The Company operates primarily in the state of California, which was the only state it produced business in prior to 1990. The Company expanded its operations into Georgia and Illinois in 1990. With the acquisition of American Fidelity Insurance Group (AFI)in December 1996, now American Mercury Insurance Group (AMI), the Company expanded into the states of Oklahoma and Texas. The Company further expanded its operations into the state of Florida during 1998.
During 1998, approximately 92% of the Company's direct premiums written, including AMI, were derived from California.
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.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997 ---------------------------------------------------------------------
Premiums earned in 1998 of $1,121.6 million increased 8.8%, reflecting unit growth which was somewhat offset by reduced average premiums per policy. The reduction in average premium per policy was primarily the result of the 7% rate decrease taken for California business in April 1998. In addition, a large portion of the new California business written during 1997, which grew at a rate of 28.5% due to a new law requiring proof of insurance to register a car, qualified for a discount on renewal in 1998. Consequently, the average premium per policy declined in 1998 as compared to 1997.
Investment income in 1998 was $96.2 million, compared with $86.8 million in 1997. The after-tax yield on average investments of $1,474.5 million (fixed maturities at cost, equities at market) was 5.91%, compared with 6.17% on average investments of $1,262.9 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. Approximately $47 million of bonds are expected to mature or be called in 1999. Average yields being obtained during the first quarter of 1999 on new investments are 50 to 75 basis points lower than the average yield realized during 1998.
Net income in 1998 was $177.5 million or $3.23 per share, (basic), compared with $156.3 million, or $2.84 per share, (basic), in 1997. Basic per share results are based on 55.0 million average shares in 1998 and 55.0 million average shares in 1997. Diluted per share results were $3.21 in 1998 and $2.82 in 1997.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996 ---------------------------------------------------------------------
Premiums earned in 1997 of $1,031.3 million (including $65.1 million contributed by AMI) increased 36.6%, primarily reflecting unit growth and the fact that 1996 results only include one month of premiums from AMI. Without the impact of the AMI results, premiums earned increased 28.9%. Average premium per policy for the year declined slightly. Net premiums written in 1997 of $1,086.2 million (including $72.8 million contributed by AMI) increased 36.5% over a year earlier (28% excluding the impact of AMI results), continuing a growth trend which began in the second quarter of 1994. Growth in written premiums in California of 28.5% for all of 1997 was aided by a new California law that became effective January 1, 1997 which requires proof of insurance for the registration (new or renewal) of a motor vehicle. The greater part of the new business generated by the new law occurred in the first half of 1997, and provided for only the minimum liability coverage required by law. The average premium on this business was substantially less than that produced by full coverage policies, which constitute a majority of the Company's total premium volume.
Investment income in 1997, including a contribution from AMI of $6.3 million, was $86.8 million, compared with $70.2 million in 1996. The after-tax yield on average investments of $1,262.9 million, including AMI, (fixed maturities at cost, equities at market) was 6.17%, compared with 6.50% on average investments of $975.1 million in 1996. The effective tax rate on investment income was 10.3% in 1997, compared with 9.7% in 1996. The effective tax rate was increased, and the effective after-tax yield was reduced slightly, by the inclusion of AMI for the full year 1997. The slightly higher tax rate on investment income in 1997 reflects an increase in the proportion of investment income derived from taxable bonds held by AMI and dividends on equities,
principally perpetual preferred stocks. 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 will continue in 1998. Bonds matured and called in 1997 totaled $54.0 million, compared with $72.9 million in 1996.
Realized investment gains in 1997 were $5.0 million, compared with realized losses of $3.2 million in 1996. The gains and losses in both years reflect principally income-enhancing swaps of both fixed maturities and equity securities, including perpetual preferred stocks. The losses realized in 1996 were designed to utilize expiring capital gains tax benefits.
Net cash provided from operating activities in 1998, was $192.1 million, while funds derived from the sale, redemption or maturity of investments was $941.5 million, of which approximately 79% was represented by the sale of equity securities. The amortized cost of fixed-maturity investments increased by $97.8 million during the year. Equity investments, including perpetual preferred stocks, increased by $50.5 million at cost, while short-term cash investments decreased by $13.7 million. The amortized cost of fixed-maturities available for sale that were sold, called or matured during the year was $195.2 million.
The Company's cash and short term investments totaled $47.9 million at December 31, 1998. Together with funds generated internally, such liquid assets are more than adequate to pay claims without the sale of long term investments.
or "junk" bonds. In 1995, the Company adopted a policy to place a small proportion of its investments in the taxable sector in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1998 bond holdings rated below investment grade totaled $13.6 million at market (cost $12.7 million), or 1% of total investments. The average rating of the $1,203 million bond portfolio (at amortized cost) was AA-, while the average effective maturity, giving effect to anticipated early call, approximates 7.3 years. The modified duration of the bond portfolio at year-end was 5.8 years, reflecting the heavy weighting of high coupon issues, including housing issues subject to sinking funds, and other issues which are pre-refunded or are expected to be called prior to their maturity. Duration measures the length of time it takes to receive all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered 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 also maintains a $100 million line of credit, of which $3 million was drawn on at December 31, 1998 and is due October 31, 1999. The line
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 1998, the Company purchased 580,000 shares of the common stock in the open market at an average price of $41.83. The shares purchased were retired.
As of December 31, 1998, 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 Mercury Casualty Company's participation percentage, and recently published statistical information from the CEA, the Company, at December 31, 1998, estimates its assessment exposure to a "Northridge" - type earthquake to be approximately $3.2 million and its maximum total exposure to CEA assessments to be approximately $6.5 million.
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 $767.2 million at December 31, 1998, and net written premiums for the twelve months ended on that date of $1,144.1 million, the ratio of writings to surplus was approximately 1.5 to 1.
The American Mercury Group, acquired by the Company in December 1996 and which represents approximately 6% of the Company's total premiums written, is in the process of completing the modifications necessary, including the conversion to new critical systems, to become Year 2000 compliant. The Company expects to have their critical systems to be Year 2000 compliant by the second quarter of 1999.
Other non-critical systems are already Year 2000 compliant or are in the process of being modified or converted to become Year 2000 compliant. The Company expects to have its non-critical systems to be Year 2000 compliant by the
While the Year 2000 considerations are not expected to materially impact the Company's internal operations, they may have a material effect on some of the Company's agents, suppliers and financial institutions with whom the Company conducts business, and thus indirectly affect the Company. The Company has commenced a program to ascertain the compliance status of those companies with whom the Company conducts material business. This program includes sending out questionnaires to our major business partners regarding their Year 2000 readiness. Based on the responses received to date, the Company does not anticipate any material impact on its operations or financial condition.
Mercury General is developing business resumption contingency plans specific to the Year 2000. Business resumption contingency plans address the actions that would be taken if critical business functions cannot be carried out in the normal manner upon entering the next century due to system or supplier failure.
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. 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.
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 statement of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method.
Net premiums written during 1998, 1997 and 1996 were $1,144,051,000, $1,086,241,000 and $795,873,000, respectively.
One agent produced direct premiums written of approximately 19%, 18% and 17% of the Company's total direct premiums written during 1998, 1997 and 1996, respectively. This agency was sold during 1998 to a large national broker. The buyer has informed the Company that they intend to continue producing business for the Company. No other agent accounted for more than 2% of direct premiums written.
Buildings and furniture and equipment are depreciated over 30-year and 5- year to 10-year periods, respectively, on a combination of straight-line and accelerated methods. Automobiles are depreciated over 5 years, using an accelerated method.
Deferred income taxes result from temporary differences in the recognition of income and expense for tax and financial reporting purposes. The Company accounts for income taxes in accordance with SFAS 109, "Accounting for Income Taxes".
Traditionally, it has been the Company's policy not to invest in high yield or non-investment grade bonds. In 1995, the Company adopted a policy allowing a small percentage of its investments to be placed in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's.
At December 31, 1998 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, 1998, 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.
Policy acquisition costs incurred and amortized to income are as follows:
The terms of the loan agreements include certain affirmative and negative covenants, all of which are met by the Company at December 31, 1998.
Decreases in incurred losses relating to 1998 and 1996 reflects the favorable loss experience during these years attributable to a number of combined factors which have produced favorable frequency and severity trends.
Effective November 30, 1996 the Company acquired all of the issued and outstanding common stock of American Mercury Insurance Company, formerly American Fidelity Insurance Company, including its subsidiaries as described in Note 1, for $35.0 million. The acquisition was paid for in cash with funds raised by increasing the Company's notes payable under the bank credit agreement discussed in Note 5. On December 30, 1996 the Company contributed an additional $15.0 million to AMI. The acquisition was accounted for using the purchase method and resulted in a minimal amount of goodwill. The purchase agreement includes an indemnification by the seller on the loss and loss adjustment expense reserves of AMI at the acquisition date, excluding the mechanical breakdown line, to avoid any impact on the Company's financial statements from any future adverse development on the acquisition date loss reserves.
The following unaudited proforma consolidated results of operations show 1996 results, as though the acquisition occurred on January 1, 1996 (Amounts in thousands except per share date):
The Insurance Companies are subject to the financial capacity guidelines established by the Office of the Commissioner of Insurance of their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For the year 1999, the direct insurance subsidiaries of the Company are permitted to pay approximately $98 million in dividends to the Company without the prior approval of the Commissioner of Insurance of the state of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay dividends.
The Insurance Companies' statutory net income, as reported to regulatory authorities, was $173,473,000, $147,255,000, and $97,979,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The statutory policyholders' surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 1998 and 1997 was $767,223,000 and $679,359,000, 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 $2,074,000, $1,885,000 and $1,583,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan (ESOP) that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends received by the ESOP. Dividends received by the ESOP on unallocated shares are used to pay debt service and the ESOP shares serve as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the debt of the ESOP, which was $5,000,000, $2,000,000 and $3,000,000 at December 31, 1998, 1997 and 1996, respectively, is recorded in the balance sheet as other liabilities. The shares pledged as collateral are reported as unearned ESOP compensation in the shareholders' equity section of the balance sheet. As shares are committed to be released from collateral, the Company reports compensation expense equal to the current market price of the shares, and reduces unearned ESOP compensation by the original cost of the shares. The difference between the market price and cost of the shares is charged to common stock. As shares are committed to be released from collateral, the shares become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of accrued interest. ESOP compensation expense was $970,000, $5,368,000 and $1,509,000 in 1998, 1997 and 1996, respectively. The ESOP shares as of December 31 were as follows:
In May 1995 the Company adopted The 1995 Equity Participation Plan (the "1995 Plan") which succeeds the Company's 1985 Plan. Under the 1995 Plan, 5,400,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. During 1995, the Company granted incentive stock options under both the 1995 Plan and the 1985 Plan. The options granted become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date of the grant. The options expire in 10 years. At December 31, 1998 no awards other than options have been granted.
A reconciliation of the numerator and denominator, adjusted for a two-for-one stock split effective September 1997, used in the basic and diluted earnings per share calculation is presented below: