Management's Discussion and Analysis of Financial Condition and Results ----------------------------------------------------------------------- of Operations -------------
In September 1996, the California Insurance Commissioner issued new permanent rating factor regulations designed to implement the requirements that automobile insurance rates be determined by (1) driving safety record, (2) years of driving experience, (3) miles driven per year and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further requires that each of the four factors be applied in decreasing order of importance.
The California private passenger automobile insurance marketplace continues to be extremely competitive which has placed downward pressure on rates. In April 1998, the Company reduced its average premium rate by 7%. Since 1999 was the first full year with the rate decrease in effect, average 1999 rates were lower than average 1998 rates. The Company has continued to increase its marketing efforts for both name recognition and lead generation purposes. Total amounts spent on advertising efforts during 1999 exceeded 1998 expenditures by approximately 70%. The Company believes that its advertising program is important to create brand awareness and to remain competitive in the current insurance climate.
The GAAP loss ratio in 1999 (loss and loss adjustment expenses related to premiums earned) was 66.4% compared with 61.0% in 1998. The less favorable loss ratio is primarily related to the rate decrease taken in April 1998 which had its full impact on the Company's results in 1999.
Net premiums written in 1998 of $1,144.1 million increased 5.3% over a year earlier, continuing a growth trend which began in the second quarter of 1994. The Company increased its marketing efforts in April 1998, launching a fully integrated radio and billboard advertising program. Although the campaign has not met expectations, the Company believes continuing the advertising program is necessary in the current competitive climate. The California automobile insurance marketplace remains intensely competitive. Most of the major direct writers, who represent the Company's chief competition, have instituted one or more rate reductions over the last twenty-four months and many have significantly increased their marketing efforts.
The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 26.6% in 1998 and 25.1% in 1997. The increase in the expense ratio was largely attributable to increased base commissions and profit-related bonuses to agents, expenses associated with the advertising program implemented in April 1998, and start up costs from the Company's entry into the Florida market.
Investment income in 1998 was $96.2 million, compared with $86.8 million in 1997. The after-tax yield on average investments of $1,474.0 million (cost basis) was 5.92%, compared with 6.17% on average investments of a $1,263.2 million in 1997. The effective tax rate on investment income was 9.3% in 1998, compared to 10.3% in 1997. The lower tax rate in 1998 reflects the benefits derived from replacing taxable issues held in the AMI investment portfolio, when purchased in December 1996, to non-taxable issues throughout the 1997 and 1998 fiscal years. The redemption of bonds acquired during higher interest periods has been a negative influence on realized yields in each of the last several years and is expected to continue in 1999. Bonds matured and called in 1998 totaled $65.3 million, compared with $54.0 million in 1997.
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.
Net cash provided from operating activities in 1999, was $188.9 million, while funds derived from the sale, redemption or maturity of investments was $558.3 million, of which approximately 80% was represented by the sale of equity securities. The amortized cost of fixed-maturity investments increased by $108.3 million during the year. Equity investments, including perpetual preferred stocks, increased by $18.4 million at cost, while short-term cash investments decreased by $2.4 million. The amortized cost of fixed-maturities available for sale that were sold, called or matured during the year was $112.9 million.
The Company's unrestricted cash and short term investments totaled $48.6 million at December 31, 1999. Together with funds generated internally, such liquid assets are more than adequate to pay claims without the sale of long term investments.
Equity holdings of $209.8 million at market (cost $238.9 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 23.1% of total shareholders' equity.
The Company had outstanding debt at December 31, 1999 of $92 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 as capital to AMI. The loan agreement may be extended annually for additional periods of one year each to maintain the three year maturity date. Due to an increase in interest rate spreads in the loan syndication market during 1999, the Company did not extend the maturity for an
additional one year period. The Company will reevaluate extending the current 2002 maturity date of this loan during 2000. 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 current effective rates, the net interest cost on the loan approximates 6.53%.
The Company also maintains a $100 million line of credit, of which $17 million was drawn on at December 31, 1999 and is due October 26, 2000. The line 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. Based on the current effective rates the net interest cost on the loan approximates 6.76%. The 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 2000.
Under the stock repurchase program, the Company may purchase over a one- year period up to $200 million of Mercury General's common stock. The purchases may be made from time to time in the open market at the discretion of management. The program will be funded by the sale of lower yielding tax-exempt bonds, the proceeds of the $100 million credit facility and internal cash generation. During 1999, the Company purchased 371,200 shares of the common stock in the open market at an average price of $22.73. Since the inception of the program in 1998 through December 31, 1999, the Company has purchased 951,200 shares of common stock at an average price of $34.41. The shares purchased were retired.
As of December 31, 1999, the Company had no material commitments for capital expenditures.
The California Earthquake Authority (CEA) is a Quasi-Governmental organization that was established in 1996 to provide a market for earthquake coverage to California homeowners. During the second quarter of 1998, the Company began placing all new and renewal earthquake coverage offered with its homeowners policy through the California Earthquake Authority. The Company receives a small fee for placing business with the CEA.
Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company's participation percentage multiplied by the amount of the total assessment. Based upon information provided by the CEA, the Company's maximum total exposure to CEA assessments at October 28, 1999, is approximately $11.5 million.
The Company incurred total costs of approximately $600,000 to modify its systems for Year 2000 compliance. The Company did not experience material Year 2000 problems and does not expect to incur any additional costs related to Year 2000 matters.
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, Mercury Indemnity Company of Illinois, 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. American Mercury MGA, Inc. (AMMGA),is 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. Effective October 31, 1999 the financial statements also include Concord Insurance Services, Inc., ("Concord") a Texas insurance agency controlled by MGC. Concord is discussed further in Note 8. All of the subsidiaries as a group, including AML, but excluding AFIMC, AMMGA, and Concord, 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.
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 nonsinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date.
Temporary unrealized investment gains and losses on securities available for sale are credited or charged directly to shareholders' equity as accumulated other comprehensive income, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statements of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method. Included in realized losses for 1999 is a $6.0 millionwrite-down of a preferred stock investment that became other than temporarily impaired during the third quarter of 1999.
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 Statement of Financial Accounting Standards No. 115 (SFAS No. 115), "Accounting for Certain Investments in Debt and Equity Securities", the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 and were drawn from standard trade data sources such as market and broker quotes. The carrying value of receivables, accounts payable and other liabilities is equivalent to the estimated fair value of those items. The 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.
During 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share", which requires presentation of basic and diluted earnings per share for all publicly traded companies effective for fiscal years ending after December 15, 1997. Note 15 contains the required disclosures which make up the calculation of basic and diluted earnings per share.
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 separate disclosure as operating segments.
Statement of Position 97-3 (SOP 97-3), "Accounting by Insurance and Other Enterprises for Insurance Related Assessments", provides guidance on the timing of recognition and measurement of liabilities for insurance related assessments. SOP 97-3 prescribes liability recognition when three conditions are met: (1) an assessment has been imposed or information available prior to the issuance of the financial statements indicates that it is probable that an assessment will be imposed, (2) the event obligating an entity to pay an imposed or probable assessment has occurred on or before the date of the financial statements and (3) the amount of the assessment can be reasonably estimated. It is effective for financial statements with fiscal years beginning after December 15, 1998. The Company initially adopted SOP 97-3 in 1999 with no impact to the Financial Statements.
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 implementation of SOP 98-1 in 1999 provided less than a $.01 contribution to 1999 earnings per share (diluted).
Statement of Financial Accounting Standards No. 133 (SFAS No. 133) "Accounting for Derivative Instruments and Hedging Activities" became effective for fiscal years beginning after June 15, 1999. Statement of Financial Accounting Standards No. 137 (SFAS No. 137) "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" defers the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. The Company is currently evaluating the impact that it will have on the Consolidated Financial Statements. The Company will adopt this new Standard on January 1, 2001.
In 1998, non-cash financing activities included receipt of $276,000 of common stock tendered at market value to exercise stock options.
On December 30, 1997, the Company paid $1,750,000 of principal plus $87,500 of interest to the seller of AMI. This amount represented repayment of a one year note which secured the seller's guaranty of the collectibility of certain assets of AMI.
The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 1998 are as follows:
At December 31, 1999 bond holdings rated below investment grade totaled approximately 1% of total investments. The average Standard and Poor's rating of the bond portfolio is AA. The amortized cost and estimated market value of fixed maturities available for sale at December 31, 1999, 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.
Interbank rate (LIBOR). Based on current effective rates, net interest cost on the $75 million loan and the $17 million draw at December 31, 1999 is approximately 6.53% and 6.76%, respectively.
Current................................ $ 418 $ 327 $ 291 Deferred............................... -- -- -- ------ ------ ------ $ 418 $ 327 $ 291 ====== ====== ======
Total Current................................ $36,953 $57,564 $54,738 Deferred............................... (2,123) 190 (1,265) ------ ------ ------ Total............................. $34,830 $57,754 $53,473 ====== ====== ======
Year ended December 31, (Amounts in thousands) ------------------------ 1999 1998 1997 ---- ---- ---- Computed tax expense at 35% ..................... $ 58,989 $ 82,348 $ 73,423 Tax-exempt interest income....................... (25,398) (23,496) (19,188) Dividends received deduction..................... (3,953) (5,437) (5,389) Reduction of losses incurred deduction for 15% of income on securities purchased after August 7, 1986 4,348 4,245 3,640 Other, net....................................... 844 94 987 ------ ------ ------ Income tax expense ......................... $ 34,830 $ 57,754 $ 53,473 ====== ====== ======
Deferred tax liabilities Deferred acquisition costs (22,391) (21,681) Tax liability on net unrealized gain on securities carried at market value........ -- (27,567) Tax depreciation in excess of book depreciation.............................. (1,351) (1,545) Accretion on bonds......................... (2,008) (1,467) Other deferred tax liabilities............. (2,897) (1,163) -------- -------- Total gross deferred tax liabilities..... (28,647) (53,423) -------- -------- Net deferred tax assets (liabilities).... $ 28,541 $(22,639) ======== ========
Year ended December 31, (Amounts in thousands) ---------------------- 1999 1998 1997 ---- ---- ---- Gross reserves for losses and loss adjustment expenses at beginning of year.. $405,976 $409,061 $336,685 Less reinsurance recoverable............... (20,160) (22,791) (24,931) ------- ------- ------- Net reserves, beginning of year............ 385,816 386,270 311,754
Incurred losses and loss adjustment expenses related to: Current year........................... 781,316 693,877 641,911 Prior years............................ 7,787 (9,409) 12,818 ------- ------- ------- Total incurred losses and loss adjustment expenses.................................. 789,103 684,468 654,729 ------- ------- -------
Loss and loss adjustment expense payments related to: Current year........................... 492,314 437,612 373,823 Prior years............................ 263,805 247,310 206,390 ------- ------- ------- Total payments............................. 756,119 684,922 580,213 ------- ------- -------
Increases in prior years incurred losses in 1999 relate to a reduction in the Company's estimate of the decrease in average bodily injury cost per claim. In prior years, the average bodily injury cost had trended downward and the Company had factored this trend into its 1998 year-end reserve estimates. The actual amount of reduction in average claim costs proved to be less when developed through year-end 1999 than was originally anticipated at year-end 1998.
Concord produces annually approximately $20 million of non-standard auto business in the state of Texas and performs all duties associated with an insurance company, including underwriting and claims management. However, Concord as an agent assumes no underwriting risk. Through December 31, 1999, the Concord business was assumed 100% by an unaffiliated reinsurer. Effective January 1, 2000, the Company replaced Concord's existing reinsurer (for new and renewal business) and is assuming 100% of the risks produced by Concord. The Company plans to expand Concord's product line.
The transaction was accounted for using the purchase method of accounting, and resulted in an immaterial amount of goodwill that will be amortized using the straight-line method over a ten-year period.
The Insurance Companies' statutory net income, as reported to regulatory authorities, was $135,667,000, $173,473,000 and $147,255,000, for the years ended December 31, 1999, 1998 and 1997, respectively. The statutory policyholders' surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 1999 and 1998 was $853,794,000 and $767,223,000, respectively.
The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2008. Total rent expense under these lease agreements, all of which are operating leases, was $3,320,000,$2,074,000 and $1,885,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
Rent Rent Year Expense Income ---- ------- ------ 2000.................... $3,577 $(186) 2001.................... $3,121 -- 2002.................... $2,330 -- 2003.................... $1,393 -- 2004.................... $1,176 -- Thereafter.............. $3,784 --
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 Consolidated 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 $542,000, $454,000, and $363,000 in 1999, 1998 and 1997, respectively, and earnings per share (basic and diluted) would have been reduced by .01 in 1999 and 1998 and would have remained the same in 1997. 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 1999, 1998 and 1997: dividend yield of 3.8 percent for 1999 and 2.0 percent for prior years, expected volatility of 31.6 percent in 1999, 32.7 percent for 1998 and 30 percent for 1997 and expected lives of 7 years for all years. The risk-free interest rates used were 5.6 percent for the options granted during 1999, 5.4 percent for the options granted during 1998, and 6.4 percent for the options granted during 1997.