The Company’s properties are well maintained, adequately meet its needs, and are being utilized for their intended purposes.
The Company’s net income for the year ended December 31, 2016 decreased to $73.0 million, or $1.32 per diluted share, from $74.5 million, or $1.35 per diluted share, for the same period in 2015. Included in net income is $121.9 million of pre-tax investment income that was generated during 2016 on a portfolio of $3.5 billion at fair value at December 31, 2016, compared to $126.3 million of pre-tax investment income that was generated during 2015 on a portfolio of $3.4 billion at fair value at December 31, 2015. Also included in net income are net realized investment losses of $34.3 million and $83.8 million in 2016 and 2015, respectively.
During 2016, 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 competitive in California and in other states.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $287 million and $190 million in 2016 and 2015, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analyses indicate that they are needed.
Loss Frequency-Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. Loss frequency trends are affected by many factors such as fuel prices, the economy, the prevalence of distracted driving and collision avoidance and other technology in vehicles. Loss frequency generally increased at a modest rate in 2016.
During 2016, the Company implemented rate changes in twelve states. In California, the following rate increases were implemented or filed for DOI approval:
In February, the California DOI approved a 5.0% rate increase on MIC's private passenger automobile line of insurance business, which represented approximately 50% of the total Company's net premiums earned in 2016. This rate increase was implemented in March 2016.
In April 2016, the California DOI approved a 6.9% rate increase on CAIC's private passenger automobile line of insurance business, which represented approximately 14% of the Company’s total net premiums earned in 2016. This rate increase was implemented in June 2016.
In July 2016, CAIC filed for an additional 6.9% rate increase in its private passenger automobile line of business and is awaiting California DOI approval.
The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 10%, 5%, and 3% for 2016, 2015, and 2014 accident years, respectively.
During the years 2012 through 2016, the changes in the loss severity amounts for the three preceding accident years from the prior year amounts (BI severity variance from prior year) have ranged as follows:
The following table presents the effects on the California automobile BI loss reserves for the 2016, 2015, and 2014 accident years based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.
During 2016, the Company implemented a claims strategy that reduced the number of small dollar settlements offered shortly after the claims were reported. This strategy reduced the total number of claims expected, which had the effect of increasing the actual recorded severity across the total claims population. There were fewer small dollar claims in the calculation of actual recorded severity for the 2016 accident year compared to prior accident years. Consequently, the 16.5% increase in actual recorded severity is skewed upward due to this strategy change. Had, for example, the number of claims expected for the 2016 accident year of 29,698 been equal to the number of claims expected for the 2015 accident year of 32,216, the change in actual recorded severity for the 2016 accident year would have been 7.4%.
The Company generally estimates ultimate claim counts for an accident period based on development of claim counts in prior accident periods. For California automobile BI claims, the Company's experience indicates that approximately 4% to 7% additional claims would be reported in the year subsequent to an accident year. However, such late reported claims could be more or less than the Company’s expectations. Typically, almost every claim is reported within one year following the end of an accident year and at that point the Company has a high degree of certainty as to the ultimate claim count.
At December 31, 2016, there were 27,896 BI claims reported for the 2016 accident year and the Company estimates that these are expected to ultimately grow by approximately 6.5%. The Company believes that while actual development in recent years has ranged approximately from 4% to 7%, it is reasonable to expect that the range could be as great as between 0% and 10%. Actual development may be more or less than the expected range.
The Company evaluates its loss 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 2016, the Company reported unfavorable development of approximately $85 million on the 2015 and prior accident years’ loss and loss adjustment expense reserves, which at December 31, 2015 totaled approximately $1.15 billion. The unfavorable development in 2016 was primarily from the California and Florida automobile lines of business.
During 2016, the Company recorded catastrophe losses of approximately $27 million resulting primarily from severe storms outside of California and rainstorms in California.
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. 99.7% of the fair value of these financial instruments held at December 31, 2016 is based on observable market prices, observable pricing 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.
The Company may hold or acquire financial instruments that lack observable market prices or pricing parameters because they are less actively traded currently or in future periods. 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 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 financial instruments may be reduced 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 are not actively quoted. For a further discussion, see Note 4. Fair Value Measurement, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
At December 31, 2016, the Company’s deferred income taxes were in a net asset position mainly due to deferred tax assets generated by unearned premiums, AMT credit carryforwards, expense accruals and loss reserve discounting. These deferred tax assets were substantially offset by deferred tax liabilities resulting from deferred acquisition costs and unrealized gains on securities held. 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 of the Company’s deferred tax assets which are ordinary in character takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities that represent sources of future ordinary taxable income.
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
Net premiums written and net premiums earned in 2016 increased 5.2% and 5.9%, respectively, from 2015. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile line of insurance business and growth in the number of homeowners and commercial automobile policies written in California.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The lower expense ratio for the year ended December 31, 2016 was primarily attributable to lower advertising expenses and lower overall compensation costs, including bonuses, compared to the year ended December 31, 2015.
Income tax benefit was $2.3 million and $3.9 million for the years ended December 31, 2016 and 2015, respectively. The $1.6 million decrease in income tax benefit was mainly due to an increase in liability for uncertain tax positions in 2016 combined with a decrease in liability for uncertain tax positions in 2015.
The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio. The fair values in 2016 and 2015 were adversely affected by the increases in market interest rates.
In 2016, the increases in the fair value of equity securities were primarily due to an overall improvement in the equity markets. In 2015, the decreases in the fair value of equity securities were primarily due to a decline in the value of the Company's holdings in industrial stocks.
Net premiums written and net premiums earned in 2015 increased 5.6% and 5.8%, respectively, from 2014. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile line of insurance business and growth in the number of homeowner policies written in California and private passenger automobile policies written in several states outside of California.
The Company’s loss ratio was affected by unfavorable development of approximately $13 million and favorable development of approximately $3 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2015 and 2014, respectively. The unfavorable development in 2015 was primarily from the California homeowners and automobile lines of business outside of California, which was partially offset by favorable development in the California personal automobile line of business. The favorable development in 2014 was primarily from California personal automobile lines of insurance business partially offset by adverse development in other states. The 2015 loss ratio was also negatively impacted by a total of $19 million of catastrophe losses mostly due to severe storms outside of California, and rainstorms and wildfires in California. The 2014 loss ratio was also negatively impacted by a total of $11 million of catastrophe losses mostly due to winter freeze events in the East Coast and homeowners losses in California from severe rainstorms. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 71.5% and 70.7% for the years ended December 31, 2015 and 2014, respectively. The increase in the adjusted loss ratio was primarily due to higher loss frequency and severity.
The Company has generated positive cash flow from operations since the public offering of its common stock in November 1985, and 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 $596.0 million at December 31, 2016 as well as $70 million of credit available on a $250 million revolving credit facility, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. 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 or for future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
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 Company's portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity securities purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The holdings, which are heavily weighted with high coupon issues, are expected to be called prior to maturity. 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.
The following table presents the maturity and duration of the Company's fixed maturity securities portfolio:
The following table presents the credit quality ratings of the Company’s fixed maturity portfolio at fair value.
60.6% of the insured municipal securities, most of which are investment grade, are insured by bond insurers that provide credit enhancement in addition to the ratings reflected by the financial strength of the underlying issuers. At December 31, 2016, the average rating of the Company’s insured investment grade municipal securities was A+. The remaining 39.4% of insured municipal securities have bond insurers that have credit ratings below or equal to the financial strength of the underlying issuers; therefore, the Company believes the insurance does not provide a credit enhancement.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2016, 10.1% of the total investment portfolio at fair value was held in equity securities, compared to 9.3% at December 31, 2015.
On July 2, 2013, the Company entered into an unsecured $200 million five-year revolving credit facility, which was later expanded to a borrowing capacity of $250 million. 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 the 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%. Debt to capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. In 2016, the interest rate was LIBOR plus 112.5 basis points on the $180 million of borrowings and 12.5 basis points on the undrawn portion of the credit facility. The interest rate was approximately 1.73% at December 31, 2016.
Among other considerations, 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 the Insurance Companies of $1.44 billion at December 31, 2016, and net premiums written of $3.2 billion, the ratio of premiums written to surplus was 2.19 to 1.
The Company’s significant contractual obligations at December 31, 2016 are summarized as follows:
The Company’s debt contains various terms, conditions and covenants which, if violated by the Company, would result in a default and could result in the acceleration of the Company’s payment obligations. Amounts differ from the balances presented on the consolidated balance sheets as of December 31, 2016 because the debt amounts above include interest, calculated by using the average one-month LIBOR rate in 2016 plus the bank margin in effect.
The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, and office equipment that expire at various dates through the year 2022.
Loss and loss adjustment expense reserves represents an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2016. The Company has estimated the timing of these payments based on its historical experience and expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above. The ultimate cost of losses may vary materially from recorded amounts which are the Company’s best estimates. The loss and loss adjustment expense payments in 2016 related to prior years exceeded the payment amount disclosed on this table in our prior year filing by approximately 10%, largely due to increases in prior year loss reserve estimates and normal volatility in payment patterns. The Company believes that cash flows from operations and existing cash and investments are sufficient to meet these obligations despite the uncertainty in payment patterns. For more detailed information on the Company's liquidity and cash flows, see "Liquidity and Capital Resources-B. Cash Flows" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
The table excludes liabilities of $11.8 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments.
Consolidated Statements of Operations for the Years Ended December 31, 2016, 2015, and 2014
Consolidated Statements of Cash Flows for the Years Ended December 31, 2016, 2015, and 2014
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. 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 also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercury General Corporation’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 9, 2017 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
In our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016, and our report dated February 9, 2017 expressed an unqualified opinion on those consolidated financial statements.
Mercury General Corporation ("Mercury General") and its subsidiaries (referred to herein collectively as the "Company") are primarily engaged in writing personal automobile insurance through 14 Insurance Companies in 11 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. The private passenger automobile line of insurance business was more than 77% of the Company’s direct premiums written in 2016, 2015, and 2014, of which approximately 84%, 83%, and 83% of the private passenger automobile premiums were written in California during 2016, 2015, and 2014, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
Mercury County Mutual Insurance Company is not owned but is controlled by the Company through a management contract.
The Company did not have other comprehensive income (loss) in 2016, 2015 and 2014.
The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time an eligible item is first recognized. 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 (the "FASB") for accounting for financial instruments. See Note 2. Fair Value of Financial Instruments for additional information on the fair value option.
As required by statute, the Company’s insurance subsidiaries have securities deposited with the departments of insurance or similar governmental agencies in the states in which they are licensed to operate with fair values totaling $19 million and $21 million at December 31, 2016 and 2015, respectively.
Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that 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 premiums are earned. The Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. Deferred policy acquisition cost amortization was $562.5 million, $539.2 million, and $526.2 million during the years ended December 31, 2016, 2015, and 2014, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $40 million, $44 million, and $23 million during the years ended December 31, 2016, 2015, and 2014, respectively.
Premium revenue is recognized on a pro-rata basis over the terms of the policies in proportion to the amount of insurance protection provided. Premium revenue includes installment and other fees for services which are recognized in the periods in which the services are rendered. Unearned premiums represent the portion of the written premium related to the unexpired policy term. Unearned premiums are predominantly computed monthly on a pro-rata basis and are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other receivables. Net premiums written, a statutory measure designed to determine production levels, were $3.16 billion, $3.00 billion, and $2.84 billion in 2016, 2015, and 2014, respectively.
Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the loss reserve that is required. A key assumption in estimating loss reserves is the degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact this assumption. 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 could be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims, such as those involving the Company’s bodily injury (BI) coverages. 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 for loss reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
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.
The paid loss method analyzes historical payment patterns to estimate the amount of losses yet to be paid.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company generally determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on loss reserves established by adjusters and average losses on previous similar catastrophes.
In August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments (Topic 230)." The new guidance is intended to reduce diversity in how certain transactions are classified in the consolidated statement of cash flows. ASU 2016-15 will be effective for the Company beginning January 1, 2018. The Company is evaluating the impact that ASU 2016-15 will have on its consolidated financial statements and related disclosures.
In March 2016, the FASB issued ASU 2016-09, "Compensation - Stock Compensation (Topic 718)," which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 is effective for the Company with the quarter ending March 31, 2017. The Company is evaluating the impact that ASU 2016-09 will have on its consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)," which supersedes the guidance in Accounting Standards Codification ("ASC") 840, "Leases." ASU 2016-02 requires a lessee to recognize lease assets and lease liabilities
In May 2015, the FASB issued ASU 2015-09, "Financial Services -Insurance (Topic 944), Disclosures About Short-Duration Contracts." ASU 2015-09 requires insurance entities to provide additional disclosures related to claims liabilities. The additional disclosure requirements for the annual reports include: (1) claims development information by accident year, on a net of reinsurance basis, for the number of years for which claims incurred remain outstanding but not to exceed the most recent 10 years, and for the most recent reporting period presented, an insurer also needs to disclose the amount of total net outstanding claims for all accident years included in the claims development tables; (2) a reconciliation of claims development information and the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses; and (3) information about the claims frequency and the amount of the incurred-but-not-reported liabilities for each accident year presented. In addition, a description of the methodology used to determine the amounts disclosed is required. The roll forward of the liability for unpaid claims and claims adjustment expenses, currently required only for annual periods, will also be required for interim periods. ASU 2015-09 became effective for the Company beginning with the annual period ended December 31, 2016, and quarter periods beginning with the first quarter of 2017. Although the adoption of this standard did not have a material impact on its consolidated financial statements, the Company expanded the nature and extent of its insurance contracts disclosures.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606)." ASU 2014-09 requires entities to apply a five-step model to determine the amount and timing of revenue recognition. The model specifies, among other criteria, that revenue should be recognized when an entity transfers control of goods or services to a customer in the amount to which the entity expects to be entitled. In August 2015, the FASB issued ASU 2015-14, "Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date," which deferred the effective date of ASU 2014-09 for the Company to January 1, 2018. Through the first half of 2016, the FASB issued additional ASUs on Topic 606 that do not change the core principle of the guidance in ASU 2014-09 but merely clarify certain aspects of it. The additional ASUs also become effective for the Company beginning January 1, 2018. As the accounting for insurance contracts is outside of the scope of ASU 2014-09, the Company does not expect the adoption of this ASU to have a material impact on its financial position, results of operations, or cash flows.
The fair values of the total return swaps reflect the estimated amounts that, upon termination of the contracts, would be received for selling an asset or paid to transfer a liability in an orderly transaction at December 31, 2016 and 2015 based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract.
Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.
Other asset-backed securities: Comprised of securities that are collateralized by non-mortgage assets, such as automobile loans, 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’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.
Depreciation expense, including amortization of leasehold improvements, was $20.2 million, $20.5 million, and $22.1 million during 2016, 2015, and 2014, respectively.
On July 2, 2013, the Company entered into an unsecured $200 million five-year revolving credit facility, which later was expanded to a borrowing capacity of $250 million. 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 the 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%. Debt to capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. In 2016, the interest rate was LIBOR plus 112.5 basis points on the $180 million of borrowings and 12.5 basis points on the undrawn portion of the credit facility. The interest rate was approximately 1.73% at December 31, 2016.
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, 2016.
There were no changes in the carrying amount of goodwill during the periods presented. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during the periods presented.
In 2015, the Company recognized $1.4 million of other intangible assets for a state insurance license related to the acquisition of Workmen's Auto Insurance Company. See Note 20. Acquisition for the acquisition's cost allocation.
There was a $0.8 million increase to the total amount of unrecognized tax benefits related to tax uncertainties during 2016. The increase was mainly due to tax positions taken regarding 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.
As presented above, the balances of unrecognized tax benefits were $13.0 million and $12.2 million at December 31, 2016 and 2015, respectively. Of these totals, $11.8 million and $10.9 million at December 31, 2016 and 2015, respectively, represent unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would impact the Company’s effective tax rate.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. During the years ended December 31, 2016, 2015, and 2014, the Company recognized net interest and penalty expense, excluding refunds, of $606,000, $112,000, and $739,000, respectively. The Company carried an accrued interest and penalty balance of $3,521,000 and $2,915,000 at December 31, 2016 and 2015, respectively.
The increase in the provision for insured events of prior years in 2016 of approximately $85.4 million primarily resulted from the California and Florida automobile lines of business which experienced higher loss severity on liability coverages including Bodily Injury, Combined Single Limits and Property Damage than was originally estimated.
The decrease in the provision for insured events of prior years in 2014 of approximately $3.2 million primarily resulted from lower than expected loss severity on California personal automobile lines of insurance business partially offset by adverse development in other states.
The Company experienced pre-tax catastrophe losses and loss adjustment expenses from severe weather events of $27 million, $19 million, and $11 million in 2016, 2015, and 2014, respectively. The losses in 2016 were primarily due to severe storms outside of California, and rainstorms in California. The losses in 2015 were primarily due to severe storms outside of California, and rainstorms and wildfires in California. The losses in 2014 were primarily related to winter freeze events on the East Coast and severe rainstorms in California.
The following is information about incurred and paid claims development as of December 31, 2016, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities plus expected development on reported claims included within the net incurred claims amounts for our two major product lines: automobile and homeowners lines of business. The cumulative number of reported claims represents open claims, claims closed with payment, and claims closed without payment. It does not include an estimated amount for unreported claims. The number of claims is measured by claim event (such as a car accident or storm damage) and an individual claim event may result in more than one reported claim. The Company considers a claim that does not result in a liability as a claim closed without payment.
The reconciliation of the net incurred and paid claims development tables to the liability for claims and claim adjustment expenses in the consolidated balance sheets is as follows.
The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations. The RBC formula is used by insurance regulators to monitor capital and surplus levels. It was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance business having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements, and a number of other factors. The Company periodically monitors the RBC level of each of the Insurance Companies. As of December 31, 2016, 2015, and 2014, each of the Insurance Companies exceeded the minimum required RBC level, as determined by the NAIC and adopted by the state insurance regulators. None of the Insurance Companies’ RBC ratios were less than 375% of the authorized control level RBC as of December 31, 2016, 2015 and 2014. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
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 $8.2 million, $8.5 million, and $8.0 million for 2016, 2015, and 2014, respectively.
The Company also provides annual cash bonuses to eligible employees based on performance criteria for each recipient and for the Company as a whole. The Company performance goals were based on the Company's premium growth and combined ratio. The Company paid annual cash bonuses of $16.8 million, $20.7 million, and $19.1 million in 2016, 2015, and 2014, respectively.
No stock options were awarded in 2016, 2015, and 2014 under the 2015 Plan or 2005 Plan. The fair values of stock options awarded in 2013 under the 2005 Plan were estimated on the dates of grant using a closed-form option valuation model (Black-Scholes). The following table provides the assumptions used in the calculation of grant-date fair values of stock options awarded during 2013 based on the Black-Scholes option pricing model:
The following table presents a summary of the stock option activity under the Company’s plans for the year ended December 31, 2016:
The following table presents the restricted stock unit grants summary at December 31, 2016:
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. For 2014, 2015 and 2016 grants, vesting is based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. As of December 31, 2016, 2,500, 3,500, and 3,500 target restricted stock units granted in 2016, 2015 and 2014, respectively, have been forfeited because the recipients were no longer employed by the Company. Expired shares represent shares that did not meet the vesting requirements.
The fair value of each restricted stock unit grant was determined based on the closing price of the Company's common stock on the grant date for awards classified as equity and on each reporting date for awards classified as a liability. 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 will be recognized and any recognized compensation cost would be reversed.
Potentially dilutive securities representing approximately 27,600, 67,000, and 252,000 shares of common stock for 2016, 2015, and 2014, respectively, were excluded from the computation of diluted earnings per common share because their effect would have been anti-dilutive.
The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, and office equipment that expire at various dates through the year 2022. For leases that contain predetermined escalations of the minimum rentals, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent in other liabilities. This liability amounted to $2.4 million and $3.6 million at December 31, 2016 and 2015, respectively. Total rent expense under these lease agreements was $19.7 million, $16.0 million, and $14.6 million for 2016, 2015, and 2014, respectively.
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
On August 12, 2016, the Superior Court issued its ruling on the Writ, for the most part granting the relief sought by the Company. The Superior Court found that the Commissioner and the California DOI did commit due process violations, but declined to dismiss the case on those grounds. The Superior Court also agreed with the Company that the broker fees at issue were not premium, and that the penalties imposed by the Commissioner were improper, and therefore vacated the Order imposing the penalty. The Superior Court entered final judgment on November 17, 2016, issuing a writ requiring the Commissioner to refund the entire penalty amount within 120 days, plus prejudgment interest at the statutory rate of 7%. The Company has filed a motion with the ALJ to dismiss the false advertising OSC portion of the NNC based on the Superior Court's findings and legal reasoning. On January 12, 2017, the Commissioner filed a notice of appeal of the Superior Court's judgment entered on November 17, 2016. Since the matter has been appealed, the Company has not yet recognized in the consolidated financial statements the vacation of the Commissioner’s Order or established a receivable for the refund of the $27.6 million penalty plus any related interest owed.
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 Note 1. Summary of Significant Accounting Policies.
The following table presents summarized quarterly financial data for 2016 and 2015:
Net income for 2015 was primarily affected by net realized investment losses, and an increase in losses and loss adjustment expenses partially offset by an increase in net premiums earned. Net income for the fourth quarter of 2015 was affected by net realized investment losses of $8.2 million.
The Company paid $8 million in cash for the shares of WAIC, of which $2 million has been held in escrow for up to three years as security for any loss development on claims incurred on or prior to June 30, 2014. Based on the evaluation performed at the acquisition date and at December 31, 2015, of the claims reserves for WAIC for losses and loss adjustment expenses incurred on or prior to June 30, 2014, the Company estimated that it would recover the $2 million held in escrow and, therefore, the Company deducted it from cash consideration to arrive at the fair value of total consideration transferred. The Company recovered the $2 million held in escrow in 2016. In accordance with regulatory approval requirements, the Company made a $15 million cash capital contribution to WAIC on January 12, 2015.
The Company’s Chief Operating Decision Maker evaluates operating results based on pre-tax underwriting results which is calculated as net premiums earned less (a) losses and loss adjustment expenses; and (b) underwriting expenses (policy acquisition costs and other operating expenses).
Expenses are allocated based on certain assumptions that are primarily related to premiums and losses. The Company’s net investment income, net realized investment gains (losses), other income, and interest expense are excluded in evaluating pre-tax underwriting profit. The Company does not allocate its assets, including investments, or income taxes in evaluating pre-tax underwriting profit.