During 2020, 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 its insurance products competitive in California and in other states.
•Regulatory Uncertainty-The insurance industry is subject to strict state regulation and oversight and is governed by the laws of each state in which each insurance company operates. State regulators generally have substantial power and authority over insurance companies including, in some states, approving rate changes and rating factors, restricting cancellation and non-renewal of insurance policies, and establishing minimum capital and surplus requirements. In many states, insurance commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners. There is no certainty that current or future regulations and the interpretation of those regulations by insurance commissioners and the courts will not have an adverse impact on the Company.
•Economic Conditions-The Company’s financial condition, results of operations, and liquidity may be negatively impacted by global, national and local economic conditions, such as recessions, increased levels of unemployment, inflation, and large fluctuations in interest rates. Further, volatility in global capital markets could adversely affect the Company’s investment portfolio. The Company is not able to predict the timing and effect of these factors, or their duration and severity.
has generally experienced a significant softening of the market. Insurance carriers lowered rates to reflect lower loss frequencies as stay-at-home orders issued by the state and local governments following the COVID-19 pandemic led to a decrease in the number of accidents, although this also depends on individual state profitability and the carriers' growth appetite.
Since March of 2020, the Company has been leveraging its information technology capabilities to enable all of its employees to work from home using mobile and collaborative technologies. The Company's other technology accomplishments in 2020 include: completion of major enhancements to its core network infrastructure and application systems, including a major Guidewire software upgrade which leverages new feature enhancements and adds capacity and performance; implementation of omni-channel customer service; development of a mobile application; and deployment of major technology enhancements to its customer portal, and several other technologies, such as computer vision and machine learning for photo-based estimation, mobile appraisal and business rules engine, Usage-Based Insurance, Robotic Process Automation, and enhancements to its cloud-based business analytics capabilities.
In March 2020, the outbreak of COVID-19 was recognized as a pandemic by the World Health Organization (the "WHO"), and the outbreak has become increasingly widespread in the United States, including in the markets in which the Company operates. The pandemic has had a notable impact on general economic conditions, including, but not limited to, the temporary closures of many businesses, “shelter in place” and other governmental orders, and reduced consumer spending. The Company is following guidelines established by the Centers for Disease Control, the WHO and orders issued by the state and local governments in which the Company operates. The Company has taken a number of precautionary steps to safeguard its business and employees from COVID-19, including activating its Business Continuity Plan. Most of the Company's employees have been working remotely, with only certain operationally critical employees working on site at various locations. The Company is monitoring and assessing the impact of the COVID-19 pandemic daily, including recommendations and orders issued by federal, state and local governments. In September 2020, the Company extended its "work-from-home" policy for most of its employees to June 2021, and may further extend the policy, if necessary, based on the latest information on the pandemic's developments.
The Company’s automobile line of business began experiencing a significant decrease in loss frequency in mid to late March, and it remained lower than the historical levels through the end of 2020, although it began to increase in June and the second half of 2020 as more drivers returned to the road following the gradual reopening of businesses in California and other states. The reduction in auto loss frequency was primarily due to reduced driving resulting from the shelter-in-place orders issued by state and local governments. Due to the uncertainty regarding COVID-19, it is unclear how long auto loss frequency will remain at these lower levels. Conversely, the severity of accidents, for both bodily injury and the cost to repair vehicles, has increased primarily due to a higher percentage of high-speed serious accidents on less congested roads and freeways. The cost to repair vehicles may remain high due to supply chain and labor force issues. In addition, the Company's net premiums earned was negatively impacted as a result of premium refunds and credits voluntarily issued to policyholders by the Company, and also in compliance with the requests and directives from the California Insurance Commissioner (see B. Regulatory and Legal Matters below for additional details) and other insurance regulators in other states. COVID-19 is also impacting the ability of some of the Company’s policyholders to pay their insurance premiums, and the Company has granted limited grace periods to those needing financial assistance.
On March 27, 2020, the President of the United States signed the Coronavirus Aid, Relief, and Economic Security ("CARES") Act, a substantial tax-and-spending package intended to provide additional economic stimulus to address the financial impact of the COVID-19 pandemic. The CARES Act includes, among other items, cash payments to individuals as well as emergency grants and forgivable loans to small businesses, if they meet certain criteria. On December 27, 2020, the President signed an additional round of COVID-19 relief legislation. To the extent the Company's existing or potential policyholders, both individuals and businesses, and its independent agents are aided by such relief programs, the negative impact of the pandemic on its results of operations due to the reduced premiums written or increased uncollectible premiums is mitigated.
The Company will continue to monitor the impact of the COVID-19 pandemic, and the effects of the CARES Act and any future rounds of such relief legislation. The extent of the impact of the pandemic on the Company's business and financial results will depend largely on future developments, including the duration of the pandemic, its impact on capital and financial markets and the related impact on consumer confidence and spending, the success of efforts to contain it such as broad vaccine rollout, and the impact of actions taken in response, all of which are highly uncertain and cannot be predicted. As the impact of the COVID-19 pandemic continues to evolve, additional impacts may arise.
▪In each of February and July 2020, the California DOI approved a 6.99% rate increase on the California homeowners line of insurance business, which represented approximately 14% of the Company's total net premiums earned in 2020. The Company implemented the February rate increase in April 2020 and the July rate increase in October 2020.
In July 2019, the governor of California signed a bill that created a $21 billion fund (the "California Wildfire Fund") to help PG&E and the state's other investor-owned utility companies cover liabilities arising from future wildfires caused by their equipment. The bill requires investor-owned utility companies to put up half of the money in the California Wildfire Fund. The other half comes from surcharges paid by ratepayers across the state. In order to access the California Wildfire Fund, PG&E had to emerge from its bankruptcy proceedings by June 30, 2020. On July 1, 2020, PG&E made an announcement that it emerged out of bankruptcy and made an initial deposit of approximately $5 billion to the California Wildfire Fund. It is expected that the Company and other insurers will be reimbursed for some portion of the claims paid for its policyholders if it is determined that a wildfire is caused by equipment failure. The announcement also confirmed that PG&E has funded the Subrogation Trust Fund with $11 billion, which was set up to reimburse insurance companies and other entities that paid claims by individuals and businesses related to wildfires in recent past years. The Company received approximately $23 million, net of fees, in 2020 from the Subrogation Trust Fund. However, the subrogation recovery recognized was for losses and loss adjustment expenses previously ceded to the Company’s reinsurers, and therefore the recovery did not reduce losses and loss adjustment expenses net of reinsurance. The benefit to the Company, net of reinsurance and before taxes, was approximately $3 million, representing a reduction to reinstatement premiums previously recognized.
•The incurred loss 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 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.
•The paid loss method analyzes historical payment patterns to estimate the amount of losses yet to be paid.
BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $5,000 to $6,000 on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $15,000 to $20,000. The Company creates incurred and paid loss triangles to estimate ultimate losses utilizing historical payment and reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI loss reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity. As a larger proportion of claims from an accident year are settled, there emerges a higher degree of certainty for the loss reserves established for that accident year. At December 31, 2020, the accident years that are most likely to develop are the 2018 through 2020 accident years; however, it is possible that older accident years could develop as well.
In general, the Company expects that historical claims trends will continue with costs tending to increase, which is generally consistent with historical data, and therefore the Company believes that it is reasonable to expect inflation to continue. Many potential factors can affect the BI inflation rate, including changes in claims handling process, changes in statutes and regulations, the number of litigated files, increased use of medical procedures such as MRIs and epidural injections, general economic factors, timeliness of claims adjudication, vehicle safety, weather patterns, social inflation, and gasoline prices, among other factors; however, the magnitude of the impact of such factors on the inflation rate is unknown.
During 2020, the Company experienced a decrease in loss frequency primarily resulting from the shelter-in-place orders issued by state and local governments in response to the COVID-19 pandemic. In addition, the COVID-19 pandemic created greater uncertainty in the reserve estimates: A greater number of large claims may emerge from the 2020 accident year compared to the prior accident years as claimants may be reluctant to go to a medical provider due to the pandemic but subsequently seek monetary compensation to ease the economic hardship attributable to the pandemic. A lower percentage of minor accidents with lower average severity experienced during the pandemic are likely to push the total average severity higher. There is reduced subrogation potential due to increased single-vehicle accidents during 2020. Automobile parts and labor costs will be higher if further supply shortages emerge due to the prolonged pandemic. Based on these factors and uncertainty attributable to the pandemic, the reserve estimates for the 2020 accident year are subject to a greater degree of variability.
The following table presents the effects on the California automobile BI loss reserves for the 2020, 2019, and 2018 accident years based on possible variations in the severity recorded; however, the actual variations could be more or less than these amounts:
(2) During 2020, the Company experienced a significant reduction in loss frequency resulting from the shelter-in-place orders issued by state and local governments in response to the COVID-19 pandemic, which led to the smaller number of claims expected for the 2020 accident year compared to the prior accident years. Conversely, a higher percentage of high-speed serious accidents on less congested roads combined with a lower percentage of minor accidents had the effect of increasing the actual recorded severity across the total claims population. Consequently, the implied inflation rate recorded for the 2020 accident year is skewed upward.
The following table presents the effects on loss development of different claim counts within the broader possible range at December 31, 2020:
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. During 2020, the Company did not incur any material unexpected losses related to claims from accident periods prior to 2017.
Unexpected losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected losses in future periods. It is also possible that the Company has not identified and established a sufficient loss reserve for all material unexpected losses occurring in the older accident years, even though a comprehensive claims file review was undertaken. The Company may experience additional development on these loss reserves.
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 2020, the Company reported unfavorable development of approximately $23 million on the 2019 and prior accident years’ loss and loss adjustment expense reserves. The unfavorable development in 2020 was primarily attributable to higher than estimated losses and loss adjustment expenses in the homeowners and commercial automobile lines of insurance business, partially offset by favorable development in the private passenger automobile line of insurance business.
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. 98.3% of the fair value of these financial instruments held at December 31, 2020 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’s fixed maturity and equity securities are classified as “trading” and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-redeemable preferred stocks, are actively traded on national exchanges or trading markets, and are valued at the last transaction price on the balance sheet date.
At December 31, 2020, the Company’s deferred income taxes were in a net liability position mainly due to deferred tax liabilities generated by unrealized gains on securities held and deferred acquisition costs. These deferred tax liabilities were substantially offset by deferred tax assets resulting from unearned premiums, loss reserve discounting, and expense accruals. 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.
Net premiums earned, a GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the periods presented and earned on a pro-rata basis over the term of the policies. 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.
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Company's consolidated loss, expense, and combined ratios determined in accordance with GAAP:
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by unfavorable development of approximately $23 million and $10 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2020 and 2019, respectively. The unfavorable development in 2020 was primarily attributable to higher than estimated losses and loss adjustment expenses in the homeowners and commercial automobile lines of insurance business, partially offset by favorable development in the private passenger automobile line of insurance business, while the unfavorable development in 2019 was primarily attributable to higher than estimated defense and cost containment expenses in the California automobile line of insurance business, partially offset by favorable development in certain of the Company's other lines of insurance business.
The 2020 loss ratio was negatively impacted by a total of approximately $64 million of catastrophe losses, net of reinsurance benefits, primarily due to wildfires and windstorms in California and extreme weather events outside of California. The 2019 loss ratio was also negatively impacted by a total of approximately $53 million of catastrophe losses, net of reinsurance benefits, primarily due to wildfires and winter storms in California, a hurricane in Texas, and tornadoes and wind and hail storms in the Midwest.
Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 64.8% and 73.3% for the years ended December 31, 2020 and 2019, respectively. The decrease in the loss ratio was primarily due to a significant decrease in loss frequency in the private passenger automobile line of insurance business stemming from the substantial decrease in overall driving following the "stay-at-home" orders issued in response to the COVID-19 pandemic in the states where the Company operates, partially offset by premium refunds and credits under the "Mercury Giveback" program as described above, an increase in loss severity in the private passenger automobile line of insurance business, and higher losses in the homeowners line of insurance business.
Tax-exempt investment income, a component of total pre-tax income, remained relatively steady with the same period in 2019.
(1)The changes in fair value of the investment portfolio and note receivable resulted from the application of the fair value option.
(2)The increases in fair value of fixed maturity securities in 2020 and 2019 were primarily due to decreases in market interest rates.
Net cash provided by operating activities for the year ended December 31, 2020 was $605.6 million, an increase of $85.9 million compared to the year ended December 31, 2019. The increase was primarily due to a decrease in payments for losses and loss adjustment expenses, partially offset by a decrease in collections from reinsurers on reinsurance recoverables, an increase in payments for income taxes and a decrease in premium collections net of premium refunds. The Company utilized the cash provided by operating activities during the year ended December 31, 2020 primarily for the net purchases of investment securities and payment of dividends to its shareholders.
(2)The fair value is measured using the net asset value practical expedient. See Note 4. Fair Value Measurements of the Notes to Consolidated Financial Statements for additional information.
At December 31, 2020, 55.1% of the Company’s total investment portfolio at fair value and 73.4% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 50% corporate dividend received deduction, and private equity funds. At December 31, 2020, 92.8% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis.
Credit ratings for the Company's fixed maturity portfolio were stable in 2020, with 91.4% of fixed maturity securities at fair value experiencing no change in their overall rating. 2.6% and 6.0% of fixed maturity securities at fair value experienced upgrades and downgrades, respectively, in 2020.
(1)Intermediate ratings are included at each level (e.g., AA includes AA+, AA and AA-).
debt as a risk-free rate and have continued to invest in U.S. Treasury securities. The modified duration of the U.S. government bonds portfolio reflecting anticipated early calls was 1.0 years at December 31, 2020 and 2019.
At December 31, 2020 and 2019, respectively, 59.9% and 65.5% of the insured municipal securities, at fair value, most of which were investment grade, were 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, 2020 and 2019, the average rating of the Company’s insured municipal securities was A+, which corresponded to the average rating of the investment grade bond insurers. The remaining 40.1% and 34.5% of insured municipal securities at December 31, 2020 and 2019, respectively, were insured by non-rated or below investment grade bond insurers that the Company believes did not provide credit enhancement. The modified duration of the municipal securities portfolio reflecting anticipated early calls was 3.4 years and 3.7 years at December 31, 2020 and 2019, respectively.
At December 31, 2020 and 2019, respectively, the company had corporate securities of $241.4 million and $235.6 million, or 6.8% and 7.6% of its fixed maturity securities portfolio, at fair value. The weighted-average rating was A- at December 31, 2020 and 2019. The modified duration reflecting anticipated early calls was 1.7 years and 2.0 years at December 31, 2020 and 2019, respectively.
The Company had collateralized loan obligations of $256.9 million and $199.2 million, which represented 7.2% and 6.4% of its fixed maturity securities portfolio, at fair value, at December 31, 2020 and 2019, respectively. The weighted-average rating was AA- and A+ at December 31, 2020 and 2019, respectively. The modified duration reflecting anticipated early calls was 4.8 years and 5.2 years at December 31, 2020 and 2019, respectively.
The following table presents the equity security portfolio by industry sector at December 31, 2020 and 2019:
from the notes to pay off the total outstanding balance of $320 million under the existing loan and credit facility agreements and terminated the agreements on March 8, 2017. The remainder of the proceeds from the notes was used for general corporate purposes. The Company incurred debt issuance costs of approximately $3.4 million, inclusive of underwriters' fees. The notes were issued at a slight discount of 99.847% of par, resulting in the effective annualized interest rate, including debt issuance costs, of approximately 4.45%.
(3) The unamortized discount and debt issuance costs are associated with the publicly traded $375 million senior unsecured notes. These are amortized to interest expense over the life of the notes, and the unamortized balance is presented in the Company's consolidated balance sheets as a direct deduction from the carrying amount of the debt. The unamortized debt issuance cost of approximately $0.1 million associated with the $50 million five-year unsecured revolving credit facility maturing on March 29, 2022 is included in other assets in the Company's consolidated balance sheets and amortized to interest expense over the term of the credit facility.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and RBC ratio under the unsecured credit facility at December 31, 2020.
In 2020, the Company made capital expenditures, including capitalized software, of approximately $40.0 million primarily related to information technology.
(4)The table excludes liabilities of $6.2 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, 2020, 2019, and 2018
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2020, 2019, and 2018
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 16, 2021 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We identified the evaluation of loss reserves, excluding catastrophe losses, as a critical audit matter. Subjective auditor judgment was required to assess the Company’s selected methods and assumptions, such as paid and incurred loss development factors, used to estimate loss reserves. Specialized actuarial skills and knowledge were needed to evaluate the Company’s actuarial methodologies and the estimate of future claims payment and reporting patterns based on observed historical patterns.
• assessing the Company’s methodology for estimating loss reserves by comparing it to generally accepted actuarial methods
(1)American Mercury Lloyds Insurance Company is not owned but is controlled by the Company through its attorney-in-fact, Mercury Select Management Company, Inc.
The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles ("GAAP"), which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions and balances have been eliminated.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates require the Company 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.
The Company invests, directly or indirectly through its consolidated VIEs, in limited partnerships or limited liability companies such as private equity funds. These entities are non-consolidated VIEs as the Company has determined it is not the primary beneficiary. The Company's maximum exposure to loss is limited to the total carrying value of its investment that is included in equity securities in the Company's consolidated balance sheets. At December 31, 2020 and 2019, the Company had no outstanding unfunded commitments to these VIEs whereby the Company may be called by the VIEs during the commitment period to fund the purchase of new investments and the expenses of the VIEs.
The Company evaluates goodwill and other intangible assets for impairment annually or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed their implied fair values. The Company qualitatively determines whether, more likely than not, the fair value exceeds the carrying amount of a reporting unit. There are numerous assumptions and estimates underlying the qualitative assessments including future earnings, long-term strategies, and the Company’s annual planning and forecasting process. If these planned initiatives do not accomplish the targeted objectives, the assumptions and estimates underlying the qualitative assessments could be adversely affected and have a material effect upon the Company’s financial condition and results of operations. In addition, the Company evaluates other intangible assets using methods similar to those used for goodwill described above. As of December 31, 2020 and 2019, goodwill and other intangible impairment assessments indicated that there was no impairment.
•The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing loss reserves. The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
The Company is party to a Catastrophe Reinsurance Treaty ("Treaty") covering a wide range of perils that is effective through June 30, 2021. The Treaty provides $717 million of coverage on a per occurrence basis after covered catastrophe losses exceed the $40 million Company retention limit. The Treaty specifically excludes coverage for any Florida business and for California earthquake losses on fixed property policies, such as homeowners, but does cover losses from fires following an earthquake. The Treaty provides for one full reinstatement of coverage limits with a minor exception at the top coverage layer, and includes some additional minor territorial and coverage limits.
The fair value of each restricted stock unit ("RSU") grant is determined based on the market price on the grant date for awards classified as equity and on each reporting date for awards classified as liability. Compensation cost is recognized based on management’s best estimate of the performance goals that will be achieved at the end of the performance period, taking into account expected forfeitures. If the minimum performance goals are not expected to be met, no compensation cost is recognized and any recognized compensation cost would be reversed. See Note 16. Share-Based Compensation for additional disclosures.
As of December 31, 2020 and 2019, the Company had no contract assets, contract liabilities, capitalized costs to obtain or fulfill a contract, or remaining performance obligations associated with unrecognized revenues.
The balance of capitalized implementation costs for cloud computing arrangements, net of accumulated amortization, was $4.8 million and $4.4 million at December 31, 2020 and December 31, 2019, respectively, which is included in other assets in the Company's consolidated balance sheets. The accumulated amortization was $2.1 million and $0.3 million at December 31, 2020 and December 31, 2019, respectively. The total amortization expense related to such capitalized implementation costs was $1.8 million and $0.3 million for the years ended December 31, 2020 and 2019, respectively, which is included in other operating expenses in the Company's consolidated statements of operations. The Company had no amortization expenses related to such capitalized implementation costs for the year ended December 31, 2018.
The Company's investment portfolio, not including accrued investment income, was not affected by Topic 326 as it applies the fair value option to all of its investments.
The following table presents a summary of changes in allowance for credit losses on premiums receivable:
Generally, the Company uses a default analysis to estimate uncollectible reinsurance recoverables. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral and any liabilities held by
the Company subject to a right of offset, and future default factors used to estimate the probability that the reinsurer may be unable to meet its future obligations in full. The determination of the future default factor is based on a historical default factor published by a major rating agency applicable to the particular financial strength rating class. Application of future default factors also requires considerable judgment and assumptions, such as timing of loss payments and duration of the outstanding recoverable balances. Based on its past experiences with major catastrophes, the Company assumed that the majority of the reinsurance recoverable balances on unpaid losses outstanding at December 31, 2020 will be billed and collected or written off over the course of the next 5 years, and that the outstanding reinsurance recoverable balances on paid losses will be collected or written off within a year.
AM Best's Financial Strength Ratings of the Company's reinsurers ranged between B++ and A++ at December 31, 2020. While a ratings downgrade would result in an increase in provision for uncollectible reinsurance recoverables and a charge to earnings in that period, a downgrade in and of itself does not imply that the Company will be unable to collect all of the reinsurance recoverables from the reinsurers in question. To the extent the creditworthiness of the Company's reinsurers were to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the allowance for uncollectible reinsurance recoverables. The Company monitors credit risk by reviewing the credit ratings of its reinsurers, adequacy of letters of credit, and broader industry risks such as catastrophes impacting our reinsurers.
The following table presents a summary of changes in allowance for credit losses on reinsurance recoverables:
The Company made certain accounting policy elections for its accrued interest receivables on the adoption date of Topic 326 as allowed: a) an election to present accrued interest receivable balances separately from the associated financial assets on the balance sheet, and b) an election not to measure an allowance for credit losses on accrued interest receivable amounts and instead write off uncollectible accrued interest amounts in a timely manner by reversing interest income.
As a general policy, the Company writes off the accrued interest receivable balance when it receives a default notice or when the scheduled interest payment is not received, unless management determines that the default is temporary considering all of the relevant information. The Company believes that for the majority of its investment securities, writing off the uncollectible interest receivable balance within a year from the due date is considered timely. In all cases, the Company writes off the accrued interest receivable immediately if management determines that it is not reasonably expected that the payment will be received. The Company did not have any cumulative-effect adjustment as a result of adopting Topic 326 for its accrued interest receivables. The Company's accrued interest receivable balances are included in accrued investment income receivables in its consolidated balance sheets. There were no accrued interest receivable amounts considered uncollectible or written off for the years ended December 31, 2020, 2019 and 2018.
In March 2020, the Financial Accounting Standards Board ("FASB") issued ASU 2020-04, "Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting." ASU 2020-04 provides optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments in this ASU apply only to contracts, hedging relationships, and other transactions that reference LIBOR or other interbank offered rates expected to be discontinued because of reference rate reform. ASU 2020-04 is effective for all entities as of March 12, 2020 through December 31, 2022. The Company expects to apply the
optional expedients in this ASU to its unsecured credit facility that references LIBOR (see Note 8), when the facility is modified with a replacement rate before LIBOR expires. The Company does not expect any material impact on its consolidated financial statements and related disclosures resulting from applying this ASU.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, options sold, accounts payable, and unsecured notes payable. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried at fair value in the consolidated balance sheets.
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 cost of investments sold is determined on a first-in and first-out method, and realized and unrealized gains and losses are included in net realized investment gains (losses) in the Company's consolidated statements of operations. See Note 3. Investments for additional information.
The fair value of the Company’s publicly traded $375 million unsecured notes at December 31, 2020 and 2019 was obtained from a third party pricing service.
The Company obtained unadjusted fair values on 98.3% of its investment portfolio from an independent pricing service. For a private equity fund that was classified as Level 3 and included in equity securities at December 31, 2019, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value. The fair value of the private equity fund was $1.2 million at December 31, 2019. The Company reclassified this fund from Level 3 to private equity funds measured at net asset value ("NAV") at March 31, 2020, due to the use of the practical expedient based on NAV in measuring the fair value of the fund.
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.
Common stock: Comprised of actively traded, exchange listed U.S. and international equity securities and valued based on unadjusted quoted prices for identical assets in active markets.
Options sold: Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.
Mortgage-backed securities: Comprised of securities that are collateralized by residential and commercial mortgage loans and valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. The Company had holdings of $17.6 million and $18.9 million in commercial mortgage-backed securities at December 31, 2020 and 2019, respectively.
Private equity fund: Private equity fund that was not measured at NAV was valued based on underlying investments of the fund or assets similar to such investments in active markets, taking into consideration specific unadjusted broker quotes based on net fund value and unobservable inputs from at least one knowledgeable outside security broker related to liquidity assumptions.
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 gains or losses in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
(1) The private equity fund was reclassified from Level 3 to private equity funds measured at net asset value due to the use of the NAV practical expedient in measuring the fair value of the fund at March 31, 2020.
There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy in 2020 and 2019. A private equity fund was reclassified from Level 3 to private equity funds measured at net asset value at March 31, 2020, as described above.
At December 31, 2020 and 2019, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
The following tables present the carrying value and fair value of the Company’s financial instruments disclosed, but not carried, at fair value, and the level within the fair value hierarchy at which such instruments are categorized:
Depreciation expense, including amortization of leasehold improvements, was $28.0 million, $23.2 million, and $19.9 million for 2020, 2019, and 2018, respectively.
The Company has operating leases for office space for insurance operations and administrative functions, automobiles for certain employees and general uses, and office equipment such as printers and computers. In addition, the Company has finance leases for electronic data processing ("EDP") equipment. As of December 31, 2020, the Company's leases had remaining terms ranging from less than 1 year to approximately 7 years. These leases may contain provisions for periodic adjustments to rates and charges applicable under such lease agreements. These rates and charges also may vary with the Company's level of use. Certain of these leases include one or more options to renew or early terminate, and the exercise of these options is at the Company's sole discretion. Certain leases also include options to purchase the leased property. The Company's lease agreements do not contain any residual value guarantees.
As of December 31, 2020, the Company had additional lease commitments that have not yet commenced of approximately $5 million with each lease term ranging from approximately 3 years to 4 years. These leases will commence in 2021.
(1)On March 8, 2017, the Company completed a public debt offering issuing $375 million of senior notes. The notes are unsecured senior obligations of the Company, with a 4.4% annual coupon payable on March 15 and September 15 of each year commencing September 15, 2017. These notes mature on March 15, 2027. The Company used the proceeds from the notes to pay off the total outstanding balance of $320 million under the existing loan and credit facility agreements and terminated the agreements on March 8, 2017. The remainder of the proceeds from the notes was used for general corporate purposes. The Company incurred debt issuance costs of approximately $3.4 million, inclusive of
(3)The unamortized discount and debt issuance costs are associated with the publicly traded $375 million senior unsecured notes. These are amortized to interest expense over the life of the notes, and the unamortized balance is presented in the Company's consolidated balance sheets as a direct deduction from the carrying amount of the debt. The unamortized debt issuance costs of approximately $0.1 million associated with the $50 million five-year unsecured revolving credit facility maturing on March 29, 2022 are included in other assets in the Company's consolidated balance sheets and amortized to interest expense over the term of the credit facility.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and risk based capital ("RBC") ratio under the unsecured credit facility at December 31, 2020.
Debt maturities for each of the next five years and thereafter as of December 31, 2020 are as follows:
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2020 and 2019.
Other intangible assets with definite useful lives are amortized on a straight-line basis over their useful lives. Other intangible assets amortization expense was $1.0 million, $5.1 million, and $5.5 million for the years ended December 31, 2020, 2019 and 2018, respectively. None of the intangible assets with definite useful lives are anticipated to have a residual value.
The Company and its subsidiaries file a consolidated federal income tax return. The income tax expense (benefit) consisted of the following components:
(1) As a result of a determination made by the Office of Management and Budget in 2018, the Company reversed the previously recorded provisional 6.6% sequestration reduction to its alternative minimum tax (“AMT”) credit, which originally resulted from repeal of the corporate AMT and reclassification of AMT credit carryforwards to current taxes receivable as a refundable credit.
There was a $1.4 million decrease to the total amount of unrecognized tax benefits related to tax uncertainties during 2020. The decrease was the result of a payment of an assessment related to a California Franchise Tax Board (“FTB”) audit for tax years 2014 through 2016. The Company does not expect any changes in unrecognized tax benefits to have a material impact on its consolidated financial statements within the next 12 months.
If a reasonable settlement is not reached, the Company intends to pursue other options, including a formal hearing with the FTB, an appeal with the California Office of Tax Appeals, or litigation in Superior Court.
The Company believes that the resolution of these examinations and assessments will not have a material impact on the financial position of the Company.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. The Company recognized an accrued net expense (benefit) related to interest and penalty of approximately $0.2 million, $(0.1) million, and $0.5 million for the years ended December 31, 2020, 2019 and 2018, respectively. The net benefit for the year ended 2019 was largely due to the reversal of accrued interest and penalty following the updates from the FTB for tax years 2014 through 2016. The Company carried an accrued interest and penalty balance of approximately $3.1 million and $2.8 million at December 31, 2020 and 2019, respectively.
The increase in the provision for insured events of prior years in 2019 of approximately $9.8 million primarily resulted from higher than estimated defense and cost containment expenses in the California automobile line of insurance business, partially offset by favorable development in certain of the Company's other lines of insurance business.
(1) The information for the years 2011 to 2019 is presented as unaudited supplemental information.
The Insurance Companies are subject to the financial capacity guidelines established by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. As of December 31, 2020, the insurance subsidiaries of the Company are permitted to pay approximately $222 million in dividends in 2021 to Mercury General without the prior approval of the DOI of domiciliary states. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2020, 2019, and 2018, the Insurance Companies paid Mercury General ordinary dividends of $121 million, $114 million, and $135 million, respectively.
On February 12, 2021, the Board of Directors declared a $0.6325 quarterly dividend payable on March 31, 2021 to shareholders of record on March 17, 2021.
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, 2020, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
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, 2020, 2019 and 2018, 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 350% of the authorized control level RBC as of December 31, 2020, 2019 and 2018. 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 $11.2 million, $9.9 million, and $9.0 million for 2020, 2019, and 2018, respectively.
The Plan also includes an employee stock ownership plan that covers substantially all employees. The Board of Directors authorizes the Plan to purchase the Company’s common stock in the open market for allocation to the Plan participants. No purchases were made during the past three years.
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 RSU or deferred stock awards. As of December 31, 2020, the Company had 70,000 stock options granted and outstanding and 4,830,000 shares of common stock available for future grant under the 2015 Plan.
In February 2018, the Compensation Committee of the Company's Board of Directors awarded a total of 80,000 stock options to four senior executives under the 2015 Plan which will vest over the four-year requisite service period. 10,000 of these stock options were forfeited in February 2019 following the departure of a senior executive. The fair values of these stock options were estimated on the date of grant using a closed-form option valuation model (Black-Scholes). No stock options were awarded in 2020 and 2019 under the 2015 Plan.
Expected volatility is based on historical volatility of the Company’s stock over the term of the stock options. The Company estimated the expected term of stock options, which represents the period of time that stock options granted are expected to be outstanding, by using historical exercise patterns and post-vesting termination behavior. The risk free interest rate is determined based on U.S. Treasury yields with equivalent remaining terms in effect at the time of the grant.
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, 2020. The aggregate intrinsic value of stock options exercised in 2019 and 2018 was $217,064 and $42,000, respectively. There were no stock options exercised in 2020. The total fair value of stock options vested in each of 2020 and 2019 was $141,584. There were no stock options vested in 2018.
Potentially dilutive securities representing approximately 67,500, 0, and 78,500 shares of common stock for 2020, 2019, and 2018, respectively, were excluded from the computation of diluted earnings (loss) per common share because their effect would have been anti-dilutive. For the year ended December 31, 2018, the dilutive impact of incremental shares was excluded as the Company generated a net loss.
The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, office equipment, and EDP equipment that expire at various dates through the year 2028. See Note 7. Leases for additional information on leases and future lease payments as of December 31, 2020.
On April 13, 2020, the California Insurance Commissioner issued Bulletin 2020-3 ordering insurers to make an initial premium adjustment within 120 days from the date of the Bulletin 2020-3 to adversely impacted California policyholders for the months of March and April 2020. The Commissioner granted insurers flexibility in determining how to quickly and fairly process the premium refunds. On May 15, 2020, the California Insurance Commissioner issued Bulletin 2020-4 extending the directives in Bulletin 2020-3 through May 31, 2020. The Bulletin 2020-8, originally issued on June 25, 2020 and amended on December 3, 2020, extended the previous directives of Bulletin 2020-3 and Bulletin 2020-4 through June 30, 2020, as well as any months subsequent to June 2020 because the COVID-19 pandemic continued to result in projected loss exposures remaining overstated or misclassified. The total amount of premiums returned to the Company's policyholders through refunds or credits in 2020 was approximately $128 million. The Company's net premiums earned was reduced by approximately $128 million for the twelve months ended December 31, 2020 as a result of these premium refunds and credits.
The following table presents summarized quarterly financial data for 2020 and 2019:
Net income for 2020 was primarily attributable to net premiums earned, net investment income, and net realized investment gains, partially offset by losses and loss adjustment expenses, including catastrophe losses and unfavorable development on prior accident years' loss and loss adjustment expense reserves, and operating expenses. Major factors contributing to net income for the fourth quarter of 2020 were underwriting profit and increases in the fair values of the Company’s fixed maturity and equity securities due to the overall improvement in fixed maturity and equity markets.
The following table presents the Company’s net premiums earned and direct premiums written by line of insurance business for the years ended: