017, 2016, and 2015 was $142,000.
As of December 31, 2017, all of stock options outstanding were vested, and no additional compensation expenses related to these stock options will be recognized in the Company's consolidated statements of operations.
The following table presents the restricted stock unit grants summary at December 31, 2017:
The following table presents a summary of restricted stock unit awards activity, based on target vesting, during the years indicated:
In March 2017, approximately $3.6 million was paid upon the vesting of 61,445 RSUs awarded in 2014 resulting from the attainment of performance goals above the target threshold during the three-year performance period ended December 31, 2016.
In February 2016, 88,074 shares of common stock, net of 58,822 shares withheld for payroll taxes, were issued upon the vesting of 146,896 RSUs awarded in 2013 resulting from the attainment of performance goals above the target threshold during the three-year performance period from 2013 to 2015.
Potentially dilutive securities representing approximately 0, 27,600, and 67,000 shares of common stock for 2017, 2016, and 2015, respectively, were excluded from the computation of diluted earnings per common share because their effect would have been anti-dilutive.
The following table presents future minimum commitments for operating leases as of December 31, 2017:
loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, 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 or cash flows.
There are no environmental proceedings arising under federal, state, or local laws or regulations to be discussed.
Many businesses are 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, volatility in global capital markets could adversely affect the Company’s investment portfolio. 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.
Net income for 2017 was primarily attributable to net premiums earned, net investment income and net realized investment gains, partially offset by operating expenses, and losses and loss adjustment expenses, including catastrophe losses and unfavorable development on prior accident years' loss and loss adjustment expense reserves. The primary causes of the net income for the fourth quarter of 2017 were the increases in the fair value of the Company’s fixed maturity and equity securities due to the overall market improvement, net investment income, and a net tax benefit of $7.4 million due to the effect of the Act.
Net income for 2016 was primarily attributable to net premiums earned and net investment income, partially offset by net realized investment losses, operating expenses, and losses and loss adjustment expenses, including catastrophe losses and unfavorable development on prior accident years' loss and loss adjustment expense reserves. The primary cause of the net loss for the fourth quarter of 2016 was the declines in the fair value of the Company’s fixed maturity securities due to the rising market interest rates.
The Company paid $8 million in cash for the shares of WAIC, of which $2 million had been held in escrow for up to three years as security for any loss development on claims incurred on or prior to June 30, 2014. Based on the evaluation performed at the acquisition date and at December 31, 2015, of the claims reserves for WAIC for losses and loss adjustment expenses incurred on or prior to June 30, 2014, the Company estimated that it would recover the $2 million held in escrow and, therefore, the Company deducted it from cash consideration to arrive at the fair value of total consideration transferred. The Company recovered the $2 million held in escrow in 2016. In accordance with regulatory approval requirements, the Company made a $15 million cash capital contribution to WAIC on January 12, 2015.