The home office of the California Companies and the Company’s computer facilities are located in Brea, California in 238,000 square feet of office space owned by the Company.
The Company’s executive offices are located in a 36,000 square foot office building in Los Angeles, California, owned by Mercury Casualty. The Company occupies approximately 95% of the building and leases the remaining office space to others.
In November 2001, the Company purchased twelve acres of land in Rancho Cucamonga, California. Construction of a 100,000 square foot office building commenced in 2002 with completion anticipated in 2003. In 2002, the Company purchased an additional six and one half acres of land adjacent to the twelve acres of land. This space will be used to support the Company’s recent growth and future expansion. Any space in the building that is not occupied by the Company may be leased to outside parties.
The Company operates primarily in the state of California, which was the only state it produced business in prior to 1990. The Company expanded its operations into Georgia and Illinois in 1990. With the acquisition of American Fidelity Insurance Group (“AFI”) in December 1996, now AMI, the Company expanded into the states of Oklahoma and Texas. The Company expanded its operations into the state of Florida during 1998 and further expansion into Texas occurred with the Concord Insurance Services, Inc. transaction in December 1999 and the Mercury County Mutual Insurance Company (“MCM”) transaction in September 2000. In 2001, the Company expanded into Virginia and New York.
During 2002, approximately 85.1% of the Company’s net premiums written were derived from California.
Effective March 1, 2002, the Company implemented a 4.1% rate increase for new and renewal California private passenger automobile insurance written by MIC, which represents approximately 50% of company-wide premiums written, and a 6.9% combined rate increase for new and renewal California private passenger automobile insurance written by MCC and Cal Auto, which represent approximately 26% of company-wide premiums written. The Company also implemented an additional 3.2% rate increase for California private passenger automobile insurance written by MIC, and an additional 6.9% rate increase in California private passenger automobile insurance written by MCC and Cal Auto effective November 1, 2002.
Despite the increases, the Company believes that its rates will remain competitive in the marketplace. During 2002, the Company continued its marketing efforts for name recognition and lead generation. The Company believes that its marketing effort combined with price and reputation makes the Company very competitive in California.
Since March 31, 1994, Private Passenger Automobile policies in force in California have increased from approximately 300,000 to 950,000 at December 31, 2002, an annual rate of increase of approximately 14%. Policy count growth for the year 2002 was at a 15% rate, an improvement over 2001 when the rate was at 7%. Management believes the increase is due in large part to favorable competitive rates, a good reputation and a highly visible and targeted advertising strategy.
In September 1996, the California Insurance Commissioner issued permanent rating factor regulations requiring automobile insurance rates to be determined by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The regulations further require that each of the four factors be applied in decreasing order of importance.
The Company submitted a proposed rating plan in response to these regulations in March 1997. The Company’s plan was approved by the California DOI and became effective October 1, 1997. Although the rate changes produced some minor dislocations, implementation of the plan has not materially changed the Company’s overall competitive position or its profitability.
The California DOI has required all insurers offering persistency discounts to make class plan filings by January 15, 2003, removing the portability of these discounts. Persistency discounts represent discounts on policy rates extended to consumers based upon the number of consecutive years that the consumers carried insurance coverage. The Company made it’s filing and is currently awaiting DOI approval. The changes made in the Company’s plan are revenue neutral for the Company’s existing business. The removal of persistency discounts could have an impact on the Company’s price competitiveness in attracting new business. However, this impact, if any, is undeterminable.
The State of California has completed income tax audits on Mercury General’s California tax returns for the tax years ended December 31, 1993 through 2000. As part of these audits, the California Franchise Tax Board (“FTB”) is challenging Mercury General’s ability to deduct a portion of its management and interest expenses. Upon completion of these audits, the FTB proposed assessments of approximately $7.6 million, plus interest, for tax years 1993 through 1996. The Company has formally appealed the proposed assessments and expects a hearing before the California State Board of Equalization (“SBE”) will take place in March 2003.
Management strongly disagrees with the positions taken by the FTB and believes that the issues will ultimately be resolved in favor of the Company. Accordingly, no provision for additional state income tax liabilities for the tax years 1993 through 1996 has been made in the consolidated financial statements.
Management has taken actions to minimize any potential tax liabilities on 2001 and future inter-company dividends. However, if management’s actions are ineffective or the issue is not resolved favorably with the State of California, additional state taxes of approximately 9% (6% after the federal tax benefit of deducting state taxes) could be owed on dividends Mercury General receives from its insurance subsidiaries. While the Company intends to continue paying dividends to its shareholders, an unsatisfactory conclusion to the inter-company dividend issue could affect future dividend policy.
The Company is also involved in proceedings incidental to its insurance business (See Item 3. Legal Proceedings, and Note 11 of Notes to Consolidated Financial Statements).
The Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits incidental to our business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the financial statement footnotes if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the
ultimate outcome of contingent liabilities, management does not expect them to have a material effect on the consolidated operations or financial position.
At December 31, 2002, the Company had on its books approximately $7.3 million in Goodwill related to the 1999 acquisition of Concord and approximately $9.3 million of intangible assets with indefinite useful lives related to the MCM acquisition.
Total losses and expenses in 2002, excluding interest expense of $4.1 million, were $1,721.5 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $20.0 million, compared with an underwriting gain of $6.1 million in 2001.
The GAAP loss ratio (loss and loss adjustment expenses related to premiums earned) was 73.2% in 2001 and 72.2% in 2000. The less favorable loss ratio is primarily driven by higher loss ratios in the California automobile and homeowners lines of business which are primarily offset by lower loss ratios in Florida, Georgia and Illinois automobile lines of business.
The principal sources of funds for Mercury General’s insurance subsidiaries are premiums, sales and maturity of invested assets and dividend and interest income from invested assets. The principal uses of funds for Mercury General’s insurance subsidiaries are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments. Mercury General’s insurance subsidiaries generate substantial positive cash flows, particularly when the Company experiences growth, from operations as premiums are typically received in advance of the time when claim payments are required. The Company expects cash flow from operations along with its cash and short-term cash investment portfolio of $300 million to continue to satisfy the Company’s liquidity requirements. Management increased cash and short term cash investments by nearly $225 million when other longer term investment opportunities were considered unattractive as a result of the current interest rate environment.
Fixed maturity investments of $1,565.8 million (amortized cost), include $14.2 million (amortized cost) of sinking fund preferred stocks, principally utility issues. The market value of all fixed maturities exceeded cost by $67.1 million at December 31, 2002.
The Company has recently commenced writing covered call options through listed exchanges and over the counter with the intent of generating additional income or return on capital. The Company as the writer of an option bears the market risk of an unfavorable change in the price of the security underlying the written option. The options written thus far have been covered call options on equity securities that it already owns as mandated by statutory regulation. The financial impact of these transactions was not significant in 2002. The board of directors has authorized investments in underlying securities for this program not to exceed $20 million.
The Company continually evaluates the recoverability of its investment holdings. When a decline in value of fixed maturities or equity securities is considered other than temporary, the Company writes the security down to fair value by recognizing a loss in the Consolidated Statement of Income. The Company recognized losses of $71.7 million of investment write-downs considered to be other than temporarily impaired during 2002. Declines in value considered to be temporary, are charged as unrealized losses, net of taxes to shareholders’ equity as accumulated other comprehensive income. At December 31, 2002, the Company had a net unrealized gain on all investments of $64.8 million before income taxes which is comprised of unrealized gains of $102.9 million offset by unrealized losses of $38.1 million. Of these unrealized losses, approximately $27 million relate to fixed maturities which are current on their debt servicing obligations. The remaining unrealized losses of approximately $11.1 million relate to equity securities for which approximately 64% of the unrealized losses represent securities with unrealized losses of less than 10% of their amortized costs. The Company has concluded that the gross unrealized losses of $38.1 million at December 31, 2002 were temporary in nature. However, facts and circumstances may change which could result in a decline in market value considered to be other than temporary.
Consolidated Statements of Income for Each of the Years in the Three-Year Period Ended December 31, 2002
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
Net premiums written during 2002, 2001 and 2000 were $1,865,046,000, $1,442,886,000, and $1,272,447,000, respectively.
One broker produced direct premiums written of approximately 16%, 17% and 18% of the Company’s total direct premiums written during 2002, 2001 and 2000, respectively. No other agent or broker accounted for more than 2% of direct premiums written.
Liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The ceded amounts are immaterial and are carried in other assets and other receivables. Earned premiums are stated net of deductions for ceded reinsurance.
In 2000, notes payable with a discounted value of $5,889,000 were issued as part of the consideration for the right to manage and control MCM (See Note 8 in Notes to Consolidated Financial Statements).
The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”. Disclosure of stock-based compensation determined in accordance with SFAS No. 148 is presented in Note 13 in Notes to Consolidated Financial Statements.
after May 15, 2002. All other provisions of SFAS No. 145 are applicable to financial statements issued on or after May 15, 2002. Management of the Company anticipates that the adoption of SFAS No. 145 will not have a material effect on the Company’s earnings or financial position.
In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This Interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. Management of the Company anticipates that the adoption of this Interpretation is not expected to have a material impact on the Company’s financial statements.
Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148 (See Note 13 in Notes to Consolidated Financial Statements).
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51” (“FIN No. 46”). FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. FIN No. 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The implementation of FIN No. 46 is not expected to have a material impact on the Company’s financial statements.
Gross gains and losses realized on the sales of investments (excluding calls and other than temporarily impaired securities) are shown below:
The Company had outstanding debt at December 31, 2002 of $128.9 million. Included in the total debt is the proceeds from an August 7, 2001, public debt offering where the Company issued $125 million of senior notes payable under a $300 million shelf registration filed with the SEC in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year. The notes mature on August 15, 2011. The Company incurred debt issuance costs of approximately $1.3 million, inclusive of underwriter’s fees. These costs are deferred and then amortized as a component of interest expense over the term of the notes. The notes were issued at a slight discount at 99.723%, making the effective annualized interest rate including debt issuance costs approximately 7.44%. At December 31, 2002, the book value of the debt was $124.7 million and the fair market value was $138.6 million.
a hearing scheduled for March 2003 before the California State Board of Equalization (“SBE”). Although the ultimate outcome of these audits is uncertain, management believes the Company will prevail for all years under audit. Accordingly, no provision for additional state income tax liabilities has been made in the consolidated financial statements.
In a recent court ruling that affects the tax years 1997 through 2000, a statute that allowed Mercury General a tax deduction for the dividends received from its wholly-owned insurance subsidiaries was held unconstitutional on the grounds that it discriminated against out-of-state insurance holding companies. Based on the court ruling, the FTB is taking the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB is disallowing dividend-received deductions for all insurance holding companies, regardless of domicile, for tax years ending on or after December 1, 1997. The Company has been assessed $17.3 million plus interest for the 1997 through 2000 tax years. The Company intends to protest the proposed assessments. The FTB has recently begun an audit of the 2001 tax year.
The increase in the provision for insured events of prior years in 2002, 2001 and 2000 largely relates to an increase in the ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated. The increases in severity over what was recorded are the result of inflationary trends in health care costs, auto parts and body shop labor costs.
Effective September 30, 2000, the Company completed a transaction with Employers Reinsurance Corporation purchasing the authority and right to manage and control Elm County Mutual Insurance Company. Effective January 2, 2001, the name was changed to Mercury County Mutual Insurance Company (“MCM”). The results of operations of MCM, which are not material to the Company, are included in the consolidated financial statements of the Company effective September 30, 2000.
The MCM transaction was accounted for using the purchase method of accounting and resulted in a small amount of an intangible asset. As required by SFAS No. 142, the Company has assessed the asset which at December 31, 2002 was $9.3 million and determined that it is not impaired. Also, per SFAS No. 142, the Company will no longer amortize this asset after 2001 as it has an indefinite life. Total amortization expense in 2001 related to this asset was $1.0 million.
The Insurance Companies’ statutory net income, as reported to regulatory authorities, was $14,792,000, $93,720,000 and $103,937,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The statutory policyholders’ surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 2002 and 2001 was $1,014,935,000 and $1,045,104,000, respectively.
The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2008. Total rent expense under these lease agreements, all of which are operating leases, was $4,815,000, $4,428,000 and $4,138,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
In addition to the commitments above, the Company will be investing approximately $15 million in 2003 for construction of a 100,000 square foot office building in Rancho Cucamonga, California. Completion of the project is projected in 2003.
fees and should be liable for them. The plaintiff is seeking an elimination of the broker fees and restitution of previously paid broker fees. Following a four-day trial, in December 2002, proposed findings of fact and conclusions of law in favor of the plaintiff were issued stating that the Company’s brokers are indistinguishable from agents and should not charge broker fees, and that the broker fees are attributable to the Company, suggesting the Company could be held responsible for restitution. The Company filed objections to the proposed findings of fact and conclusions of law and requested a hearing. A hearing on the Company’s objections was granted and is scheduled for March 18, 2003. The Company intends to continue to vigorously defend this case.
In Dan O’Dell, individually and On behalf of others similarly situated v. Mercury Insurance Company, Mercury General Corporation (Los Angeles Superior Court), filed July 12,2002, the plaintiffs are challenging the Company’s use of certain automated database vendors to assist in valuing total loss claims. The plaintiff is seeking to have the case certified as a class action. The plaintiffs allege that these automated databases systematically undervalue total loss claims to the detriment of insureds. The plaintiffs are seeking actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with four other similar cases, and also with three other cases relating to medical payment claims (discussed below). The Company intends to vigorously defend this lawsuit jointly with other defendants in the coordinated proceedings.
The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. (See Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations-Overview, and Note 6 of Notes to Consolidated Financial Statements.)
Dividends paid per-share in 2002, 2001 and 2000 were $1.20, $1.06 and $0.96, respectively and dividends paid in total in 2002, 2001 and 2000 were $65,173,000, $57,430,000 and $51,910,000, respectively.
Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2002, 2001 and 2000: dividend yield of 3.2 percent in 2002, 2.4 percent for 2001 and 2.2 percent for 2000, expected volatility of 33.6 percent in 2002, 34.2 percent in 2001 and 33.4 percent in 2000 and expected lives of 6 years in 2002 and 2001 and 7 years in 2000. The risk-free interest rates used were 4.4 percent for options granted during 2002, 4.9 percent for the options granted during 2001 and 6.4 percent for the options granted during 2000.
A summary of the status of the Company’s plans as of December 31, 2002, 2001 and 2000 and changes during the years ending on those dates is presented below:
The following table summarizes information regarding the stock options outstanding at December 31, 2002:
The diluted weighted shares excludes incremental shares of 8,000, 104,000 and 126,000 for 2002, 2001 and 2000, respectively. These shares are excluded due to their antidilutive effect.