The Company leases additional office space for operations. Office location is not crucial to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space. For future expansion, the Company owns 6.3-acre and 5.9-acre parcels of land in Brea and Rancho Cucamonga, California, respectively.
Certain statements in this Annual Report on Form 10-K or in other materials the Company has filed or will file with the SEC (as well as information included in oral statements or other written statements made or to be made by the Company) contain or may contain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results, and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause the Company’s actual business, prospects, and results of operations to differ materially from the historical information contained in this Annual Report on Form 10-K and from those that may be expressed or implied by the forward-looking statements contained in this Annual Report on Form 10-K and in other reports or public statements made by the Company.
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty insurance industry has been highly cyclical, with periods of high premium rates and shortages
of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a significant impact on the Company’s ability to grow and retain business.
Inflation-The largest cost component for automobile insurers is losses, which include medical, replacement automobile parts, and labor costs. There can be significant variation in the overall increases in medical cost inflation, and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
In April 2010, the California DOI ("CDI") 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 CDI in February 2010. The 2010 NNC included allegations of 35 instances of noncompliance with applicable California insurance law and sought to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and reserved the right to seek monetary penalties. In April 2010, the Company submitted a Statement of Compliance and Notice of Defense to the CDI, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each allegation. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense did not establish to the satisfaction of the CDI that the alleged noncompliance did not exist, and the matters described in the 2010 NNC were not able to be resolved informally with the CDI. While continuing to dispute the CDI's allegations, the Company implemented various changes requested by the CDI and engaged in settlement discussions in the interest of avoiding further litigation. On March 2, 2015, MIC, MCC and CAIC entered into an agreement with the CDI, pursuant to which all allegations in the 2010 NNC were settled for $1 million, which was subsequently paid, and the case was resolved.
In March 2006, the CDI 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 CDI sought to impose a fine for each policy on which the Company allegedly permitted an agent to charge a broker fee, to impose 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 administrative law judge (the "ALJ") bifurcated the 2004 NNC between (a) the CDI’s order to show cause (the "OSC"), in which the CDI asserts the false advertising allegations and accusation, and (b) the CDI’s notice of noncompliance, in which the CDI asserts the unlawful rate allegations. In February 2012, the ALJ submitted a proposed decision dismissing the NNC, based on conduct by the CDI and the Commissioner in violation of the Company's due process rights. Specifically, the ALJ found that the CDI's attorneys and the Commissioner engaged in improper ex parte communication, and commenced a rule making in order to supersede unfavorable evidentiary rulings by the ALJ. The Commissioner rejected the ALJ's proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, but the challenge was unsuccessful. The Court did not rule on the merits of the ALJ's due process concerns, but merely held that the Company was required to exhaust its administrative remedies before seeking relief in the Superior Court. The case was referred back to the ALJ, and the due process issues raised by the ALJ's dismissal were preserved for later appeal. Following an evidentiary hearing in April 2013, post-hearing briefs and an unsuccessful mediation, the ALJ closed the evidentiary record on April 30, 2014. Although a proposed decision was to be submitted to the Commissioner on or before June 30, 2014, after which the Commissioner would have 100 days to accept, reject or modify the proposed decision, or required further evidence, the proposed decision was submitted on December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ's proposed decision, which became the Commissioner's adopted Order. The Company received notice of this Order on January 10, 2015. The decision and Order found that from the period July 1, 1996 through 2006, the Company's "brokers" were actually operating as "de facto agents" and that the charging of "broker fees" by these producers constituted the charging of "premium" in excess of the Company’s approved rates. The Order assessed a civil penalty in the amount of $27.6 million against the Company. The Company denies the allegations and/or findings in the Order, and believes that no monetary penalties are warranted. On February 9, 2015, the Company filed a Writ of Administrative Mandamus and Complaint for Declaratory Relief (the "Writ") in the Orange County Superior Court seeking, among other things, to require the Commissioner to vacate the Order, to stay the Order while the Superior Court action is pending, and to judicially declare as invalid the Commissioner’s interpretation of certain provisions of the California Insurance Code. Subsequent to the filing of the Writ, a consumer group petitioned and was granted the right to intervene in the Superior Court action. The court did not order a stay, and the $27.6 million assessed penalty was accrued in 2014 and paid in March 2015. The Company filed an amended Writ on September 11, 2015, adding an explicit request for a refund of the penalty, with interest. The court initially scheduled the matter for hearing on March 14, 2016, with the opening brief due October 19, 2015. The Company filed its opening brief, but the Commissioner then requested an extension of time to file an opposing brief and for the hearing on the Writ. The extension was granted, and the hearing is now scheduled for June 13, 2016. The Company intends to vigorously defend itself against the allegations, and seeks reversal of the $27.6 million assessed fine, unless a reasonable settlement can be reached.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see Note 17. Commitments and Contingencies-Litigation, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
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 method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of insurance business which have a long operating history.
Material damage ("MD") reserves, including collision and comprehensive property damage-approximately 20% of total reserves
The following table presents the typical closure patterns of BI claims in the Company's California personal automobile insurance coverage:
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 2015, 2014, and 2013, respectively. At December 31, 2015, the loss severity for the amounts recorded at December 31, 2014 changed by (2.7)%, 1.7%, and 1.3% for the 2014, 2013, and 2012 accident years, respectively. Comparatively, at December 31, 2014, the loss severity for the amounts recorded at December 31, 2013 changed by (3.1)%, (1.3)%, and 0.4% for the 2013, 2012, and 2011 accident years, respectively.
There are many other potential factors that can affect the number of claims reported after an accident period ends. These factors include changes in weather patterns, a change in the number of litigated files, the number of automobiles insured, and whether the last day of the accident period falls on a weekday or a weekend. However, the Company is unable to determine which, if any, of the factors actually impact the number of claims reported and, if so, by what magnitude.
The following table presents the effects on loss development of different claim count within the broader possible range at December 31, 2015:
Unexpected losses are generally not provided for in the current loss reserve because they are not known or expected and tend to be unquantifiable. Once known, the Company establishes a provision for the losses, but it is not possible to provide any meaningful sensitivity analysis as to the potential size of any unexpected losses. These losses can be caused by many factors, including unexpected legal interpretations of coverage, ineffective claims handling, regulations extending claims reporting periods, assumption of unexpected or unknown risks, adverse court decisions as well as many unknown factors.
Discussion of losses and loss reserves and prior period loss development at December 31, 2015
During 2015, the Company recorded catastrophe losses of approximately $19 million which were primarily the result of severe storms outside of California, and rainstorm and wildfire losses in California.
Financial instruments recorded in the consolidated balance sheets include investments, receivables, total return swaps, accounts payable, options sold, and secured and unsecured notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values. All investments are carried on the consolidated balance sheets at fair value, as described in Note 2. Fair Value of Financial Instruments, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
The Company’s effective income tax rate can be affected by several factors. These generally include tax-exempt investment income, other nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate was (5.5)% for 2015, compared to 28.1% for 2014. The decrease in the effective tax rate is mainly due to a $176.9 million decrease in total pre-tax income for 2015 compared to the total pre-tax income for 2014, while tax-exempt investment income, a component of total pre-tax income, remained relatively consistent. The decrease in pre-tax income was primarily due to a shift from net realized investment gains of $81.2 million in 2014 to net realized investment losses of $83.8 million in 2015. The Company’s effective tax rate for the year ended December 31, 2015 was lower than the statutory tax rate primarily as a result of tax-exempt investment income earned.
Legal Matters" above and Note 17. Commitments and Contingencies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies.
losses mostly due to severe storms outside of California, and rainstorm and wildfire losses 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.
Income tax (benefit) expense was $(3.9) million and $69.5 million for the years ended December 31, 2015 and 2014, respectively. The $73.4 million decrease in income tax expense to an income tax benefit was primarily due to a $176.9 million reduction in total pre-tax income, while tax-exempt investment income, a component of total pre-tax income, remained relatively consistent compared to the same period in 2014. The decrease in pre-tax income was primarily due to a change in net realized investment gains of $81.2 million in 2014 to net realized investment losses of $83.8 million in 2015.
Net premiums written and net premiums earned in 2014 increased 4.1% and 3.6%, respectively, from 2013. 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 and homeowners lines of insurance business.
The Company’s loss ratio was affected by favorable development of approximately $3 million and unfavorable development of approximately $3 million on prior accident years’ losses and loss adjustment expense reserves for the years ended December 31, 2014 and 2013, respectively. The favorable development in 2014 was primarily from California personal automobile lines of insurance business partially offset by adverse development in other states. The unfavorable development in 2013 was primarily from the Florida private passenger automobile line of insurance business. 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. 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. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 70.7% and 72.0% for the years ended December 31, 2014 and 2013, respectively. The Company attributes the improved accident year loss ratio to the impact of rate increases which exceeded underlying loss cost trends in 2014.
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each respective period.
The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio. The fair value increases in 2014 were primarily caused by the overall improvement in the municipal bond market, and the fair value decreases in 2013 were primarily caused by the overall decline in the municipal bond market.
Net cash provided by operating activities in 2015 was $190.2 million, a decrease of $56.2 million compared to 2014. The decrease was primarily due to the increase in paid losses, loss adjustment expenses, and operating expenses, which included the $27.6 million penalty assessed by the California DOI as discussed in "Regulatory and Legal Matters" above, partially offset by an increase in premiums collected. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of A+, at fair value at December 31, 2015, consistent with the average rating at December 31, 2014. The Company’s municipal bond holdings of which 98.4% were tax exempt, represented 85.6% of its fixed maturity portfolio at December 31, 2015, at fair value, and are broadly diversified geographically.
The Company had $26.7 million, or 0.9% of its fixed maturity portfolio, at fair value, in U.S. government bonds and agencies and mortgage-backed securities (Agencies) at December 31, 2015. In April 2015, Fitch affirmed its AAA rating for U.S. government-issued debt, although a significant increase in government deficits and debt could lead to a downgrade. Standard and Poor’s affirmed the U.S. Treasury’s short-term credit rating of AAA indicating that the short-term capacity of the U.S. to meet its financial commitment on its outstanding obligations is strong. The Company understands that market participants continue to use rates of return on U.S. government debt as a risk-free rate and have continued to invest in U.S. Treasury securities.
The Company had $2.5 billion at fair value ($2.4 billion at amortized cost) in municipal bonds at December 31, 2015, of which $799.6 million were insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was AA- at December 31, 2015.
At December 31, 2015, the average rating of the Company’s municipal bonds insured by 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 issuers. 9.0% of the remaining insured bonds are non-rated or below investment grade, and the Company does not believe that bond insurers provide credit enhancement to the municipal bonds that they insure.
At December 31, 2015 and 2014, respectively, the mortgage-backed securities portfolio of $49.8 million and $47.7 million at fair value ($49.6 million and $45.5 million at amortized cost) was categorized as loans to "prime" borrowers except for $5.4 million and $6.2. million ($5.3 million and $5.5 million at amortized cost) of Alt-A mortgages. 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 $37.3 million and $32.5 million ($37.6 million and $32.3 million at amortized cost) in commercial mortgage-backed securities at December 31, 2015 and 2014, respectively.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities at December 31, 2015 was B, consistent with the weighted-average rating at December 31, 2014. The weighted-average rating of the entire mortgage backed securities portfolio was A- at December 31, 2015, compared to BBB+ at December 31, 2014 .
Included in fixed maturities securities are collateralized loan obligations of $50.5 million and $22.2 million, which represented 1.5% and 0.7% of the total investment portfolio, and had durations of 5.7 years and 5.4 years at December 31, 2015 and 2014, respectively.
Equity holdings of $315.4 million consist of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and private equity funds. The net losses in 2015 due to changes in fair value of the Company’s equity portfolio were $23.0 million. The primary cause of the decrease in the value of the Company's equity securities was the overall decline in the utilities and industrial sectors in 2015.
The following table presents the equity security portfolio by industry sector at December 31, 2015 and 2014:
Beginning in 2015, insurance companies were required to file an Own Risk and Solvency Assessment ("ORSA") with the insurance regulators in their domiciliary states. 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 is intended to be used by state insurance regulators to evaluate the risk exposure and quality of the risk management processes within insurance companies to assist in conducting risk-focused financial examinations and for determining the overall financial condition of insurance companies. The Company filed its ORSA Summary Report with the California DOI in November 2015. Compliance with the ORSA requirements did not have a material impact on the Company's consolidated financial statements.
During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company, and none of the findings reported to date is expected to be material to the Company’s financial position.
As of December 31, 2015, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
The Company’s significant contractual obligations at December 31, 2015 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, 2015 because the debt amounts above include interest, calculated by using the average one-month LIBOR rate in 2015 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 2021.
Reserve for losses and loss adjustment expenses is an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2015. 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.
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2015, 2014, and 2013
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the Company) as of December 31, 2015 and 2014, 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, 2015. 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, 2015, 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, 2016 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
California domiciled insurance company acquired in 2015. See Note 20. Acquisition.
Certain reclassifications have been made in the 2014 consolidated financial statements to conform to the classifications in 2015.
to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates.
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 in the Company's consolidated statements of operations, while interest and dividend income on investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company's consolidated statements of operations.
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 $3.00 billion, $2.84 billion, and $2.73 billion in 2015, 2014, and 2013, respectively.
The Company analyzes loss reserves quarterly primarily using the incurred loss, paid loss, claim count development, and average severity methods described below. 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 insurance business or coverage within a line of insurance business. The Company may also evaluate qualitative factors such as known changes in laws or legal ruling that could affect claims handling or other external environmental factors or internal factors that could affect the settlement of claims. When establishing the loss reserve, the Company will generally analyze the results from all of the methods
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company 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.
Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the periods presented. Diluted earnings per share is based on the weighted average shares of common stock and potential dilutive securities outstanding during the periods presented. At December 31, 2015 and 2014, potential dilutive securities consisted of outstanding stock options and restricted stock units ("RSUs") granted from the Company's 2013 Long Term Incentive Plan. See Note 16. Earnings Per Share, for the required disclosures relating to the calculation of basic and diluted earnings per share.
In February 2015, the FASB issued ASU 2015-02, "Consolidation (Topic 810) Amendments to the Consolidation Analysis" affecting the consolidation evaluation of limited partnerships and similar entities, fees paid to a decision maker or a service provider as a variable interest, and variable interests in a variable interest entity held by related parties of the reporting entities. The amendments are effective for annual and interim reporting periods beginning after December 15, 2015. The adoption of the new standard will not have a material impact on the Company's consolidated financial statements.
The financial instruments recorded in the consolidated balance sheets include investments, receivables, options sold, total return swaps, accounts payable,and secured and unsecured notes payable. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair values. All investments are carried at fair value on the consolidated balance sheets.
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 $0.3 million and $0.2 million were included in other liabilities at December 31, 2015 and 2014, respectively.
At December 31, 2015, fixed maturity holdings rated below investment grade and non-rated comprised 1.3% 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 following table presents the estimated fair values of the Company's fixed maturity securities at December 31, 2015 by contractual maturity. 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.
Level 1 Measurements-Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure that reasonable fair values are used in pricing the investment portfolio.
Total return swaps: Valued based on multi-dimensional 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.
The following table presents a summary of changes in fair value of Level 3 financial assets and financial liabilities:
Depreciation expense, including amortization of leasehold improvements, was $20.5 million, $22.1 million, and $24.6 million during 2015, 2014, and 2013, respectively.
On February 13, 2014, Fannette Funding LLC ("FFL"), a special purpose investment vehicle, formed by and consolidated into the Company, entered into a total return swap agreement with Citibank. Under the total return swap agreement, FFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest on the outstanding notional amount of the underlying obligations. The total return swap is secured by approximately $30 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets. The Company paid interest equal to LIBOR plus 135 basis points on approximately $95 million of underlying obligations as of December 31, 2015. The agreement had an initial term of one year, subject to annual renewal, and was renewed for an additional one-year term expiring February 13, 2017, with interest equal to LIBOR plus 145 basis points.
Other intangible assets with definite useful lives are amortized on a straight-line basis over their useful lives. Other intangible assets amortization expense was $6.0 million in each of the years ended December 31, 2015, 2014, and 2013. None of the intangible assets with definite useful lives are anticipated to have a residual value.
The following table presents the estimated future amortization expense related to other intangible assets as of December 31, 2015:
The income tax (benefit) expense reflected in the consolidated statements of operations is reconciled to the federal income tax (benefit) expense on income before income taxes based on a statutory rate of 35% as shown in the table below:
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting basis and the respective tax basis of the Company’s assets and liabilities, and expected benefits of utilizing net operating loss, capital loss, and tax-credit carryforwards. The ultimate realization of deferred tax assets is dependent upon
The Company had an alternative minimum tax credit carryforward balance of $36.3 million and $31.2 million at December 31, 2015 and 2014, respectively, which is not subject to expiration.
The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return only if, the positions are "more-likely-than-not" sustainable. Once this threshold has been met, the Company’s measurement of its expected tax benefits is recognized in its financial statements.
There was a $0.4 million decrease to the total amount of unrecognized tax benefits related to tax uncertainties during 2015. The decrease was the result of 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.
The Insurance Companies prepare their statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance departments of their domiciliary states. Prescribed statutory accounting practices primarily include those published as statements of statutory accounting principles by the National Association of Insurance Commissioners (the "NAIC"), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2015, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
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 $20.7 million, $19.1 million, and $0.0 million in 2015, 2014, and 2013, respectively.
In February 2015, the Company adopted the 2015 Incentive Award Plan (the "2015 Plan"), replacing the 2005 Equity Incentive Plan (the "2005 Plan") which expired in January 2015. The 2015 Plan was approved at the Company's Annual Meeting of Shareholders in May 2015. A maximum of 4,900,000 shares of common stock under the 2015 Plan are authorized for issuance upon exercise of stock options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. As of December 31, 2015, only stock options and restricted stock unit awards have been granted under these plans. Beginning January 1, 2008, stock options granted, for which the Company has recognized share-based compensation expense, become exercisable at a rate of 25% per year beginning one year from the date granted, are granted at the closing price of the Company's stock on the date of grant, and expire after 10 years. Prior to January 1, 2008, stock options granted became exercisable at a rate of 20% per year.
The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between the Company’s closing stock price and the stock option exercise price, multiplied by the number of in-the-money stock options) that would have been received by the stock option holders had all stock options been exercised on December 31, 2015. The aggregate intrinsic values of stock options exercised were $303,000, $1,160,000, and $862,000 during 2015, 2014, and 2013, respectively. The total fair values of stock options vested were $142,000, $142,000, and $146,000 during 2015, 2014, and 2013, respectively.
As of December 31, 2015, $202,000 of total unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average remaining contractual life of 1.4 years.
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. 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 previously recognized compensation cost would be reversed.
The following table presents future minimum commitments for operating leases as of December 31, 2015:
The Company has also accrued a liability for the estimated cost to continue to defend itself in the false advertising OSC. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the false advertising OSC will be material to the its financial position.
markets are functioning normally. The Company is unable to predict the impact of current and future global economic conditions on the United States, and California, where the majority of the Company’s business is produced.
The basic and diluted earnings per share do not sum due to rounding.
Net income during 2015 was primarily affected by net realized investment losses, an increase in losses and loss adjustment expenses partially offset by an increase in net premiums earned. Net income during the fourth quarter of 2015 was affected by net realized investment losses of $8.2 million as compared with net loss during the fourth quarter of 2014 which was affected by net realized investment losses of $21.6 million and by the $27.6 million penalty assessed by the California DOI and accrued by the Company in the fourth quarter of 2014.
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.
The Property and Casualty business segment offers several insurance products to the Company’s individual customers and small business customers. These insurance products are: private passenger automobile which is the Company’s primary business, and related insurance products such as homeowners, commercial automobile and commercial property. These insurance products are primarily sold to the Company’s individual customers and small business customers, which increases retention of the Company’s private personal automobile client base. The insurance products comprising the Property and Casualty business segment are sold through the same distribution channels, mainly through independent and 100% owned insurance agents, and go through a similar underwriting process.
The Company’s Chief Operating Decision Maker evaluates operating results based on pre-tax underwriting results which is calculated as net premiums earned less (i) incurred losses and loss adjustment expenses; and (ii) 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 (losses) gains, 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.
The following table presents operating results by reportable segment for the years ended:
The following table presents the Company’s direct premiums written and net premiums earned by line of insurance business for the years ended:
"Other" represents net premiums written and earned from an operating segment that does not meet the quantitative thresholds required to be considered a reportable segment. This operating segment offers automobile mechanical breakdown warranties which are sold through auto dealerships and credit unions.