From time to time, forward-looking statements are also included in the Company’s quarterly reports on Form 10-Q and current reports on Form 8-K, in press releases, in presentations, on its web site, and in other materials released to the public. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report or statement. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise.
In line with the goal of improving operating efficiencies outside California and overall long-term profitability, the Company restructured its claims operations in states outside of California resulting in a workforce reduction of approximately 100 employees,
The Company’s net income for the year ended December 31, 2017 increased to $144.9 million, or $2.62 per diluted share, from $73.0 million, or $1.32 per diluted share, for the same period in 2016. Included in net income is $124.9 million of pre-tax investment income that was generated during 2017 on a portfolio of $3.7 billion at fair value at December 31, 2017, compared to $121.9 million of pre-tax investment income that was generated during 2016 on a portfolio of $3.5 billion at fair value at December 31, 2016. Also included in net income are net realized investment gains (losses) of $83.7 million and $(34.3) million in 2017 and 2016, respectively, and catastrophe losses, net of reinsurance benefits, of approximately $79.0 million and $27.0 million in 2017 and 2016, respectively.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $341 million and $292 million in 2017 and 2016, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
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 years 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.
Loss Frequency-Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. Loss frequency trends are affected by many factors such as fuel prices, the economy, the prevalence of distracted
The Company implemented Guidewire’s InsuranceSuite in 2010, which is a widely adopted industry software leader. Over the past several years, InsuranceSuite has been deployed in most of the states and lines of business in which the Company operates. Throughout 2017, there have been numerous enhancements to the Company's information technology systems to make them easier and more intuitive for agents, customers, shoppers, and internal users. The Company will continue to invest in improving user experiences with its information technology systems.
In April 2017, the California DOI approved a 6.9% rate increase on the California homeowners line of insurance business, which represented approximately 12% of the Company's total net premiums earned in 2017. This rate increase became effective in August 2017.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer's insurance broker. The California DOI 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 bifurcated the 2004 NNC between (a) the California DOI’s order to show cause (the “OSC”), in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance (the “NNC”), in which the California DOI asserts the unlawful rate allegations. In February 2012, the administrative law judge (“ALJ”) submitted a proposed decision dismissing the NNC, but the Commissioner rejected the ALJ’s proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, and the Commissioner responded with a demurrer. Following a hearing, the Superior Court sustained the Commissioner’s demurrer, based on the Company’s failure to exhaust its administrative remedies, and the Company appealed. The Court of Appeal affirmed the Superior Court's ruling that the Company was required to exhaust its administrative remedies, but expressly preserved for later appeal the legal basis for the ALJ’s dismissal: violation of the Company’s due process rights. 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, the proposed decision was not submitted until December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ’s proposed decision, which became the Commissioner’s adopted order (the "Order"). 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, and assessed a civil penalty in the amount of $27.6 million against the Company. 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
On August 12, 2016, the Superior Court issued its ruling on the Writ, for the most part granting the relief sought by the Company. The Superior Court found that the Commissioner and the California DOI did commit due process violations, but declined to dismiss the case on those grounds. The Superior Court also agreed with the Company that the broker fees at issue were not premium, and that the penalties imposed by the Commissioner were improper, and therefore vacated the Order imposing the penalty. The Superior Court entered final judgment on November 17, 2016, issuing a writ requiring the Commissioner to refund the entire penalty amount within 120 days, plus prejudgment interest at the statutory rate of 7%. On January 12, 2017, the California DOI filed a notice of appeal of the Superior Court's judgment entered on November 17, 2016. While the appeal is still pending, the California DOI returned the entire penalty amount plus accrued interest, a total of $30.9 million, to the Company in June 2017 in order to avoid accruing further interest. Because the matter has been appealed, the Company has not yet recognized the $30.9 million as a gain in the consolidated statements of operations; instead, the Company recorded the $30.9 million plus interest earned, a total of approximately $31.1 million at December 31, 2017, in other liabilities in the consolidated balance sheets. The Company had filed a motion to dismiss the false advertising portion of the case based on the Superior Court's findings, but the ALJ denied that motion after the appeal was filed. The ALJ did, however, grant the Company's alternative request to stay further proceedings pending the final determination of the appeal. The Company has 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 its financial position.
The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with loss reserve estimates. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory and legal environments, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its loss reserve by looking at historical patterns and trends and projecting these out to current loss reserves. The underlying factors
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.
BI loss reserves are generally the most difficult to estimate because they take longer to close than other coverages. BI coverage in the Company’s policies includes injuries sustained by any person other than the insured, except in the case of uninsured
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, and gasoline prices, among other factors; however, the magnitude of the impact of such factors on the inflation rate is unknown.
During the years 2013 through 2017, the changes in the loss severity amounts for the three preceding accident years from the prior year amounts (BI severity variance from prior year) have ranged as follows:
The following table presents the effects on loss development of different claim count within the broader possible range at December 31, 2017:
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 2017, the Company incurred losses totaling approximately $15 million related to adverse legal outcomes on three separate large claims from accident periods prior to 2014.
At December 31, 2017 and 2016, the Company recorded its point estimate of approximately $1.51 billion and $1.29 billion ($1.45 billion and $1.28 billion, net of reinsurance), respectively, in loss and loss adjustment expense reserves, which included approximately $668.4 million and $534.8 million ($626.7 million and $532.5 million, net of reinsurance), respectively, of incurred-but-not-reported liabilities ("IBNR"). IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2017 and 2016, and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company evaluates its 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 2017, the Company reported unfavorable development of approximately $54 million on the 2016 and prior accident years’ loss and loss adjustment expense reserves. The unfavorable development in 2017 was primarily from higher than estimated California automobile and property losses.
During 2017, the Company recorded catastrophe losses of approximately $168 million ($79 million net of reinsurance benefits), resulting primarily from wildfires in Northern and Southern California, severe rainstorms in California, and the impact of Hurricane Harvey in Texas and Hurricane Irma in Florida and Georgia.
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.
Company's deferred tax balances at December 31, 2017 that were computed at the new corporate rate of 21%, rather than the preenactment rate of 35%. Additional adjustments were made to account for the impact of the Act on the realizability of the Company's tax credit carryforwards and tax balances at December 31, 2017. The amounts of income tax adjustments resulting from the Act related to loss reserve discounting and alternative minimum tax ("AMT") credits are provisional amounts based on reasonable estimates of the Company’s tax obligations using the latest information available and are subject to changes as additional information becomes available. These adjustments resulted in a net tax benefit of approximately $7.4 million, which is reflected in net income for the twelve months ended December 31, 2017.
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies' consolidated loss, expense, and combined ratios determined in accordance with GAAP:
Income tax expense (benefit) was $22.2 million and $(2.3) million for the years ended December 31, 2017 and 2016, respectively. The $24.5 million increase in income tax expense was mainly due to a significant increase in pretax income of $96.4 million, partially offset by a net tax benefit of approximately $7.4 million resulting from the income tax effect of the Act.
The following table presents the Company’s consolidated loss, expense, and combined ratios determined in accordance with GAAP:
The Company’s loss ratio was affected by unfavorable development of approximately $85 million and $13 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2016 and 2015, respectively. The unfavorable development in 2016 was primarily from the California and Florida automobile lines of business. The unfavorable development in 2015 was primarily from the California homeowners and automobile lines of business outside of California, which
was partially offset by favorable development in the California personal automobile line of business. The 2016 loss ratio was also negatively impacted by a total of $27 million of catastrophe losses mostly due to severe storms outside of California and rainstorms in California. The 2015 loss ratio was also negatively impacted by a total of $19 million of catastrophe losses mostly due to severe storms outside of California, and rainstorms and wildfires in California. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio for the year ended December 31, 2016 was 71.6%, which is comparable to 71.5% for the year ended December 31, 2015.
The lower expense ratio for the year ended December 31, 2016 was primarily attributable to lower advertising expenses and lower overall compensation costs, including bonuses, compared to the year ended December 31, 2015.
The following tables present the components of net realized investment (losses) gains included in net income:
The following table presents the estimated fair value of fixed maturity securities at December 31, 2017 by contractual maturity in the next five years.
At December 31, 2017, 67.9% of the Company’s total investment portfolio at fair value and 87.6% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and private equity funds. At December 31, 2017, 89.4% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any direct investment in sub-prime lenders.
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, 2017, consistent with the average rating at December 31, 2016. The Company’s municipal bond holdings, of which 99.1% were tax exempt, represented 88.4% of its fixed maturity portfolio at December 31, 2017, at fair value, and are broadly diversified geographically.
The Company had $2.56 billion and $2.45 billion, or 88.4% and 87.0% of its fixed maturity securities portfolio, at fair value ($2.49 billion and $2.43 billion at amortized cost) in municipal securities at December 31, 2017 and 2016, respectively, of which $480.6 million and $722.7 million, respectively, were insured by bond insurers. The underlying ratings for insured municipal bonds have been factored into the average rating of the securities by the rating agencies with no significant disparity between the absolute bond ratings and the underlying credit ratings as of December 31, 2017 and 2016.
At December 31, 2017 and 2016, respectively, the mortgage-backed securities portfolio of $27.2 million and $39.8 million, or 0.9% and 1.4% of the Company's fixed maturity securities portfolio, at fair value ($26.5 million and $39.1 million at amortized cost) was categorized as loans to "prime" borrowers except for $3.8 million and $4.5 million at fair value ($3.8 million and $4.5 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 $19.3 million and $30.0 million at fair value ($18.8 million and $29.6 million at amortized cost) in commercial mortgage-backed securities at December 31, 2017 and 2016, respectively.
At December 31, 2017 and 2016, respectively, the company had corporate securities of $137.5 million and $189.7 million, or 4.8% and 6.7% of its fixed maturity securities portfolio. The weighted-average rating was BBB- at December 31, 2017 and 2016. The modified duration reflecting anticipated early calls was 2.6 years and 2.4 years at December 31, 2017 and 2016, respectively.
The Company had collateralized loan obligations of $105.2 million and $86.5 million, which represented 3.6% and 3.1% of its fixed maturity securities portfolio at December 31, 2017 and 2016, respectively. The weighted-average rating was A+ and
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2017, 14.4% of the total investment portfolio at fair value was held in equity securities, compared to 10.1% at December 31, 2016.
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 amounts outstanding under the existing loan and credit facilities and 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%.
On March 29, 2017, the Company entered into an unsecured credit agreement that provides for revolving loans of up to $50 million and matures on March 29, 2022. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is greater than or equal to 25%. Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to total capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to total capital ratio was 17.6% at December 31, 2017, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of February 2, 2018, there have been no borrowings under this facility.
Among other considerations, industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to statutory policyholders’ surplus should not exceed 3.0 to 1. Based on the combined surplus of all the Insurance Companies of $1.59 billion at December 31, 2017, and net premiums written in 2017 of 3.2 billion, the ratio of premiums written to surplus was 2.02 to 1.
The Company’s significant contractual obligations at December 31, 2017 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, 2017 because the debt amounts above include interest, calculated at the stated 4.4% coupon rate, and exclude the discount and issuance costs of the debt.
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 2023.
Loss and loss adjustment expense reserves represents an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2017. The Company has estimated the timing of these payments based on its historical experience and expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above. The ultimate cost of losses may vary materially from recorded amounts which are the Company’s best estimates. The Company believes that cash flows from operations and existing cash and investments are sufficient to meet these obligations despite the uncertainty in payment patterns. For more detailed information on the Company's liquidity and cash flows, see "Liquidity and Capital Resources-B. Cash Flows" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
Consolidated Statements of Operations for the Years Ended December 31, 2017, 2016, and 2015
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2017, 2016, and 2015
Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016, and 2015
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes and financial statement schedules I, II, and IV (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
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, 2017, 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 8, 2018 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Mercury General Corporation and subsidiaries’ (the “Company”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Mercury General Corporation ("Mercury General") and its subsidiaries (referred to herein collectively as the "Company") are primarily engaged in writing personal automobile insurance through 14 Insurance Companies in 11 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. The private passenger automobile line of insurance business was more than 76% of the Company’s direct premiums written in 2017, 2016, and 2015, of which approximately 85%, 84%, and 83% of the private passenger automobile premiums were written in California during 2017, 2016, and 2015, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
The Company did not have other comprehensive income (loss) in 2017, 2016 and 2015.
The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time an eligible item is first recognized. The primary reasons for electing the fair value option were simplification and cost benefit considerations as well as the expansion of the use of fair value measurement by the Company consistent with the long-term measurement objectives of the Financial Accounting Standards Board (the "FASB") for accounting for financial instruments. See Note 2. Financial Instruments for additional information on the fair value option.
In the normal course of investing activities, the Company either forms or enters into relationships with variable interest entities ("VIEs"). A VIE is an entity that either has investors that lack certain essential characteristics of a controlling financial interest, such as simple majority kick-out rights, or lacks sufficient funds to finance its own activities without financial support provided by other entities. The Company performs ongoing qualitative assessments of the VIEs to determine whether the Company has a controlling financial interest in the VIE and therefore is the primary beneficiary. The Company is deemed to have a controlling financial interest when it has both the ability to direct the activities that most significantly impact the economic performance of the VIE and the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. Based on the Company's assessment, if it determines it is the primary beneficiary, the Company consolidates the VIE in its consolidated financial statements.
The Company also invests directly in limited partnerships such as private equity funds. These investments 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 that is included in equity securities in the Company's consolidated balance sheets. At December 31, 2017 and 2016, the Company had no outstanding unfunded commitments to these VIEs whereby the Company may be called by the partnerships during the commitment period to fund the purchase of new investments and the expenses of the partnerships.
Fixed assets are stated at historical cost less accumulated depreciation and amortization. The useful life for buildings is 30 to 40 years. Furniture, equipment, and purchased software are depreciated on a combination of straight-line and accelerated methods over 3 to 7 years. The Company has capitalized certain consulting costs, payroll, and payroll-related costs for employees related to computer software developed for internal use, which are amortized on a straight-line method over the estimated useful life of the software, generally not exceeding 7 years. In accordance with applicable accounting standards, capitalization ceases no later than the point at which a computer software project is substantially complete and ready for its intended use. Leasehold improvements are amortized over the shorter of the useful life of the assets or the life of the associated lease.
The Company periodically assesses long-lived assets or asset groups including building and equipment, for recoverability when events or changes in circumstances indicate that their carrying amounts may not be recoverable. If the Company identifies an indicator of impairment, the Company assesses recoverability by comparing the carrying amount of the asset to the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset. An impairment loss is recognized when the carrying amount is not recoverable and is measured as the excess of carrying value over fair value. There were no impairment charges during 2017, 2016, and 2015.
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, 2017 and 2016, goodwill and other intangible impairment assessments indicated that there was no impairment.
with the reinsurance deduction recorded in other receivables. Net premiums written, a statutory measure designed to determine production levels, were $3.22 billion, $3.16 billion, and $3.00 billion in 2017, 2016, and 2015, respectively.
Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the loss reserve that is required. A key assumption in estimating loss reserves is the degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact this assumption. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount could be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims, such as those involving the Company’s bodily injury ("BI") coverages. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. However, since the provisions for loss reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
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, 2017, potential dilutive securities consisted of outstanding stock options, while at December 31, 2016, such securities consisted of outstanding stock options and restricted stock units ("RSUs") granted under the Company's 2014 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.
At December 31, 2017, the Company’s deferred income taxes were in a net liability position, which included a combination of ordinary and capital deferred tax benefits and expenses. In assessing the Company's ability to realize deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generating sufficient taxable income of the appropriate character within the carryback and carryforward periods available under the tax law. Management considers the reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to maximize the full benefits of its deferred tax assets. Although realization is not assured, management believes that it is more likely than not that the Company’s deferred tax assets will be realized.
Liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. Unpaid losses and unearned premiums that are ceded to reinsurers are carried in reinsurance recoverables and other receivables, respectively, in the Company's consolidated balance sheets. Earned premiums are stated net of deductions for ceded reinsurance.
In May 2017, the FASB issued Accounting Standards Update ("ASU") 2017-09, "Compensation - Stock Compensation (Topic 718), Scope of Modification Accounting." ASU 2017-09 provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. ASU 2017-09 is effective for the Company beginning January 1, 2018. The Company does not anticipate that ASU 2017-09 will have a material impact on its consolidated financial statements and related disclosures.
In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)." ASU 2014-09 requires entities to apply a five-step model to determine the amount and timing of revenue recognition. The model specifies, among other criteria, that revenue should be recognized when an entity transfers control of goods or services to a customer in the amount to which the entity expects to be entitled. In August 2015, the FASB issued ASU 2015-14, "Revenue from Contracts with Customers (Topic 606), Deferral of the Effective Date," which deferred the effective date of ASU 2014-09 for the Company to January 1, 2018. Subsequently, the FASB has issued additional ASUs on Topic 606 that do not change the core principle of the guidance in ASU 2014-09 but merely clarify certain aspects of it. The additional ASUs is also effective for the Company beginning January 1, 2018. Two methods of transition are permitted upon adoption: full retrospective and modified retrospective. The Company adopted ASU 2014-09 along with the related additional ASUs on Topic 606 on January 1, 2018, using the modified retrospective transition method. The Company did not have any material cumulative-effect adjustment as a result of the adoption, mostly because the accounting for insurance contracts is outside of the scope of ASU 2014-09. In addition, the adoption of ASU 2014-09 and the overall Topic 606 will not have any material impact on our consolidated financial statement line items in the year of adoption. The Company will make the additional required disclosures under Topic 606, starting with the Company's consolidated financial statements that include the initial adoption date.
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 as realized gains from investments on the expiration date. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security 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 $0.12 million and $0.02 million were included in other liabilities in the Company's consolidated balance sheets at December 31, 2017 and 2016, respectively.
The fair value of the Company’s publicly traded $375 million unsecured note at December 31, 2017 was obtained from a third party pricing service. The fair value of the Company's $180 million unsecured note at December 31, 2016 approximated the carrying value.
The following table presents gains (losses) due to changes in fair value of investments that are measured at fair value pursuant to application of the fair value option:
The following table presents the estimated fair values of the Company's fixed maturity securities at December 31, 2017 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 2 measurements-Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.
Mortgage-backed securities: Comprised of securities that are collateralized by residential 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 $19.3 million and $30.0 million in commercial mortgage-backed securities at December 31, 2017 and 2016, respectively.
The fair value of the Company’s publicly traded $375 million unsecured note at December 31, 2017 was based on the spreads above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes.
The fair value of the Company's $180 million unsecured note at December 31, 2016 was based on the unadjusted quoted price for similar notes in active markets. In addition, the fair value of this unsecured note approximated its carrying value, as the interest rate on this security was variable and approximated current market interest rates.
See Note 7. Notes Payable for additional information on secured and unsecured notes.
Depreciation expense, including amortization of leasehold improvements, was $21.1 million, $20.2 million, and $20.5 million during 2017, 2016, and 2015, respectively.
The unamortized discount and debt issuance costs of approximately $3.7 million 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 $0.2 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.
As a result of the Tax Cuts and Jobs Act of 2017 (the "Act"), the Company’s deferred tax assets and liabilities were remeasured using the new corporate tax rate of 21% that is effective for tax years beginning January 1, 2018, rather than the pre-enactment corporate tax rate of 35%. Additionally, the Company recorded a provisional 6.6% sequestration reduction to its alternative minimum tax (“AMT”) credit resulting from repeal of the corporate AMT and reclassification of AMT credit carryforwards to current taxes receivable as a refundable credit. These adjustments resulted in a net tax benefit of approximately $7.4 million, which is reflected in net income for the twelve months ended December 31, 2017.
There was a $3.3 million decrease to the total amount of unrecognized tax benefits related to tax uncertainties during 2017. The decrease was the result of tax positions taken regarding federal tax credits, settlement of California audit for tax years 2003 through 2010, and state tax apportionment issues based on management’s judgment and latest information available. The Company does not expect any changes in such unrecognized tax benefits to have a material impact on its consolidated financial statements within the next 12 months.
If unrecognized tax benefits were recognized, $10.1 million and $11.8 million, including accrued interest, penalties and federal tax benefit related to unrecognized tax benefits, would impact the Company’s effective tax rate at December 31, 2017 and 2016, respectively.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. The Company recognized an accrued net (benefit) expense related to interest and penalty of $(1,104,000), $606,000, and $112,000 for the years ended December 31, 2017, 2016, and 2015, respectively. The net benefit for the year ended December 31, 2017 is largely due to reversal of accrued interest and penalty following the settlement with the FTB for tax years 2003 through 2010. The Company carried an accrued interest and penalty balance of $2,417,000 and $3,521,000 at December 31, 2017 and 2016, respectively.
The Company experienced pre-tax catastrophe losses and loss adjustment expenses of approximately $168 million ( $79 million net of reinsurance benefits), $27 million, and $19 million in 2017, 2016, and 2015, respectively. There were no reinsurance benefits used for catastrophe losses in 2016 and 2015. The losses in 2017 were primarily due to wildfires in Northern and Southern California, severe rainstorms in California, and the impact of Hurricane Harvey in Texas and Hurricane Irma in Florida and Georgia. The losses in 2016 were primarily due to severe storms outside of California, and rainstorms in California. The losses in 2015 were primarily due to severe storms outside of California, and rainstorms and wildfires in California.
The following is information about incurred and paid claims development as of December 31, 2017, net of reinsurance, as well as cumulative claim frequency and the total of incurred-but-not-reported liabilities plus expected development on reported claims included within the net incurred claims amounts for our two major product lines: automobile and homeowners lines of business. As the information presented is for these two major product lines only, the total incurred and paid claims development shown below does not correspond to the aggregate development presented in the table above, which is for all product lines and includes unallocated claims adjustment expenses. The cumulative number of reported claims represents open claims, claims closed with payment, and claims closed without payment. It does not include an estimated amount for unreported claims. The number of claims is measured by claim event (such as a car accident or storm damage) and an individual claim event may result in more than one reported claim. The Company considers a claim that does not result in a liability as a claim closed without payment.
(1) The information for the years 2008 to 2016 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, 2017, the insurance subsidiaries of the Company are permitted to pay approximately $167 million in dividends in 2018 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 2017, 2016, and 2015, the Insurance Companies paid Mercury General ordinary dividends of $109 million, $111 million, and $133 million, respectively.
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, 2017, 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, 2017, 2016, and 2015, 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 400% of the authorized control level RBC as of December 31, 2017, 2016 and 2015. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. The matching contributions, at a rate set by the Board of Directors, totaled $8.6 million, $8.2 million, and $8.5 million for 2017, 2016, and 2015, respectively.
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.
No stock options were awarded in 2017, 2016, and 2015 under the 2015 Plan or 2005 Plan. The fair values of stock options awarded in 2013 under the 2005 Plan were estimated on the dates of grant using a closed-form option valuation model (Black-Scholes). The following table provides the assumptions used in the calculation of grant-date fair values of stock options awarded during 2013 based on the Black-Scholes option pricing model:
The following table presents a summary of the stock option activity under the Company’s plans for the year ended December 31, 2017:
The following table presents information regarding stock options outstanding at December 31, 2017:
The restricted stock units vest at the end of a three-year performance period beginning with the year of the grant, and then only if, and to the extent that, the Company’s performance during the performance period achieves the threshold established by the Compensation Committee of the Company’s Board of Directors. For 2015 and 2016 grants, vesting is based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. As of December 31, 2017, 12,500 and 13,500 target restricted stock units granted in 2016 and 2015, respectively, have been forfeited because the recipients were no longer employed by the Company. Expired shares represent shares that did not meet the vesting requirements.
At December 31, 2016, the Company determined that it was probable that the Company's Board of Directors would modify the payment method for the vested 2014 grant awards and pay for the vested awards in cash in lieu of shares of the Company's common stock. As a result, the 2014 grants were reclassified from equity to liability awards at December 31, 2016. $3.4 million of the amount previously recognized in additional paid-in capital for the 2014 grant awards was reclassified to other liabilities in the consolidated balance sheets at December 31, 2016. Additional $0.2 million was reclassified from additional paid-in capital to other liabilities at the vesting date of February 28, 2017 for the 2014 grant awards, based on the additional amount of awards vested from December 31, 2016 through the vesting date.
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 2023. For leases that contain predetermined escalations of the minimum rentals, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent in other liabilities. This liability amounted to $1.5 million and $2.4 million at December 31, 2017 and 2016, respectively. Total rent expense under these lease agreements was $14.7 million, $19.7 million, and $16.0 million for 2017, 2016, and 2015, respectively.
The CEA is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. The Company places all new and renewal earthquake coverage offered with its homeowners policies directly with the CEA. The Company receives a small fee for placing business with the CEA, which is recorded as other income in the consolidated statements of operations. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 3, 2017, the most recent date at which information was available, was approximately $66.2 million. There was no assessment made in 2017.
The following table presents summarized quarterly financial data for 2017 and 2016:
WAIC is a Los Angeles-based non-standard, private passenger automobile insurance company that operates predominantly in California. The Company intends to use the WAIC non-standard automobile product to complement the Company’s preferred and standard product offerings.