Since December 1986, Mercury General's executive offices are located in a 40,000 sq. ft. office building owned by Mercury Casualty Company. The Company occupies approximately 95% of the building and leases the remaining office space to others.
The Company leases most of its other California offices under short-term leases. Office location is not material to the Company's operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.
The Company did business only in the state of California until 1990, when it began operations in Georgia and Illinois. During 1995, approximately 98% of its direct premiums written were in California. Since November 1988, the Company's California insurance operations have been subject to the provisions of Proposition 103, a state-wide initiative passed by the California voters. The provision of Proposition 103 that has the most significant current impact on the Company is a requirement that no rate may be used by a property and casualty insurer in California after November 8, 1989 that has not been approved by the California Insurance Commissioner (the "Commissioner").
In February 1994, the Commissioner approved new rates which were designed to improve the Company's competitive position for new insureds. These rate changes, which became effective on May 1, 1994, provided for decreases in premium rates for insureds new to the Company or its agents. Further rate modifications were approved and made effective on October 15, 1995. The 1994 and 1995 rate changes have resulted in a substantial increase in new business being submitted to the Company. Automobile policies in force in California have increased by approximately 87,000 to 391,898 since the new rates were first established, an annual rate of increase of over 18%, compared with an annualized growth rate of 9.1% over the prior eighteen month period. Net premiums written since July 1, 1994 have increased at a compounded rate of 15.6%, compared with average annual premium growth of 3.7% over the preceding five and one-half years following passage of Proposition 103 in 1988.
Premiums earned in 1995 increased 16.4%, primarily reflecting unit growth. Average premium per policy for the year was substantially unchanged. Net premiums written in 1995 increased 15.6% over a year earlier, continuing a growth trend which began in the second quarter of 1993.
The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 24.4%, compared with 25.2% in 1994. The improvement reflects both economies related to greater premium volume and smaller provisions for agent and employee incentive bonuses in 1995.
Premiums earned in 1994 increased 11.7%, reflecting unit growth. Average premium per policy was substantially unchanged by the May 1, 1994 rate revisions. Direct premiums written in the first half of 1994 increased 10.7% over a year earlier, continuing the growth trend which began in the second quarter of 1993. During the last half of 1994, this increase accelerated to 14.1% over the prior year as a result of the May 1, 1994 rate revisions.
Realized investment losses in 1994 were $9.9 million, compared with realized gains of $3.0 million in 1993. The losses reflect principally yield- enhancing swaps of both fixed maturities and equity securities, including perpetual preferred stocks. The 1993 gains arose in significant part from the redemption of fixed-maturity investments. The realized capital losses were undertaken to recapture capital gains taxes paid in prior years.
The loss ratio in 1993 was 61.0%, compared with 60.6% in 1992. The 1992 ratio was computed without adjustment for the impact of the Proposition 103 rate refund provision. The historically low loss ratios in both years reflect, principally, the seasoned characteristics of the Company's existing book of business and the continued favorable loss severity trends in the automobile bodily injury line in California. Reduced exposure to unprofitable assigned risk business contributed to the improvement, as did continued favorable loss reserve development. The more competitive rates which will apply to new business effective on May 1, 1994 are expected to produce an increase in the proportion of new, unseasoned risks insured by the Company. Loss experience on new business is characteristically less favorable than that of seasoned business.
The expense ratio (policy acquisition costs and other expenses related to premiums earned) was 25.0% in 1993, compared with 24.5% in 1992. The expense ratio has remained at or below 25% in each of the last five years.
Net investment income in 1993 was $54.1 million, compared with $53.0 million in 1992. Average invested assets in 1993 (fixed maturities at cost/equities at market) were $683.9 million, a year-to-year increase of 5.4%. Reflecting the declining trends in interest rates in 1993, the average pre-tax yield for the period was 7.9% in 1993 and 8.2% in 1992. The effective tax rate on investment income was 10.9% in 1993 and 12.5% in 1992. The year-to-year decrease of approximately 25 basis points in the overall portfolio yield was significantly related to the maturity and call of approximately $134.4 million of relatively high coupon fixed maturity investments acquired in prior higher interest rate environments.
Realized investment gains were $3.0 million in 1993 and $5.2 million in 1992. The 1993 gains arose in significant part from calls of fixed-maturity investments. Sales of equity securities in 1993, particularly in the fourth quarter, produced losses of $1.7 million, partially offsetting the taxable gains generated by the early call of fixed maturity investments.
Income before taxes was $125.5 million, compared with $108.0 million in 1992. The provision for final settlement of the Proposition 103 refund obligation in 1992 reduced income before income taxes by $18.6 million.
The income tax provision in 1993 was $29.3 million, an effective tax rate of 23.3%, compared with a tax provision of $24.7 million, an effective rate of 22.9%, in the corresponding 1992 period. Excluding the impact of the rate refund
The market value of all investments (fixed-maturities and equity securities) held at market as "Available for Sale" exceeded the amortized cost of $855.9 million at December 31, 1995 by $38.8 million. That unrealized gain, reflected in shareholders' equity net of applicable tax effects, was $25.2 million at December 31, 1995 compared with an unrealized loss of $12.7 million at December 31, 1994. The increase in market values since December 31, 1994 reflects principally the substantial decline in intermediate and long term interest rates which occurred during the period.
The Company's cash and short term investments totaled $31.4 million at December 31, 1995. Together with funds generated internally, such liquid assets are more than adequate to pay claims without the sale of investments.
(maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is a much better indicator of price volatility than simple maturity alone. Bond holdings are broadly diversified geographically, and, within the tax-exempt sector, consist largely of high coupon revenue issues, many of which have been pre-refunded and escrowed with U.S. Treasuries. General obligation bonds of the large eastern cities have generally been avoided.
The Company holds no direct obligations of Orange County, California, which has filed for protection under the bankruptcy laws. The Company does, however, hold $8.8 million principal amount of bonds issued by entities within Orange County, some of which may be affected by losses arising from participation in the Orange County investment pool. Exclusive of those bonds that have been either insured or pre-refunded with U.S. Treasuries, the Company's total holdings of issues affected by investments in the Orange County pool approximates $7.7 million based on market value at December 31, 1995. The Company has reviewed those holdings and believes that it will incur no losses as a result of the Orange County bankruptcy filing.
In March 1994, the Company's Employee Stock Ownership Plan (the Plan) purchased 161,000 shares of Mercury's common stock in the open market at a price of $29.75 per share. The purchases were funded by a $5.0 million bank loan to the Plan which is guaranteed by the Company. The shares are being allocated to employees over a five year period, with the initial allocation made in December 1994, and the debt is being retired by Company contributions to the Plan over the same time period. Since dividends on unallocated shares held by the Plan are tax deductible if they are used for debt service, as are Company contributions to the Plan, the net, after-tax interest cost to the Company for the borrowed funds used for the Plan stock purchase is less than the nominal 6.98% fixed rate of interest on the loan.
In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1995. Each of the companies' policyholders' surplus exceeded the highest level of recommended capital requirements.
Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to statutory policyholders' surplus should not exceed 3.0 to 1. Based on the combined surplus of all of the licensed insurance subsidiaries of $479.1 million at December 31, 1995, and net written premiums for the twelve months ended on that date of $636.6 million, the ratio of writings to surplus was approximately 1.3 to 1.
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 Indemnity Company of Georgia and Mercury Indemnity Company of Illinois. Collectively, the subsidiaries 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.
The Company adopted Statement of Financial Accounting Standards No. 115 ("SFAS No. 115"), "Accounting for Certain Investments in Debt and Equity Securities" on December 31, 1993. The Company transferred all $281,937,000 of Fixed Maturities, at amortized cost on that date to Fixed Maturities Available for Sale. Fixed maturities available for sale include those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. Short-term investments are carried at cost, which approximates market. Investments in equity securities, which include common stocks and non-redeemable preferred stocks, are carried at market.
Insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are computed on the monthly pro rata basis. The liability is stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets.
Effective January 1, 1993, the Company provides for income taxes in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS No. 109") "Accounting for Income Taxes." Deferred income taxes result from temporary differences in the recognition of income and expense for tax and financial reporting purposes. The adoption of SFAS No. 109 on January 1, 1993 did not have a material effect on the Company's financial condition or its results of operations. The recoverability of the deferred tax asset is demonstrated by the recoverability of taxes paid in previous years and the availability of tax planning strategies.
In accordance with SFAS No. 113, the liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The ceded amounts are immaterial and are carried in other assets and other receivables. Earned premiums are stated net of deductions for ceded reinsurance.
Interest paid during 1995, 1994, and 1993 was $1,970,000, $1,001,000, and $791,000 respectively. Income taxes paid were $18,954,000 in 1995, $19,315,000 in 1994, and $34,679,000 in 1993.
The amortized cost and estimated market value of fixed maturities available for sale at December 31, 1995, 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.
Notes payable at December 31, 1995 consists of two unsecured notes payable dated December 20, 1994. The combined principal amount on the notes of $25,000,000 is payable on December 20, 1997. The interest cost of the loans is variable and related to the London Interbank Rate (LIBOR). Based on the rate effective through March 19, 1996, the net interest cost on the loans at December 31, 1995 is 6.4%.
The terms of the debt agreement include certain affirmative covenants, all of which are met by the Company at December 31, 1995.
The Omnibus Budget Reconciliation Act of 1993 increased the corporate tax rate from 34% to 35% effective January 1, 1993. Under SFAS No. 109, the effects of the higher corporate tax rate are recognized in determining tax on deferred items in the period that includes the date of enactment. The effect of the tax rate change on the deferred liability was not material to the consolidated financial position of the Company.
The "temporary differences" that give rise to a significant portion of the deferred tax asset (liability) relate to the following:
The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 1995, there were no material permitted statutory accounting practices utilized by the Insurance Companies. The NAIC is working on a project to codify statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. When complete, that project will most likely change the definition of prescribed versus permitted statutory accounting practices and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements.
The Company is obligated under several noncancellable lease agreements providing for office space that expire at various dates through the year 2000. Total rent expense under these lease agreements, all of which are operating leases, was $1,461,000, $1,492,000 and $1,653,000 for the years ended December 31, 1995, 1994 and 1993, respectively. Mercury Casualty Company will receive minimum future rentals on various noncancellable operating leases on a building purchased in Brea in October 1992. The annual rental commitments, expressed in thousands, are as follows:
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 $773,000, $762,000 and $593,000 for the plan years ended December 31, 1995, 1994 and 1993.
The Company adopted a stock option plan in October 1985 (the "1985 Plan") under which 2,700,000 shares were reserved for issuance. Options granted during 1985 were exercisable immediately. Subsequent options granted become exercisable 20% per year beginning one year from the date granted. All options were granted at the market price on the date of the grant.
In May 1995 the Company adopted The 1995 Equity Participation Plan (the "1995 Plan") which succeeds the Company's 1985 Plan. Under the 1995 Plan, 2,700,000 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 the 1994 and 1995 Plans. The options granted during 1995 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.