Implementing rate changes varies by state with California and Georgia requiring prior approval from the DOI before a rate can be implemented. Illinois and Texas only require that rates be filed with the DOI, while Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be “excessive, inadequate or unfairly discriminatory.”
Effective July 15, 2002, the Company implemented a 10.1% rate increase in Florida private passenger automobile insurance and has also taken rate increases in other states where business is written. The Company received approval for an approximate 7.1% rate increase for Florida private passenger automobile insurance, effective February 1, 2003 for new business and March 10, 2003 for renewal business.
A 6.9% rate increase on the California’s homeowner’s line of business was approved and became effective on May 15, 2002. The Company also received approval for an additional 6.9% California homeowner’s rate increase that was implemented December 15, 2002.
The Company has pending rate increases on its California private passenger automobile insurance of 4.6% on MIC and 6.9% on MCC and Cal Auto. The Company will continue to seek additional rate increases in California as well as other states at a rate that keeps pace with or exceeds loss cost inflation.
In a recent court ruling that affects the tax years 1997 through 2000, a statute that allowed Mercury General a tax deduction for the dividends received from its wholly-owned insurance subsidiaries was held unconstitutional on the grounds that it discriminated against out-of-state insurance holding companies. Based on the court ruling, the FTB is taking the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB is disallowing dividend-received deductions for all insurance holding companies, regardless of domicile, for tax years ending on or after December 1, 1997 (See Note 6 “Income Taxes” to the Consolidated Financial Statements). The Company has been assessed $17.3 million plus interest for the 1997 through 2000 tax years. The Company intends to protest the proposed assessments. The FTB has recently begun an audit of the 2001 tax year.
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.
The Company carries its fixed maturity and equity investments at market value as required for securities classified as “Available for Sale” by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). In most cases, market valuations were drawn from 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. The Company constantly evaluates its investments for other than temporary declines and writes them off as realized losses through the Statement of Income, as required by SFAS No. 115 when recovery of the net book value appears doubtful. Temporary unrealized investment gains and losses are credited or charged directly to shareholders’ equity as accumulated other comprehensive income, net of applicable taxes. It is possible that future information will become available about the Company’s current investments that would require accounting for them as realized losses due to other than temporary declines in value. The financial statement effect would be to move the unrealized loss from accumulated other comprehensive income on the Balance Sheet to realized investment losses on the Statements of Income.
The California private passenger automobile insurance marketplace is experiencing rising premium rates. The Company and virtually all of its competitors have filed and implemented rate increases, which helped spur the Company’s premium growth during 2002 (See Overview).
Investment income in 2002 was $113.1 million, compared with $114.5 million in 2001. The after-tax yield on average investments of $2,035.3 million (cost basis) was 4.87%, compared with 5.41% on average investments of $1,828.5 million (cost basis) in 2001. The effective tax rate on investment income was 12.4% in 2002, compared to 13.6% in 2001. The lower tax rate in 2002 reflects a shift in the mix of the Company’s portfolio from taxable to non-taxable issues. Bonds matured and called in 2002 totaled $120.5 million, compared to $67.6 million in 2001. Assuming market interest rates remain the same, the Company expects approximately $300 million of bonds to
mature or be called in 2003. The proceeds will be reinvested into securities meeting the Company’s investment profile and will earn lower yields than previously generated.
Net realized investment losses in 2002 were $70.4 million, compared with net realized gains of $6.5 million in 2001. Included in the net realized investment losses for 2002 are $71.7 million of investment write-downs that the Company considered to be other-than-temporarily impaired. The investment write-downs were on investments primarily in the telecommunications and energy sectors.
Net income in 2002 was $66.1 million or $1.21 per share (diluted), compared with $105.3 million or $1.94 per share (diluted), in 2001. Diluted per share results are based on 54.5 million average shares in 2002 and 54.4 million shares in 2001. Basic per share results were $1.22 in 2002 and $1.94 in 2001.
The GAAP expense ratio in 2001 (policy acquisition costs and other operating expenses related to premiums earned) was 26.4% compared with 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.
Investment income in 2001 was $114.5 million compared with $106.5 million in 2000. The after-tax yield on average investments of $1,828.5 million (cost basis) was 5.41%, compared with 5.56% on average investments of $1,710.2 million (cost basis) in 2000. The effective tax rate on investment income in 2001 was 13.6%, compared with 10.6% in 2000. The higher tax rate and decrease in investment yields in 2001 reflect a shift in the Company’s portfolio mix from non-taxable to taxable issues. Bonds matured and called in 2001 totaled $67.6 million compared with $45.6 million in 2000.
Realized investment gains in 2001 were $6.5 million compared with realized losses of $3.9 million in 2000.
The income tax provision of $19.5 million in 2001 represented an effective 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.
Mercury General 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, Mercury General’s insurance subsidiaries are entitled to pay, without extraordinary approval, dividends of approximately $98 million in 2003, less dividends paid during the preceding twelve month period. The actual amount of dividends paid from insurance subsidiaries to Mercury General during 2002 was $75 million. As of December 31, 2002, Mercury General also had approximately $36 million in fixed maturity securities, equity securities and cash that can be utilized to satisfy its direct holding company obligations.
Net cash provided from operating activities in 2002 was $342.6 million, an increase of $143.1 million over 2001. This increase was primarily due to the growth in premiums collected of $338.7 million over 2001; reflecting increases in both policy sales and rates partially offset by an increase in losses paid in 2002. The Company has reinvested a portion of cash provided by operating activities in the construction of additional office space and the purchase and development of information technology. Excess cash not used in investing and financing activities was invested in short term cash investments. Funds derived from the sale, redemption or maturity of investments of $663.5 million, were reinvested by the Company generally in higher rated fixed maturity and equity securities.
The market value of all investments held at market as “Available for Sale” exceeded the amortized cost of $2,085.9 million at December 31, 2002 by $64.8 million. That unrealized gain, reflected in shareholders’ equity, as Accumulated Other Comprehensive Income, net of applicable tax effects, was $42.1 million at December 31, 2002 compared with a gain of $17.0 million at December 31, 2001. The increase in unrealized gains at December 31, 2002 is due mainly to the write-down of investments that the Company considered to be other than temporarily impaired.
Equity holdings of $231.0 million at market (cost $233.3 million), including perpetual preferred issues, are largely confined to the public utility and finance sectors and represent about 21% of total shareholders’ equity.
On August 7, 2001, the Company completed a public debt offering issuing $125 million of senior notes payable under a $300 million shelf registration filed with the SEC in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year commencing February 15, 2002. These notes mature on August 15, 2011. The Company used the proceeds from the senior notes to retire amounts payable under existing revolving credit facilities, which were terminated. 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 swap significantly reduced interest expense in 2002, but does expose the Company to higher interest expense in future periods, should LIBOR rates increase. The effective annualized interest rate in 2002 was 2.9%. The swap is accounted for as a fair value hedge under SFAS No. 133 (See
Consolidated Statements of Comprehensive Income for Each of the Years in the Three-Year Period Ended December 31, 2002
Consolidated Statements of Shareholders’ Equity for Each of the Years in the Three-Year Period Ended December 31, 2002
Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2002
The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. In 2002, 2001 and 2000, over 85% of the net written premiums were from California.
The consolidated financial statements include the accounts of Mercury General Corporation (the “Company”) 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). American Mercury MGA, Inc. (AMMGA), is a wholly owned subsidiary of AMIC. AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact, AFIMC. MCM is not owned by the Company but is controlled through a management contract. The results of MCM are included in the financial statements effective September 30, 2000. MCM is discussed further in Note 8 of the Notes to Consolidated Financial Statements. The financial statements also include Concord Insurance Services, Inc., (Concord) a Texas insurance agency owned by the Company. 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.
Under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“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 of the Notes to Consolidated Financial Statements 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 Reinsurance Corporation note in the MCM transaction. The terms of the notes are discussed in Note 5 of the Notes to Consolidated Financial Statements.
Goodwill and other intangible assets represent the excess of the purchase price of acquired businesses over the fair value of net assets acquired using the purchase method of accounting. Included in the Company’s balance sheet are goodwill of $7.3 million and other intangible assets of $9.3 million. The Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”, as of January 1, 2002. The goodwill and other intangible assets were determined to have an indefinite useful life and in accordance with SFAS No. 142 are not amortized, but tested for impairment annually. The fair value of goodwill and other intangibles are measured annually based upon projected discounted operating cash flows using a market rate of interest to discount the cash flows. No impairment was recorded at December 31, 2002. Prior to January 2002, the Company amortized these assets over their expected useful lives and recorded amortization expense for goodwill and other intangible assets of $1.9 million in 2001 and $1.2 million in 2000.
The Insurance Companies, as primary insurers, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.
Interest paid during 2002, 2001 and 2000, was $6,435,000, $4,610,000 and $7,357,000, respectively. Income taxes paid were $21,154,000 in 2002, $20,089,000 in 2001 and $14,609,000 in 2000.
The tax benefit realized on stock options exercised and included in cash provided from operations in 2002, 2001 and 2000 was $389,000, $587,000 and $549,000, respectively.
In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs and it applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. Under SFAS No. 143, a company is required to 1) record an existing legal obligation associated with the retirement of a tangible long-lived asset as a liability when incurred and the amount of the liability be initially measured at fair value, 2) recognize subsequent changes in the liability that result from (a) the passage of time and (b) revisions in either the timing or amount of estimated cash flows and 3) upon initially recognizing a liability for an asset retirement obligation, an entity shall capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, with earlier application encouraged. The adoption of SFAS No. 143 will not have a material impact on the financial statements.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Terminations Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred as opposed to the date of an entity’s commitment to an exit plan as required under EITF 94-3. SFAS No. 146 also requires that measurement of the liability associated with exit or disposal activities be at fair value. SFAS No. 146 is effective for the Company for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the Company’s financial statements.
In October 2002, the FASB issued SFAS No. 147, “Acquisition of Certain Financial Institutions” (“SFAS No. 147”), which addresses the financial accounting and reporting for the acquisition of all or a part of a financial institution, except for transactions between two or more mutual enterprises. Under SFAS No. 147, the acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, Business Combinations. SFAS No. 147 also provides guidance on accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises. SFAS No. 147 is effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions related to accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises are effective on October 1, 2002. Management of the Company anticipates that the adoption of SFAS No. 147 is not expected to have a material impact on the Company’s financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS No. 148”) which amends SFAS Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The
At December 31, 2002, bond holdings rated below investment grade were less than 2% of total investments. The average Standard and Poor’s rating of the bond portfolio was AA. The amortized cost and estimated market value of fixed maturities available for sale at December 31, 2002 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
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 swap agreement terminates on August 15, 2011 and includes an early termination option exercisable by either party on the fifth anniversary or each subsequent anniversary by providing sufficient notice, as defined. The swap significantly reduced interest expense in 2002, but does expose the Company to higher interest expense in future periods, should LIBOR rates increase. The effective annualized interest rate in 2002 was 2.9%. The swap is accounted for as a fair value hedge under SFAS No. 133.
As part of the Mercury County Mutual Insurance Company transaction, the Company agreed to make annual $1 million payments to Employers Reinsurance Corporation over 7 years beginning September 30, 2001. At December 31, 2002, the Company was carrying a note payable for $4.2 million, which represents the discounted value of the five remaining annual payments using a 7% rate.
The State of California has completed income tax audits on Mercury General Corporation for tax years ended December 31, 1993 through 1996. As part of these audits the California Franchise Tax Board (“FTB”) is challenging the Company’s ability to deduct a portion of its management and interest expenses. Upon completion of the audits for tax years ended December 31, 1993 through 1996, the FTB proposed assessments of approximately $7,600,000, plus interest. The Company has formally appealed the proposed assessments and is currently awaiting
The Company has estimated the Risk-Based Capital Requirements of each of the Insurance Companies as of December 31, 2002 according to the formula issued by the NAIC. Each of the Insurance Companies’ policyholders’ surplus exceeded the highest level of minimum required capital.
In Sheila Leivas, Individually And On Behalf Of All Others Similarly Situated vs. Mercury Insurance Company (Orange County Superior Court), filed July 12, 2002, the Company is defending a suit involving a dispute over premium retained by the Company during a time when the plaintiff was not covered following a voluntary cancellation of the policy and prior to reinstatement of the policy. The plaintiff is seeking to have the case certified as a class action. The plaintiff is seeking actual and punitive damages, and injunctive relief. The Company was successful on its demurrer to the plaintiff’s original complaint. The plaintiff has filed an amended complaint and the Company intends to file a demurrer to the amended complaint. The Company intends to continue to vigorously defend this case.
A stay of all actions is currently in place in the coordinated proceedings in which O’Dell and Goodman case are included. Hearings on the demurrers and other preliminary motions of the defendants are expected to take place sometime in the summer of 2003.
The Company, at the option of the Board of Directors, may make annual contributions to an employee profit sharing plan. The contributions are not to exceed the greater of the Company’s net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed an amount equal to 15% of the compensation paid or accrued during the year to all participants under the plan. The annual contribution was $1,500,000, $1,300,000 and $1,100,000 for plan years ended December 31, 2002, 2001 and 2000, respectively.
The Profit Sharing Plan also includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $2,030,000, $1,787,000 and $1,805,000 for the plan years ended December 31, 2002, 2001 and 2000.
Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan (“ESOP”) that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP’s debt service less dividends received by the ESOP. Dividends received by the ESOP on unallocated shares are used to pay debt service and the ESOP shares serve as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6.
Accordingly, the debt of the ESOP, which was $1,000,000, $2,000,000 and $3,000,000 at December 31, 2002, 2001 and 2000, respectively, is recorded in the balance sheet as other liabilities. The shares pledged as collateral are reported as unearned ESOP compensation in the shareholders’ equity section of the balance sheet. As shares are committed to be released from collateral, the Company reports compensation expense equal to the market price of the shares, and reduces unearned ESOP compensation by the original cost of the shares. The difference between the market price and cost of the shares is charged to common stock. As shares are committed to be released from collateral, the shares become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of accrued interest. ESOP compensation expense was $1,009,000, $862,000 and $642,000 in 2002, 2001 and 2000, respectively. The ESOP shares as of December 31 were as follows:
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, 2002 no awards other than options have been granted.
As explained in Note 1, the Company applies APB No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Consolidated Statements of Income.