The Company owns the following buildings which are mostly occupied by the Company’s employees. Space not occupied by the Company is leased to independent third party tenants.
The Company’s net income for the year ended December 31, 2013 decreased to $112.1 million, or $2.04 per diluted share, from $116.9 million, or $2.13 per diluted share, for the same period in 2012. Approximately $125 million in pre-tax investment income was generated during 2013 on a portfolio of approximately $3.2 billion at fair value at December 31, 2013, compared to $132 million pre-tax investment income during 2012 on a portfolio of approximately $3.2 billion at fair value at December 31, 2012. Included in net income are net realized investment losses of $11.4 million and gains of $66.4 million in 2013 and 2012, respectively.
During 2013, 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 its thorough underwriting process gives it an advantage over competitors. The Company's agent relationships and underwriting and claims processes are its most important competitive advantages.
In 2013, the Company continued to invest in its web-based agency systems by adding new capabilities and enhanced features such as improved motor vehicle and accident matching and reconciliation. Many agents use comparative raters to evaluate products and prices from different insurance carriers, and the Company has completed integrations with the most popular raters for the private passenger automobile and homeowner lines of business.
A new commission system is anticipated to be released in 2014 that will enhance the efficiency and flexibility of the current commission calculation and payment process.
The Company filed for a 3.9% rate increase for its California homeowners line of business in May 2009. After a rate hearing by an ALJ, the Company was ordered by the California Insurance Commissioner to reduce rates by 5.5%. The rate reduction was implemented during the second quarter of 2013. The Company subsequently filed for a rate increase that contained more recent
data, and an 8.26% rate increase was approved by the California Insurance Commissioner. The rate increase went into effect in January 2014. In addition, the Company is challenging some of the issues in Superior Court that were raised by the ALJ in the rate hearing.
In January 2013, the California DOI approved an auto body repair regulation intended to strengthen consumer protection. This regulation requires insurers to settle automobile insurance claims using repair standards described by the regulation and not by the insurers' own standards. The new ruling became effective in March 2013. While the impact of the new ruling was minimal during 2013, it may increase the cost of parts for auto repairs in the future.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) 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. The California DOI seeks to impose a fine for each policy on which the Company allegedly permitted an agent to charge a broker fee and a penalty for each policy on which the Company allegedly used a misleading advertisement and to suspend certificates of authority for a period of one year. In January 2012, the ALJ bifurcated the 2004 NNC between (a) the California DOI’s order to show cause, in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. In February 2012, the ALJ submitted a proposed decision dismissing the California DOI’s 2004 NNC. In March 2012, the California Insurance Commissioner rejected the ALJ’s proposed decision. The Company challenged the rejection in Superior Court in April 2012. Following a hearing, the Superior Court sustained the California Insurance Commissioner’s demurrer without leave to amend because it found the Company must first exhaust its administrative remedies. In January 2013, the Superior Court’s decision was subsequently affirmed on appeal. In January 2013, the ALJ heard various pending motions that had been filed by the Company in June 2011. The ALJ granted certain portions of the California DOI's motion for collateral estoppel to prevent the Company from litigating certain findings of fact reached in a prior litigation action and denied the Company's motion for governmental estoppel and laches, without prejudice, on the ground that a resolution of the motion requires specific factual findings in the context of the evidentiary hearing. The ALJ held an evidentiary hearing on the noncompliance portion of the 2004 NNC during April 2013. A mediation was held in September 2013, but the parties were unable to reach a settlement of the matter. Post-hearing briefs have been filed by the Company, the California DOI, and a consumer group. Until the evidentiary record is closed, there is no set timetable for a decision by the ALJ or, thereafter, a decision by the California Insurance Commissioner.
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see “Critical Accounting Policies and Estimates” and Note 1 of Notes to Consolidated Financial Statements.
loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.
The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with estimates for loss reserves. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its reserve by looking at historical patterns and trends and projecting these out to current reserves. The underlying factors and assumptions that serve as the basis for preparing the reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company also engages an independent actuarial consultant to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultant for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count development, and average severity methods described below. The Company also uses the paid loss development method as part of its reserve analysis. When deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $3,000 to $3,500, on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $8,500 to $10,000. 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 year, as those periods age. At December 31, 2013, the Company believes that the accident years that are most likely to develop are the 2011 through 2013 accident years; however, it is possible that older accident years could develop as well.
Unexpected losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected losses in future periods. It is also possible that the Company has not identified and established a sufficient reserve for all unexpected large losses occurring in the older accident years, even
though a comprehensive claims file review was undertaken. The Company may experience additional development on these reserves.
Discussion of losses and loss reserves and prior period loss development at December 31, 2013
At December 31, 2013 and 2012, the Company recorded its point estimate of approximately $1,039 million and $1,036 million, respectively, in losses and loss adjustment expense liabilities, which include $409.2 million and $408.9 million, respectively, of IBNR loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2013 and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For 2013, the Company reported unfavorable development of approximately $3 million on the 2012 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2012 totaled approximately $1,036 million. The unfavorable development in 2013 is largely from Florida claims that were re-opened from prior years due to a state supreme court ruling that was adverse to the insurance industry.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange traded funds. 99.5% of the fair value of financial instruments held at December 31, 2013 is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary by financial instrument. Observable market prices and pricing parameters of a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
Management’s recoverability assessment with regard 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, each 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 fully realizable at maturity. Management believes its long-term time horizon for holding these securities allows it to avoid any forced sales prior to maturity. The Company also has unrealized gains in its investment portfolio that 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 of its appreciated real estate holdings.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations and believes that its cash flow needs can be met in future periods without the forced sale of its investments. This capability assists management in controlling the timing and amount of realized losses generated during future periods. By prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability to generate capital gains and minimize tax losses in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.
Net premiums written and net premiums earned in 2013 increased 2.9% and 4.8%, respectively, from 2012. The increase in net premiums written was primarily due to higher average premiums per policy which primarily resulted from the October 2012 4% rate increase on California private passenger automobile policies as well as rate increases taken in non-California states. In addition, the Company implemented a 6.9% rate increase in July 2013 on private passenger automobile policies written in CAIC, which represented approximately 22% of total California private passenger automobile net premiums written as of December 31, 2013.
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by unfavorable development of approximately $3 million and $42 million on prior accident years’ losses and loss adjustment expense reserves for the years ended December 31, 2013 and 2012, respectively. The 2013 loss ratio was also negatively impacted by a total of $17 million of catastrophe losses mostly due to tornadoes in Oklahoma and severe storms in the Midwest and Southeast regions during 2013. The unfavorable development in 2012 was largely the result of re-estimates of California BI losses which experienced both higher average severities and more late reported claims than originally estimated at December 31, 2012. The 2012 loss ratio was also negatively impacted by a total of $39 million of catastrophe losses mostly due to Hurricane Sandy and wind and hail storms in the Midwest region during 2012. Excluding the effect of estimated prior periods' loss development and catastrophe losses, the loss ratio was 72.0% and 73.0% for the years ended December 31, 2013 and 2012, respectively.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned and did not materially change in 2013 compared to 2012. The 2013 expense ratio was affected by the consolidation of claims and underwriting operations located outside of California into hub locations, which resulted in approximately $10 million of pre-tax office closure costs and severance related expense during the first quarter of 2013. The charges added 0.1 point to the expense ratio and 0.3 point to the loss adjustment expense portion of the loss ratio. The Company expects future savings of approximately $12 million per year as a result of the workforce reduction and operational consolidation.
Included in net income are net realized investment losses of $11.4 million and gains of $66.4 million in 2013 and 2012, respectively. Net realized investment (losses) gains include losses of $44.0 million and gains of $45.5 million in 2013 and 2012, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net losses during 2013 arise from a $100.7 million market value decrease in the Company's fixed maturity securities offset by a $56.8 million market value increase in its equity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio and were negatively affected by the overall municipal market decline for 2013. The primary cause of the increase in the value of the Company’s equity securities was the overall improvement in the equity markets for 2013. The net gains during 2012 arise from $36.3 million and $9.2 million market value increases in the Company’s fixed maturity and equity securities, respectively. The primary cause of the increase in the value of the Company's fixed maturity and equity securities was the overall improvement in the municipal bond market and the equity market in 2012.
Net income was $112.1 million or $2.04 per share (basic and diluted), and $116.9 million or $2.13 per share (basic and diluted) in 2013 and 2012, respectively. Diluted per share results were based on a weighted average of 55.0 million and 54.9 million shares in 2013 and 2012, respectively. Included in net income per share were net realized investment losses, net of income taxes, of $0.14 and gains, net of income taxes, of $0.79 per share (basic and diluted) in 2013 and 2012, respectively.
Net premiums earned and net premiums written in 2012 increased 0.3% and 3.0%, respectively, from 2011. Net premiums written by the Company's California operations and non-California operations increased by $73.3 million and $3.1 million, respectively, from 2011. The increase in net premiums written was primarily due to an increase in the number of policies-in-force and slightly higher average premiums per policy. The increase in average premiums per policy partially reflected a modest shift for the California personal automobile line from six-month policies to twelve-month policies. Premiums on twelve-month policies are typically twice that of six-month policies. For 2012, fewer than 5% of California personal automobile policies were written on a twelve-month basis and more than 95% were written on a six-month basis, whereas in 2011, fewer than 1% of the California personal automobile policies were written on a twelve-month basis and over 99% were written on a six-month basis. In addition, the Company increased private passenger automobile insurance rates in twelve non-California states and grew its homeowners business in several non-California states during 2012.
Included in net income were net realized investment gains of $66.4 million and $58.4 million in 2012 and 2011, respectively. Net realized investment gains included gains of $45.5 million and $31.3 million in 2012 and 2011, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net gains during 2012 arose
from $36.3 million and $9.2 million market value increases in the Company’s fixed maturity and equity securities, respectively. The Company’s municipal bond holdings represented the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for 2012. The primary cause of the increase in the value of the Company’s equity securities was the overall improvement in the equity markets for 2012. The net gains during 2011 arose from a $62.1 million market value increase in the Company's fixed maturity securities offset by a $30.9 million market value decline in its equity securities.
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 $260 million in 2014 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of approximately $120 million during 2013. As of December 31, 2013, Mercury General had approximately $87 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The principal sources of funds for the Insurance Companies are premiums, sales and maturity of invested assets, and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General, payment of debt, and the purchase of investments.
Net cash provided by operating activities in 2013 was $209.8 million, an increase of $61.7 million compared to 2012. The increase was primarily due to increased premiums collected and reduced operating expenses, offset by an increase in paid losses and loss adjustment expenses. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders. Funds derived from the sale, redemption, or maturity of fixed maturity investments of $571.7 million were primarily reinvested by the Company in high grade fixed maturity securities.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2013:
Fixed maturities and short-term bonds at amortized cost and equities and other short-term investments at cost.
At December 31, 2013, 70.6% of the Company’s total investment portfolio at fair value and 87.1% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. At December 31, 2013, 83.3% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any direct investment in subprime lenders.
Fixed maturity securities include debt securities, 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. Short-term investments include money market accounts, options, and short-term bonds that are highly rated short duration securities and redeemable within one year.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-, at fair value, consistent with the average rating at December 31, 2012. To calculate the weighted-average credit quality ratings as disclosed throughout this Annual Report on Form 10-K, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Tax-exempt bond holdings are broadly diversified geographically. Taxable holdings consist principally of investment grade issues. At December 31, 2013, fixed maturity holdings rated below investment grade and non-rated bonds totaled $35.0 million and $13.1 million, respectively, at fair value, and represented 1.4% and 0.5%, respectively, of total fixed maturity securities. At December 31, 2012, fixed maturity holdings rated below investment grade and non-rated bonds totaled $41.4 million and $47.4 million, respectively, at fair value, and represented 1.7% and 2.0%, respectively, of total fixed maturity securities.
The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at December 31, 2013 at fair value. The Company’s estimated credit quality ratings are based on the average of ratings assigned by nationally recognized securities rating organizations. Credit ratings for the Company’s fixed maturity portfolio were stable as compared to the prior year, with 83.1% of fixed maturity securities at fair value experiencing no change in their overall rating. 9.3% of fixed maturity securities at fair value experienced downgrades, partially offset by 7.6% in credit upgrades. A majority of the downgrades were slight and still within the investment grade portfolio, except for $7.4 million at fair value that were downgraded to below investment grade during 2013.
The Company had $2.2 billion at fair value and amortized cost in municipal bonds at December 31, 2013, of which $1.0 billion were insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was A+ at December 31, 2013.
At December 31, 2013, the bond insurers providing credit enhancement were Assured Guaranty Corporation and National Public Finance Guarantee Corporation, which covered approximately 25% of the insured municipal securities. The average rating of the Company’s insured municipal bonds by these bond insurers was A, with an underlying rating of A-. Most of the insured bonds' ratings were investment grade and reflected the credit of underlying issuer. 8.6% of the remaining insured bonds are non-rated or below investment grade, and the Company does not believe that these insurers provide credit enhancement to the municipal bonds that they insure.
The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for $7.0 million and $8.2 million ($6.3 million and $7.3 million at amortized cost) of Alt-A mortgages at December 31, 2013 and 2012, 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 credit profiles stronger than those of sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. The Company had holdings of $21.9 million and $4.3 million ($21.8 million and $4.2 million at amortized cost) in commercial mortgage-backed securities at December 31, 2013 and 2012, respectively.
improve the asset risk profile in its insurance subsidiaries and to lock in and realize gains that resulted from the large stock market appreciation that occurred during 2013. Those gains can be utilized to offset capital losses for tax purposes within the next three years.
The following table presents the equity security portfolio by industry sector for 2013 and 2012:
For a further discussion, see Notes 6 and 7 of Notes to Consolidated Financial Statements.
In 2013, the Company made capital expenditures, including capitalized software, of approximately $19 million primarily related to Information Technology.
Beginning in 2015, insurance companies will be required to file an ORSA with the insurance regulators in their state of domicile. The ORSA is required to cover, among many items, a company’s risk management policies, the material risks to which the company is exposed, how the company measures, monitors, manages and mitigates material risks, and how much economic and regulatory capital is needed to continue to operate in a strong and healthy manner. The ORSA will be used by the state insurance regulator to evaluate the risk exposure and quality of the risk management processes within the insurance companies to assist in conducting risk-focused financial examinations and for determining the overall financial condition of the insurance company.
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the Company) as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2013. 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.
Mercury General Corporation (“Mercury General”) and its subsidiaries (referred to herein collectively as the “Company”) are primarily engaged in writing personal automobile insurance through 13 Insurance Companies in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. The private passenger automobile lines of insurance exceeded 79% of the Company’s direct premiums written in 2013, 2012, and 2011, of which approximately 81%, 78%, and 77% of the private passenger automobile premiums were written in California during 2013, 2012, and 2011, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions and balances have been eliminated.
The Company applies the fair value option to all fixed maturities and equity securities and short-term investments at the time an eligible item is first recognized. The cost of investments sold is determined on a first-in and first-out method and realized gains and losses are included in net realized investment (losses) gains. Gains and losses due to changes in fair value for items measured at fair value pursuant to application of the fair value option are included in net realized investment (losses) gains, while 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. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as the expansion of the use of fair value measurement by the Company consistent with the long-term measurement objectives of the Financial Accounting Standards Board (“FASB”) for accounting for financial instruments. See Note 2 for additional information regarding the fair value option.
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 $0.1 million and $0.2 million were included in other liabilities at December 31, 2013 and 2012, respectively.
In 2013, the Company formed and consolidated AFL, a special purpose investment vehicle. The Company is the sole managing member in AFL. On August 9, 2013, AFL entered into a three-year total return swap agreement with Citibank, N.A. (“Citibank”). Under the total return swap agreement, AFL receives the income equivalent on underlying obligations and pays to Citibank interest equal to LIBOR plus 120 basis points on the outstanding notional amount of the underlying obligations, which was approximately $149 million as of December 31, 2013. The total return swap agreement is secured by approximately $40 million of U.S. Treasuries as collateral, which is included in short-term investments on the consolidated balance sheets. In the event of a significant erosion in market value, AFL's position in the loan portfolio will be reduced and the Company has the option to add additional capital or terminate the total return swap agreement.
The Company's 13 insurance subsidiaries (referred to herein collectively as the “Insurance Companies”) have securities deposited with the Department of Insurance or similar governmental agency of each state in which it is licensed to operate (“DOI”) as required by statute with fair values of approximately $17 million and $16 million at December 31, 2013 and 2012, respectively.
The Company annually evaluates goodwill and other intangible assets for impairment. The Company also reviews its goodwill and other intangible assets 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. The Company qualitatively determines whether, more likely than not, the fair value exceeds the carrying amount of a reporting unit. There are numerous assumptions and estimates underlying the qualitative assessments including future earnings, long-term strategies, and the Company’s annual planning and forecasting process. If these planned initiatives do not accomplish the targeted objectives, the assumptions and estimates underlying the qualitative assessments could be adversely affected and have a material effect upon the Company’s financial condition and results of operations. As of December 31, 2013 and 2012, goodwill and other intangible impairment assessments indicated that there was no impairment.
The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development
Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assessing performance. The Company does not have any operations that require separate disclosure as reportable operating segments for the periods presented.
The annual direct premiums written attributable to the Company's lines of insurance were as follows:
The restricted stock units vest at the end of a three-year performance period beginning with the year of the grant, and then only if, and to the extent that, the Company’s performance during the performance period achieves the threshold established by the Compensation Committee of the Company's Board of Directors. 2011 grants vest based on the Company's cumulative underwriting income. 2012 grants vest based on the Company's cumulative underwriting income and net premium written growth. 2013 grants vest based on the Company's cumulative underwriting income, annual underwriting income, and net premiums written growth.
The fair value of each restricted stock unit grant was determined based on the market price on the date of grant. Compensation cost is recognized based on management’s best estimate that performance goals will be achieved. If such goals are not met, no compensation cost would be recognized and any recognized compensation cost would be reversed. For the 2012 and 2011 grants, the achievement of the performance condition set by the Compensation Committee was no longer considered probable, and previously recognized compensation costs were reversed as of December 31, 2013. See Note 14 for additional disclosures.
In February 2013, the FASB issued a new standard that requires entities to disclose additional information about items reclassified out of accumulated other comprehensive income in their financial statements. Entities are required to include information about changes in accumulated other comprehensive income balances by component and additional information about significant items reclassified out of accumulated other comprehensive income in their interim reporting periods. The Company adopted the new standard which became effective for the interim period ended March 31, 2013. The adoption of the new standard did not have any impact on the Company’s consolidated financial statements.
The following table presents (losses) gains due to changes in fair value of investments that are measured at fair value pursuant to application of the fair value option:
Gross gains and losses realized on the sales of investments, excluding options, are shown below:
At December 31, 2013, fixed maturity holdings rated below investment grade and non-rated comprised 1.5% 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, 2013 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.
Pricing inputs are other than quoted prices in active markets, which are based on the following:
The Company obtained unadjusted fair values on 99.5% of its portfolio from an independent pricing service. For 0.5% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of December 31, 2013.
Level 2 Measurements-Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.
Mortgage-backed securities: Comprised of securities that are collateralized by residential mortgage loans and valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. The Company had holdings of $21.9 million and $4.3 million at December 31, 2013 and 2012, respectively, in commercial mortgage-backed securities.
Total return swap/Interest rate swap: Valued based on models using inputs, such as interest rate yield curves, underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets, observable for substantially the full term of the contract.
Level 3 Measurements-Fair values of financial assets are based on inputs that are both unobservable and significant to the overall fair value measurement, including any items in which the evaluated prices obtained elsewhere were deemed to be of a distressed trading level.
The Company’s financial instruments, at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment (losses) gains in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
At December 31, 2013, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
On July 2, 2013, the Company entered into an unsecured $200 million five-year revolving credit facility. The interest rate on borrowings under the credit facility is based on the Company's debt to total capital ratio and ranges from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is above 25%. Commitment fees for undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is above 25%. In 2013, the interest rate was LIBOR plus 112.5 basis points on the $50 million of borrowings and 12.5 basis points on the undrawn portions of the credit facility.
The bank loan and credit facilities contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk-based capital (“RBC”) ratio. The Company was in compliance with all of its loan covenants at December 31, 2013.
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 intended to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are intended to manage the interest rate risk associated with the Company’s debts with fixed or floating rates.
On August 9, 2013, AFL entered into a three-year total return swap agreement with Citibank. Under the total return swap agreement, AFL receives the income equivalent on underlying obligations and pays to Citibank interest equal to LIBOR plus 120 basis points on the outstanding notional amount of the underlying obligations, which was approximately $149 million as of December 31, 2013. The total return swap is secured by approximately $40 million of U.S. Treasuries as collateral, which is included in short-term investments on the consolidated balance sheets.
On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate on a Bank of America $18 million LIBOR plus 50 basis points loan for a fixed rate of 4.25% that matured on March 1, 2013. The swap was designated as a cash flow hedge and the fair market value of the interest rate swap was reported as a component of other comprehensive income and amortized into earnings over the term of the hedged transaction. On October 4, 2011, the Company refinanced the $18 million loan that was scheduled to mature on March 1, 2013 with a Union Bank $20 million LIBOR plus 40 basis points loan that matures on January 2, 2015. The related interest swap was deemed to become ineffective and was no longer designated as a hedge. The related interest rate swap expired on March 1, 2013.
The Company and its subsidiaries file a consolidated federal income tax return. The provision for income tax expense consists of the following components:
The income tax provision reflected in the consolidated statements of operations is reconciled to the federal income tax on income before income taxes based on a statutory rate of 35% as shown in the table below:
There was a $4.9 million increase to the total amount of unrecognized tax benefits related to tax uncertainties during 2013. The increase was the result of tax positions taken regarding federal tax credit carryforwards and state tax apportionment issues based on management's best judgment given the facts, circumstances and information available at the reporting date. The Company does not expect any changes in such unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months.
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 2014, the insurance subsidiaries of the Company are permitted to pay approximately $260 million in dividends to Mercury General without the prior approval of the DOI of domiciliary states. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2013, 2012, and 2011, the Insurance Companies paid the Company ordinary dividends of $120 million, $145 million, and $0, respectively, and extraordinary dividends of $0, $0, and $270 million, respectively.
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. The matching contributions, at a rate set by the Board of Directors, totaled $8.1 million, $7.2 million, and $7.2 million for 2013, 2012, and 2011, respectively.
In 2013, the fair value of stock option awards was estimated on the date of grant using a closed-form option valuation model (Black-Scholes) based on the following table, which provides the weighted-average values of assumptions used in the calculation of grand-date fair values during the years ended December 31, 2013. No stock options were awarded in 2012 and 2011.
A summary of the stock option activity under the Company’s plans as of December 31, 2013 and changes during the year then ended is presented below:
A reconciliation of the numerators and denominators of the basic and diluted earnings per share calculation for income from operations is presented below:
The following table presents future minimum commitments for operating leases as of December 31, 2013:
The CEA is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. The Company places all new and renewal earthquake coverage offered with its homeowners policies directly with the CEA. The Company receives a small fee for placing business with the CEA, which is recorded as other income in the consolidated statements of operations. 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 the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 1, 2013, the most recent date at which information was available, was approximately $60.4 million. There was no assessment made in 2013.
In April 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to MIC, MCC, and CAIC based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI in February
The Company is also involved in proceedings relating to assessments and rulings made by the FTB. See Note 9.
Many businesses are still experiencing a slow recovery from the severe economic recession. Though optimism is growing, economists and analysts expect that the global recovery will remain modest and uneven in 2014 due in large part to continuing political disagreements in Washington that may cause businesses and consumers to limit spending. Further, softness in the European banking sector and the Japanese fiscal condition continue to lead to weaker global economic growth, heightened financial vulnerabilities and some negative rating actions. The Company is unable to predict the duration and severity of current global economic conditions and their impact on the United States, and California, where the majority of the Company’s business is produced. If economic conditions do not show improvement, there could be an adverse impact on the Company’s financial condition, results of operations, and liquidity.
The dilutive impact of incremental shares is excluded from net loss position in accordance with GAAP.
Net income during 2013 was primarily affected by higher net premiums earned offset by catastrophe related losses, and declines in the fair value of the Company's investment portfolio due to the overall decline in the municipal markets. Net income during 2013 was also affected by the consolidation of claims and underwriting operations located outside of California into hub locations, which resulted in approximately $10 million of pre-tax office closure costs and severance related expense during the
first quarter of 2013. The primary causes of the net loss during the second quarter of 2013 were driven by increased losses resulting from catastrophe losses due to tornadoes in Oklahoma and severe storms in the Midwest and the Southeast regions, and declines in the fair value of the Company’s municipal and equity securities due to the overall decline in the municipal and equity markets.
Net income during 2012 was primarily affected by slightly higher net premiums earned and lower operating expenses, offset by unfavorable development on loss reserves, catastrophe related losses, and higher loss frequency and severity on the California private passenger automobile line of business. The decrease in operating expenses in 2012 was primarily due to ongoing cost reduction efforts and lower profitability related expenses. The unfavorable development of loss reserves is largely the result of re-estimates of California BI losses . The primary causes of the net loss during the second quarter of 2012 were driven by unfavorable development on loss reserves, catastrophe losses in the Midwest region, and declines in the fair value of the Company’s equity securities due to the overall decline in the equity markets. The net loss during the fourth quarter of 2012 was primarily due to increased losses resulting from catastrophe losses from Hurricane Sandy, high seasonal frequency in California, and declines in the fair value of the Company’s municipal and equity securities due to the overall decline in the municipal and equity markets.