The Company owns the following buildings which are mostly occupied by the Company’s employees. The space not occupied by the Company is leased to independent third party tenants. In addition, the Company owns a 4.2 acre parcel of land in Brea, California for future expansion. The Company leases all of its other 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. The Company’s properties are well maintained, adequately meet its needs and are being utilized for their intended purposes.
Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California automobile insurance markets; the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies; the achievement of the synergies and revenue growth from the acquisition of AIS; the Company’s success in managing its business in states outside of California; the impact of potential third party “bad-faith” legislation, changes in laws or regulations, tax position challenges by the California Franchise Tax Board (“FTB”), and decisions of courts, regulators and governmental bodies, particularly in California; 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; the investment yields the Company is able to obtain with its investments in comparison to recent yields and the general market risk associated with the Company’s investment portfolio; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters in the markets served by the Company; the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives; the Company’s ability to realize current deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other uncertainties, all of which are difficult to predict and many of which are beyond the Company’s control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods.
The Company expects to continue its growth by expanding into new states in future years with the objective of achieving greater geographic diversification. There are challenges and risks involved in entering each new state, including establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems, and finding qualified agents to represent the Company. The Company does not expect to enter into any new states during 2010.
The Company’s net income for the year ended December 31, 2009 increased to $403.1 million or $7.32 per diluted share from a net loss of $(242.1) million, or $(4.42) per diluted share, for the same period in 2008. The Company also generated income from its investment portfolio. Approximately $145 million in pre-tax investment income was generated during 2009 on a portfolio of approximately $3.1 billion at fair value at December 31, 2009, compared to $151 million pre-tax investment income during 2008 on a portfolio of approximately $2.9 billion at fair value at December 31, 2008. Included in net income (loss) are net realized investment gains of $346.4 million in 2009 compared with net realized investment losses of $550.5 million in 2008. Net realized investment gains include gains of $395.5 million in 2009 due to changes in the fair value pursuant to election of the fair value accounting option compared with losses of $525.7 million in 2008.
During 2009, 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 very competitive in California and in other states.
The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower rates yet realize better margins than many competitors.
Effective January 1, 2009, the Company acquired AIS with the expectation that the acquisition would result in various benefits including enhanced revenue and profits, greater market presence and development, and enhancements to the Company’s product portfolio and customer base. In 2009, the AIS operations were fully integrated into the Company.
Underwriting Cycle and Competition-The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company has historically seen premium growth in excess of 20% during hard markets. Premium growth rates in soft markets have been from slightly
In 2009, the Company continued the implementation of its internet agency portal, Mercury First, which is now in use in New York, Virginia, and Florida. The Company plans to roll out Mercury First to the remaining states in which it operates with private passenger auto in 2010 and several states with homeowners and commercial auto in 2011. Mercury First is a single entry point for agents providing a broad suite of capabilities. One of its most powerful tools is a Point of Sale (POS) system that allows agents to easily obtain and compare quotes and write new business. Mercury First is also an easy-to-use agency portal that provides a customized work queue for each agency user showing new business leads, underwriting requests and other pertinent customer information in real time. Agents can also assist customers with processing payments, reporting claims or updating their records. The system enables quick access to documents and forms and empowers the agents with several self-service capabilities. Additional POS solutions for commercial auto and homeowners lines are planned to be in use in 2010.
The Company has developed a NextGen computer system to replace its legacy underwriting, billings, claims and commissions systems for private passenger auto. The NextGen system was designed to be a multi-state, multi-line system to enable the Company to enter new states more rapidly, as well as to improve response times to legislative and regulatory changes. The Company has completed the rollout of NextGen for all underwriting, billing, claims, and commission functions supporting the private passenger auto line in seven states (Virginia, New York, Florida, California, Georgia, Illinois, and Texas), and expects that NextGen will be implemented in the remaining states in which the Company operates during 2010 and 2011. During 2009, the Company entered into a pilot program with Guidewire, a commercially available software solution, for the homeowners line of business to replace legacy platforms. Guidewire implementation will begin in 2010.
As part of the Company’s commitment to service excellence, the Company launched an initiative in 2008 to improve its call center technologies. The initiative’s goal is to enhance telephony infrastructure using Voice over Internet Protocol, centralized call recording, quality monitoring, and workforce management software. The technology has been integrated with the Company’s claim processing software and deployed to the centralized customer service call center. The Company also implemented Astonishing Customers Everyday in 2009, a highly streamlined loss application system which enhances the personal auto claims process including automated rental car reservations, repair services, and a new roadside assistance program.
The process for implementing rate changes varies by state, with California, Georgia, New York, New Jersey, Pennsylvania and Nevada requiring prior approval from the respective DOI before a rate may be implemented. Illinois, Texas, Virginia, Arizona, and Michigan 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. During 2008, the Company implemented automobile and homeowners insurance rate decreases in California. During 2009, the Company implemented automobile rate increases in four other states and a decrease in one other state.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance (“NNC”) to the NNC originally issued in February 2004 alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. Through this action, the California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee, which the California DOI contends is the use of an unapproved rate, rating plan or rating system. Further, the California DOI seeks to impose a penalty for each and every date on which the Company allegedly used a misleading advertisement alleged in the NNC. Finally, based upon the conduct alleged, the California DOI also contends that the Company acted fraudulently in violation of Section 704(a) of the California Insurance Code, which permits the California Commissioner of Insurance to suspend certificates of authority for a period of one year. The Company filed a Notice of Defense in response to the NNC. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company, denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. While a hearing before the administrative law judge had been set to start on September 14, 2009, the hearing has been vacated and continued to a future date to be determined. This matter has been the subject of five continuations since the original NNC was issued in 2004.
The preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $2,500 to $3,000, on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $7,500 to $9,000. The Company creates incurred and paid loss triangles to estimate ultimate losses utilizing historical payment and reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity. As a larger proportion of claims from an accident year are settled, there becomes a higher degree of certainty for the reserves established for that accident year. Consequently, there is a decreasing likelihood of reserve development on any particular accident
The Company believes that it is reasonably possible that the California automobile BI inflation rate could vary from recorded amounts by as much as 10%, 5%, and 3% for 2009, 2008, and 2007, respectively. For example, at December 31, 2009, the loss severity for the amounts recorded at December 31, 2008 decreased by 8.5%, 3.1% and 0.1% for the 2008, 2007, and 2006 accident years, respectively. Comparatively, at December 31, 2008, the loss severity increased for the amount recorded at December 31, 2007 by 5.6%, 3.7%, and 1.5% for the 2007, 2006, and 2005 accident years, respectively. The following table shows the effects on the 2009, 2008, and 2007 accident year California BI loss reserves based on possible variations in the severity recorded, however, the variation could be more or less than these amounts.
For the 2009 accident year, the Company experienced increases in the average amounts paid on closed claims and slower claim file closings. This generally indicates that there will be increases in loss severity. As a result, the Company believes that the inflation rate for the 2009 accident year is likely to be higher than the inflation rate for the 2008 accident year. As discussed previously, there are many factors that impact inflation, but their impact on the recent inflation rate is currently unknown.
At December 31, 2009, there were 25,684 BI claims reported for the 2009 accident year and the Company estimates that these are expected to ultimately grow by 5.9%. The Company believes that while actual development in recent years has ranged between approximately 2% and 10%, it is reasonable to expect that the range could be as great as between 0% and 12%. Actual development may be more or less than the expected range.
The Company’s insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. 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, net of investment income. To the extent that any of the Company’s lines of business become substantially unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business. At December 31, 2009 and 2008, the Company established premium deficiency reserves for New Jersey operations of $0 and $639,000, respectively, after anticipating 4.5% and 4.4% investment income in 2009 and 2008, respectively.
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, 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 value of receivables and accounts payable approximate their fair market values. All investments are carried on the balance sheet at fair value, as disclosed in Note 1 of Notes to Consolidated Financial Statements.
Certain financial instruments that the Company holds or acquires may lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise is not actively quoted. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.
At December 31, 2009, the Company’s deferred income taxes were in a net asset position materially due to unearned premiums, expense accruals, loss reserve discounting, and deferred tax recognition of capital losses. 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.
Management’s recoverability assessment with regards to its capital deferred tax assets is based on estimates of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of which would contribute to the realization of deferred tax benefits. The Company expects to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a significant portion of the unrealized loss positions at year-end, are not subject to default risk. Thus, the principal amounts are believed to be fully realizable at maturity. The Company has a long-term horizon for holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The Company also has unrealized gains in its investment portfolio which could be realized through asset dispositions, at management’s discretion. Further, the Company has the capability to generate additional realized capital gains by entering into a sale-leaseback transaction using one or more properties of its appreciated real estate holdings. Finally, the Company has an established history of generating capital gain premiums earned through its common stock call option program. Based on the continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and the Company’s favorable track record in generating net capital gains from this program in both upward and downward markets, management believes it will be able to generate sufficient amounts of capital gains from this program, if necessary, to recover recorded capital deferred tax assets.
Goodwill and other intangible assets arise primarily as a result of business acquisitions and consist of the excess of the cost of the acquisitions over the tangible and intangible assets acquired and liabilities assumed and identifiable intangible assets acquired. The Company annually evaluates goodwill for impairment using widely accepted valuation techniques to estimate the fair value of its reporting units. The Company also reviews its goodwill for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill may exceed its implied fair value. As of December 31, 2009, the fair value of the Company’s reporting units substantially exceeds their carrying value.
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
The expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The expense ratio was 29.0% and 28.5% in 2009 and 2008, respectively. The expense ratio slightly increased primarily due to the impact of the amortization of AIS deferred commissions paid prior to the acquisition and severance payments related to a reduction in workforce during 2009, offset by other cost reduction programs. Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. Now that AIS is a wholly-owned subsidiary, commissions are no longer paid or deferred, and direct expenses are reflected in the expense ratio. Further, to improve profitability, the Company implemented several cost reduction programs including a salary freeze, a suspension of the employee 401(k) matching program, and a workforce reduction primarily located in California.
Included in net income (loss) are net realized investment gains of $346.4 million in 2009 compared with net realized investment losses of $550.5 million in 2008. Net realized investment gains include gains of $395.5 million in 2009 due to changes in the fair value of total investments pursuant to election of the fair value accounting option compared with losses of $525.7 million in 2008. The gains during 2009 arise from the market value improvements on the Company’s fixed maturity ($261.9 million) and equity securities ($133.6 million). The primary cause of the significant gains in the Company’s portfolio was the overall improvement in the bond and equity markets. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement during 2009. The Company’s large holdings of energy related stocks also experienced growth in value during 2009, in excess of the 23.5% growth in the S&P 500 Index.
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Net premiums earned and net premiums written in 2008 decreased approximately 6.2% and 7.8%, respectively, from 2007. Net premiums written by the Company’s California operations were $2.2 billion in 2008, a 6.2% decrease from 2007. Net premiums written by the Company’s non-California operations were $589.0 million in 2008, a 13.1% decrease from 2007. The decrease in net premiums written is primarily due to a small decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.
portion of net premiums written that is recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
The loss ratio was 73.3% and 68.0% in 2008 and 2007, respectively. There were unfavorable developments of approximately $89 million and $19 million on prior accident years’ loss reserves for 2008 and 2007, respectively. Excluding the effect of prior accident years’ loss development, the loss ratios were 70.1% and 67.4% in 2008 and 2007, respectively. The increase in the loss ratio excluding the effect of prior accident years’ loss development is primarily due to higher severity in the California automobile lines of business which was partially offset by lower frequency in the same lines.
The expense ratio was 28.5% and 27.4% in 2008 and 2007, respectively. The increase in the expense ratio largely reflects costs such as payroll, benefits, and advertising that have not declined in proportion to the decline in premium volumes; an increase in technology-related expenses; the establishment of the product management function; and approximately $2 million of AIS acquisition-related expenses.
The combined ratio 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; and a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio was 101.8% and 95.4% in 2008 and 2007, respectively.
Included in net (loss) income are net realized investment losses of $550.5 million in 2008 compared with net realized investment gains of $20.8 million in 2007. Net realized investment losses of $550.5 million in 2008 include losses of $525.7 million due to changes in the fair value of total investments pursuant to election of the fair value accounting option. These losses, primarily in fixed maturity securities, arise from the market value declines on the Company’s holdings during 2008 resulting from ongoing downgrades of municipal bond insurers, widening credit spreads, economic downturn impacting municipalities and the lack of liquidity in the market.
Net (loss) income was $(242.1) million or $(4.42) per diluted share and $237.8 million or $4.34 per diluted share in 2008 and 2007, respectively. Diluted per share results were based on a weighted average of 54.9 million shares and 54.8 million shares in 2008 and 2007, respectively. Basic per share results were $(4.42) and $4.35 in 2008 and 2007, respectively. Included in net income were net realized investment (losses) gains, net of income taxes, of $(6.54) and $0.25 per share (diluted and basic) in 2008 and 2007, respectively.
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 $153.3 million in 2010. Actual ordinary dividends paid from the Insurance Companies to Mercury General during 2009 were $110 million. As of December 31, 2009, Mercury General also had approximately $68 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $341.7 million at December 31, 2009, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
Net cash provided by operating activities in 2009 was $189.0 million, an increase of $124.4 million over 2008. The increase was primarily due to a decrease in losses and loss adjustment expenses paid and tax expenses paid in 2009 compared with 2008. Additionally, the Company had operating cash flows in 2009 generated by AIS after the acquisition. The Company utilized the cash provided from operating activities primarily for the payment of dividends to its shareholders and the purchase and development of information technology. Funds derived from the sale, redemption or maturity of fixed maturity investments of $456.3 million were primarily reinvested by the Company in high grade fixed maturity securities.
The following table shows estimated fair value of fixed maturity securities at December 31, 2009 by contractual maturity in the next five years.
In addition, see “D. Debt” for cash flow related to the $120 million credit facility for the AIS acquisition.
The following table sets forth the composition of the total investment portfolio of the Company at December 31, 2009:
At December 31, 2009, 77.4% of the Company’s total investment portfolio at fair value and 90.0% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of perpetual preferred stocks and dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. At December 31, 2009, 96.1% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any material direct investment in subprime lenders.
During 2008, the Company recognized approximately $550.5 million in net realized investment losses, of which, approximately $274 million was related to fixed maturity securities and approximately $254 million was related to equity securities. The losses were primarily due to extreme volatility in the capital markets and a widening of credit spreads beyond historic norms in the third and fourth quarters of 2008. Included in this loss is $531.1 million related to the change in fair value of the total investment portfolio. Losses were approximately $6.4 million and $27.7 million from the sale of fixed maturity securities and equity securities, respectively.
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The nominal average maturities of the overall bond portfolio, including short-term bonds, were 12.2 years and 13.9 years at December 31, 2009 and 2008, respectively, which reflect a portfolio heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturities of the overall bond portfolio, including short-term bonds, were approximately 6.8 years and 10.8 years at December 31, 2009 and 2008, respectively, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio reflecting anticipated early calls were 5.1 years and 7.2 years, including collateralized mortgage obligations with modified durations of approximately 1.8 years and 1.7 years at December 31, 2009 and 2008, respectively, and short-term bonds that carry no duration. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in interest rates; modified duration is considered a better indicator of price volatility than simple maturity alone.
3.4% and 4.1%, respectively, of total fixed maturity securities. At December 31, 2008, fixed maturity holdings, excluding preferred shares, rated below investment grade and non-rated bonds totaled $52.3 million and $27.5 million, respectively at fair value, and represented approximately 2.1% and 1.1%, respectively, of total fixed maturity securities.
The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for approximately $14.0 million and $16.3 million ($13.2 million and $20.0 million amortized cost) of Alt-A mortgages at December 31, 2009 and 2008, respectively. Alt-A mortgage backed securities are at fixed or variable rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles than sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. At December 31, 2009, the Company had no holdings in commercial mortgage-backed securities, but had approximately $12.2 million, at fair value, in interest-only mortgage-backed securities. While these interest-only mortgage-backed securities are AAA rated U.S. Government Agency issues, their projected future cash flows can be adversely affected due to increased prepayment activity on the underlying collateral.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities is BBB+ and the weighted-average rating of the entire mortgage backed securities portfolio is AA+.
Included in fixed maturities securities are collateralized debt obligations of $47.5 million and $13.1 million, which represent approximately 1.5% and 0.4% of the total investment portfolio and have durations of 2.9 years and 5.8 years, at December 31, 2009, and 2008, respectively.
The NextGen software project began in 2002 and the total capital investment is approximately $41 million as of December 31, 2009. The Mercury First software project began in 2006 and the total capital investment is approximately $31 million as of December 31, 2009. Although the majority of the related software development costs have been expended, there will be some Mercury First development and implementation costs in the future. In accordance with applicable accounting standards, capitalization ceases no later than the point at which computer software project development is substantially complete and ready for its intended use. NextGen is currently in the implementation stage with all remaining expenditures recorded as other operating expenses.
The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations, and must have adequate reserves for claims. The minimum statutory capital requirements differ by state and are generally based on balances established by statute, a percentage of annualized premiums, a percentage of annualized loss, or RBC requirements. The RBC requirements are based on guidelines established by the NAIC. The RBC formula was 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. At December 31, 2009, the Insurance Companies had sufficient capital to exceed the highest level of minimum required capital.
As of December 31, 2009, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
The Company’s significant contractual obligations at December 31, 2009 are summarized as follows:
(4) Pursuant to the terms of the Purchase Agreement effective January 1, 2009, the Company may be required to pay up to $34.7 million over the next year as additional consideration for the AIS acquisition. Based on the projected performance of the AIS business, the Company does not expect to pay the contingent consideration.
(5) The table excludes liabilities of $6 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing of related future payments.
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We have audited Mercury General Corporation’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercury General Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to losses and loss adjustment expenses. Actual results could differ from those estimates.
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations, or other economic factors. Prior to the election of the fair value option, these securities were carried at fair value with the corresponding unrealized gains (losses), net of deferred income taxes, reported in accumulated other comprehensive income. Premiums and discounts on fixed maturities are amortized using first call date and are adjusted for anticipated prepayments. Premiums and discounts on mortgage-backed securities are adjusted for anticipated prepayment using the retrospective method, with the exception of some beneficial interests in securitized financial assets, which are accounted for using the prospective method.
The Company writes covered call options through listed and over-the-counter exchanges. When the Company writes an option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security or currency in determining whether the Company has realized a gain or loss. The Company, as writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option. Liabilities for covered call options of $1.0 million and $2.8 million were included in other liabilities at December 31, 2009 and 2008, respectively.
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. As discussed above, all investments are carried at fair value on the consolidated balance sheets, including $47.5 million of fixed maturities which are valued based on broker quotes for underlying debt instruments and the appropriate benchmark spread for similar assets in active markets. Management determined fair value estimates for auction rate securities (“ARS”) amounting to $3.3 million using discounted cash flow models. The fair value of the Company’s $120 million and $18 million secured notes is estimated based on assumptions and inputs, such as reset rates, for similar termed notes that are observable in the market. The fair value of the Company’s publicly traded $125 million unsecured notes is based on the unadjusted quoted price for similar notes in active markets. Further, see Note 3 for methods and assumptions used in estimating fair values of interest rate swap agreements, and equity contracts. Due to their short-term maturity, the carrying value of receivables and accounts payable approximate their fair market values. The following table sets forth estimated fair values of financial instruments at December 31, 2009 and 2008.
Premium notes receivable represents the balance due to the Company from policyholders who elect to finance their premiums over the policy term. The Company requires a down payment and monthly payments as part of its financing program. Premium finance fees are charged at rates that vary with the amount of premium financed and are recognized over the premium note term based upon the effective yield.
Deferred policy acquisition costs primarily consist of commissions paid to outside agents or brokers, premium taxes, salaries, and certain other underwriting costs that vary with and are primarily related to the acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in relation to the amount of premiums earned. Deferred acquisition costs are limited to the amount which will remain after deducting from unearned premiums and anticipated investment income the estimated losses and loss adjustment expenses and the servicing costs that will be incurred as the premiums are earned. The Company does not defer advertising expenses.
Fixed assets are stated at historical cost less accumulated depreciation and amortization. The useful life for buildings is 30 to 40 years, and furniture, equipment, and purchased software are depreciated on a combination of straight-line and accelerated methods over 3 to 7 years. The Company has capitalized certain consulting costs,
payroll, and payroll-related costs for employees related to computer software developed for internal use, which are amortized on a straight-line method over the estimated useful life of the software, not exceeding 5 years. In accordance with applicable accounting standards, capitalization ceases no later than the point at which a computer software project is substantially complete and ready for its intended use. Leasehold improvements are amortized over the life of the associated lease.
No independent agent accounted for more than 2% of the Company’s direct premiums written during 2009. However, AIS produced approximately 15% and 14% of the Company’s direct premiums written during 2008 and 2007, respectively, prior to the AIS acquisition.
At December 31, 2009, the Company’s deferred income taxes were in a net asset position partly due to a combination of ordinary and capital deferred tax benefits. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generating sufficient taxable income of the appropriate nature within the carryback and carryforward periods available under the tax law. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to avoid losing the full benefits of its deferred tax assets. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.
In May 2009, the FASB adopted the new standard related to subsequent events. The new standard establishes general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The Company adopted the new accounting standard which became effective for the interim reporting period ended June 30, 2009. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB issued a new standard related to determining fair value when the volume and level of activity for an asset or liability have significantly decreased and identifying transactions that are not orderly. The new standard relates to selected transactions in disrupted markets and adopts guidelines related to a significant decrease in the volume and level of activity for an asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for an asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with earlier FASB standards related to fair value measurements. The Company adopted the new standard which became effective for the interim reporting period ended June 30, 2009. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
In April 2009, the FASB issued a new accounting standard related to the recognition and presentation of other-than-temporary impairments. The new standard amends the other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. Under the new accounting standard, the portion of other-than-temporary impairment on a debt security related to credit loss is recognized in current period earnings, and the remaining portion is recognized in other comprehensive income if the holder does not intend to sell the security and it is more likely than not that the holder will not be required to sell the security prior to recovery. If requirements related to intent and ability to hold the securities are not met, interest related impairment is recorded in current period earnings. As the Company elected to apply the fair value accounting option to all available for sale investments as of January 1, 2008, the new standard is not applicable to the Company.
In April 2009, the FASB issued a new accounting standard related to accounting for contingencies in a business combination. Under the new standard, an acquirer is required to recognize assets or liabilities arising from contingencies provided that the acquisition-date fair value of that asset or liability can be determined during the measurement period. The Company adopted the new standard effective January 1, 2009. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
Effective January 1, 2008, the Company elected to apply the fair value option to all available-for-sale, fixed maturity securities, equity securities, and short-term investments existing at the time of adoption, and similar securities acquired subsequently unless otherwise noted at the time when the eligible item is first recognized. Gains and losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option are included in net realized investment gains (losses) in the Company’s consolidated statements of operations. Interest and dividend income on the investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations.
The following table reflects gains (losses) due to changes in fair value for items measured at fair value pursuant to election of the fair value option:
Net realized gains and losses from investments included gains of $338.7 million and losses of $527.7 million related to trading securities which were still held at December 31, 2009 and 2008, respectively. In 2007, net realized investment gains and losses included investment impairment write-downs of $22.7 million and also included gains of $2.0 million and losses of $1.4 million related to the change in the fair value of trading securities and hybrid financial instruments, respectively.
Accumulated unrealized gains and losses on securities available for sale as of December 31, 2007 are as follows (amounts in thousands):
At December 31, 2009, bond holdings rated below investment grade or non-rated were 6.4% 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 estimated fair values at December 31, 2009 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.
The Company obtained unadjusted fair values on approximately 98% of its portfolio from an independent pricing service. For approximately 2% of its portfolio, the Company obtained specific unadjusted broker quotes from at least one knowledgeable outside security broker to determine the fair value.
Money market instruments: Valued based on unadjusted quoted prices for identical assets.
Collateralized debt obligations: Valued based on observable inputs, such as underlying debt instruments and their appropriate benchmark spread, for identical or similar assets in active markets.
Redeemable and Non-redeemable preferred stock: Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.
Interest rate swap agreements: Valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.
Municipal securities: Comprised of certain distressed municipal securities for which valuation is based on models that are widely accepted in the financial services industry and require projections of future cash flows that are not market observable. Included in this category are $3.3 million of ARS. ARS are valued based on a discounted cash flow model with certain inputs that are significant to the valuation, but are not market observable.
Collateralized debt obligations: Valued based on underlying debt instruments and their appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.
The following table provides a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at December 31:
The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts on various equity securities are entered into to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are entered into to manage interest rate risk associated with the Company’s loans with fixed or floating rates.
There were no gains or losses on derivative instruments designated as cash flow hedges reclassified from accumulated other comprehensive income into earnings for the years ended December 31, 2009 and 2008.
The Company recognized the assets acquired and the liabilities assumed at the acquisition date, measured at their fair values as of that date. The following table summarizes the consideration paid for AIS and the allocation of the purchase price.
The fair value of the financial assets acquired includes cash, prepaid expenses, and receivables from customers. The acquired receivables of $6.6 million at fair value were fully collected during the three-month period ended March 31, 2009. The fair value of the liabilities assumed includes accounts payable and other accrued liabilities. The following table reflects the amount of revenue and net income of AIS, which are included in the Company’s consolidated statements of operations for the year ended December 31, 2009, and the revenue of the combined entity for the year ended December 31, 2008, had the acquisition date been January 1, 2008.
There were no changes in the carrying amount of goodwill for the year ended December 31, 2009 except the purchase price adjustments which were the result of additional information obtained in conjunction with the finalization of the purchase price allocation as of March 31, 2009. Goodwill is reviewed for impairment on an annual basis and between annual tests if potential impairment indicators exist. No impairment indications were identified during any of the periods presented.
Intangible assets are amortized on a straight-line basis over their weighted average lives. The weighted-average amortization periods for intangible assets with definite lives, by asset class, are: 24 years for trade names, 11 years for customer relationships, 10 years for technology, 2 years for software, and 3 years for lease agreements. Intangible assets amortization expense was $6.8 million for the year ended December 31, 2009. None of the intangible assets are anticipated to have a residual value. The following table outlines the estimated future amortization expense related to intangible assets as of December 31, 2009:
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2006 through 2008 for federal taxes and 2001 through 2008 for California state taxes.
As presented above, the balances of unrecognized tax benefits at December 31, 2009 and 2008 were $6,666,000 and $5,897,000, respectively. Of these totals, $5,530,000 and $4,914,000 represent unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would impact the Company’s effective tax rate.
Management anticipates that it is reasonably possible that the Company’s total amount of unrecognized tax benefits will increase within the next twelve months by approximately $900,000 to $1,100,000 related to its ongoing California state tax apportionment factor issues.
may be attributable to a law passed in California several years ago that extended the statute for filing claims from one year to two years. Initial indications, when the law was passed, were that this would have little impact on development patterns and therefore it was not fully factored into the reserve estimates. In hindsight, claims payouts two to four years after the period-end have increased thereby affecting the loss reserve estimates at December 31, 2007. In New Jersey, due to a short operating history and rapid growth in that state, the Company had limited internal historical claims information to estimate BI, PIP and related loss adjustment expense reserves as of December 31, 2007. Consequently, the Company relied substantially on industry data to help set these reserves. During 2008, the reserve indications using the Company’s own historical data rather than industry data led to increases in its estimates for both PIP losses and loss adjustment expenses. In particular, loss severities using Company data for the PIP coverage developed into larger amounts than the industry data suggested. In 2008, the Company started using its own historical data, rather than industry data to set New Jersey loss reserves.
In 2008 and 2007, the Company experienced pre-tax catastrophe losses of $26 million, and $23 million respectively. There were no catastrophe losses in 2009. The losses in 2008 were $20 million related to wildfires in Southern California and $6 million related to Hurricane Ike in Texas. The full $23 million of catastrophe losses in 2007 related to Southern California wildfires. In November 2009, the Company recovered approximately $5 million in a subrogation settlement related to the 2007 wildfires.
The Insurance Companies are subject to the financial capacity guidelines established by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For 2010, the direct insurance subsidiaries of the Company are permitted to pay approximately $153.3 million in dividends to the Company without the prior approval of the DOI of the states of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2009 and 2008, the Insurance Companies paid ordinary dividends to the Company of $110.0 million and $140.0 million, respectively.
The Insurance Companies prepare their statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance departments of the applicable states of domicile. Prescribed statutory accounting practices primarily include those published as statements of SAP by the 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, 2009, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
The Company’s employees are eligible to become members of the Profit Sharing Plan (the “Plan”). The Company, at the option of the Board of Directors, may make annual contributions to the Plan, and 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. No contributions were made by the Company during 2009 and 2008, compared to $1,900,000 for 2007.
In May 1995, the Company adopted the 1995 Equity Participation Plan (the “1995 Plan”) which succeeded a prior plan. In May 2005, the Company adopted the 2005 Equity Incentive Award Plan (the “2005 Plan”) which succeeded the 1995 Plan. Share-based compensation awards may only be granted under the 2005 Plan. A combined total of 5,400,000 shares of common stock under the 1995 Plan and the 2005 Plan are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. The maximum number of shares that may be issued under the 2005 Plan is 5,400,000. As of December 31, 2009, only options and restricted stock awards have been granted under these plans. Beginning January 1, 2008, options granted, for which the Company has recognized share-based compensation expense become exercisable at a rate of 25% per year beginning one year from the date granted, are granted at the market price on the date of grant, and expire after 10 years. Prior to January 1, 2008, shares became exercisable at a rate of 20% per year. The Company has no restricted stock outstanding as of December 31, 2009.
Cash received from option exercises was $393,000, $1,286,000, and $2,173,000 during 2009, 2008, and 2007, respectively. The excess tax benefit realized for the tax deduction from option exercises of the share-based payment awards totaled $5,000, $121,000, and $273,000 during 2009, 2008, and 2007, respectively.
A reconciliation of the numerators and denominators of the basic and diluted earnings per share calculation for income (loss) from operations is presented below:
The following table outlines future minimum commitments for operating leases as of December 31, 2009:
Many economists believe that the severe economic recession is over, but they expect the recovery to be slow with many businesses feeling the effects of the downturn for years to come. The Company is unable to predict the duration and severity of the current disruption in the financial markets in the United States. The recession, with rising unemployment, has contributed to declining premium revenues and could lead to further premium revenue declines in the future. If economic conditions in the United States, and in California, where the majority of the Company’s business is produced, continue to deteriorate or do not show improvement, the adverse impact on the Company’s results of operations, financial position, and cash flows may continue.
The Company evaluated subsequent events through February 18, 2010, the date the financial statements were issued, and noted no significant matters to be disclosed.
Net loss during 2008 was largely affected by changes in the fair value of the investment portfolio measured at fair value. As a result of the adoption of the fair value option on January 1, 2008, the change in unrealized gains and losses on all investments is recorded as realized gains and losses on the statements of operations. During 2008, the investment markets experienced substantial volatility due to uncertainty in the credit markets and a global economic recession. In the third and fourth quarters of 2008, this uncertainty developed into a credit crisis that led to extreme volatility in the capital markets, a widening of credit spreads beyond historic norms and a significant decline in asset values across most asset categories.