* The building has been occupied by Company employees since January 2009.
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, natural disasters on losses, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates and other factors such as changes in tax laws.
• Cost Uncertainty - Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned. Consequently, significant assumptions are made when establishing insurance rates and loss reserves. While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analysis shows that they are needed.
• Inflation - The largest cost component for automobile insurers is losses, which include medical costs, replacement automobile parts and labor costs. There can be significant variation in the overall increases in medical cost inflation and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
• Loss Frequency - Another component of overall loss costs is loss frequency, which is the number of claims per risks insured. There has been a long-term trend of declining loss frequency in the personal automobile insurance industry, which has benefited the industry as a whole. It is unknown if loss frequency in the future will decline, remain flat or increase.
During 2008, the Company continued its marketing efforts for name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation make the Company very competitive in California and in other states. Net advertising expenditures were approximately $26 million and $28 million during 2008 and 2007, respectively.
The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins than many competitors.
The Company also generated income from its investment portfolio. Approximately $151 million in pre-tax investment income was generated during 2008 on a portfolio of approximately $2.9 billion at fair market value at December 31, 2008, compared to $159 million pre-tax investment income during 2007 on a portfolio of approximately $3.6 billion at fair market value at December 31, 2007. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.
The Company currently underwrites personal automobile insurance in thirteen states: Arizona, California, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas and Virginia. The Company expects to continue its growth by expanding into new states in future years with the objective of achieving greater geographic diversification.
There are, however, challenges and risks involved in entering each new state, including establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems and finding qualified agents to represent the Company. The Company does not expect to enter into any new states during 2009.
• A catastrophe, such as a major wildfire, earthquake or hurricane, could cause a significant amount of loss to the Company in a very short period of time.
• A major regulatory change could make it more difficult for the Company to generate new business or reduce the profitability of the Company’s existing business.
The Company began developing its NextGen computer system in 2002 to replace its legacy underwriting, billings, claims and commissions systems. The NextGen system was designed to be a multi-state, multi-line system to enable the Company to enter new states more rapidly, as well as respond to legislative and regulatory changes more easily. The Company completed rollout of NextGen for all underwriting, billing, claims and commission functions supporting Private Passenger Auto in seven states (Virginia, New York, Florida, California, Georgia, Illinois, and Texas). The legacy Private Passenger Auto system has been retired.
The process for implementing rate changes varies by state, with California, Georgia, New York, New Jersey, Pennsylvania and Nevada requiring prior approval from the DOI before a rate may be implemented. Illinois, Texas, Virginia, Arizona and Michigan only require that rates be filed with the DOI, while Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be excessive, inadequate or unfairly discriminatory. During 2008, the Company implemented automobile and homeowners insurance rate decreases in California that were initially filed in August 2006 and approved by the California DOI in January 2008 as part of the Company’s compliance with regulations proposed by the California DOI and approved in July 2006, as more fully described below. In five other states, the Company implemented automobile rate increases.
In April 2007, regulations became effective that generally tighten the existing Proposition 103 prior approval ratemaking regime primarily by establishing a maximum allowable rate of return (calculated by adding 6 percent plus the average of short, intermediate, and long-term T-bill rates) and a minimum allowable rate of return of negative 6 percent of surplus. However, the practical impact of these limitations is unclear because the new regulations allow for the California DOI to grant a number of variances based on loss prevention, business mix, service to underserved communities, and other factors. In October 2007, the California DOI invited comments from consumer groups and the insurance industry in an effort to set appropriate standards for granting or denying specific variances and to provide sufficient instruction regarding what information or data to submit when an insurer is applying for a specific variance. The comment period ended on November 16, 2007. The California DOI then published proposed amendments to its regulations and held an informal workshop on them on April 7, 2008. On April 29, 2008, the Commissioner issued a new notice reflecting slight modifications to the proposed regulations and superseding the prior version. The proposed changes were approved as emergency regulations by the Office of Administrative Law (“OAL”) on May 16, 2008 and became effective as of that date.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance (“NNC”) to the NNC originally issued in February 2004 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. Through this action, the California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee, which the California DOI contends is the use of an unapproved rate, rating plan or rating system. Further, the California DOI seeks to impose a penalty for each and every date on which the Company allegedly used a misleading advertisement alleged in the NNC. Finally, based upon the conduct alleged, the California DOI also contends that the Company acted fraudulently in violation of Section 704(a) of the California Insurance Code, which permits the California Commissioner of Insurance to suspend certificates of authority for a period of one year. The Company filed a Notice of Defense in response to the NNC. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company, denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. The matter is currently in discovery and a hearing before the administrative law judge is scheduled to start on March 16, 2009. This matter has been the subject of five continuations since the original NNC was issued in 2004.
The California Franchise Tax Board (“FTB”) has audited the 1997 through 2002 and 2004 tax returns and accepted the 1997 through 2000 returns to be correct as filed. The Company received a notice of examination for the 2003 tax return from the FTB in January 2008. For the Company’s 2001, 2002, and 2004 tax returns, the FTB has taken exception to the state apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company, that are excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. In addition, for the 2004 tax return, the FTB has asserted that a portion of management fee expenses paid by Mercury Insurance Services, LLC should be disallowed. Based on these assertions, the FTB has issued notices of proposed tax assessments for the 2001, 2002 and 2004 tax years totaling approximately $5 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the California State Board of Equalization (“SBE”). An unfavorable ruling against the Company may have a material impact on the Company’s results of operations in the period of such ruling. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail on this matter.
• Variability in inflation expectations - particularly on coverages that take longer to settle such as the California automobile bodily injury coverage.
• Unexpected large individual losses or groups of losses arising from older accident periods typically caused by an event that is not reflected in the historical company data used to establish reserves.
For the Company’s California automobile lines of business, the bodily injury (BI) reserves comprise approximately 65% of the total reserve; material damage, including collision, comprehensive, and property damage (MD) reserves make up approximately 10% of the total reserve; and loss adjustment expense reserves make up approximately 25% of the total reserve. The BI reserves account for such a large portion of the total because BI claims tend to close much slower than MD claims. The majority of the loss adjustment expense reserves consist of estimated costs to defend BI claims, so those reserves also tend to close more slowly than MD claims. Loss development on MD reserves is generally insignificant because MD claims are closed quickly.
BI loss reserves are generally the most difficult to estimate because they take longer to close than most of the Company’s other coverages. The Company’s BI policy covers injuries sustained by any person other than the insured, except in the case of uninsured and underinsured motorist BI coverage, which covers damages to the insured for BI caused by uninsured or underinsured motorists. BI payments are primarily for medical costs and general damages.
Claims that close during the initial accident year reported are generally the smaller, less complex claims that settle, on average, for approximately $2,000 to $2,500 whereas the average settlement, once all claims are closed in a particular accident year, is approximately $7,500 to $9,000. The Company creates incurred loss triangles to estimate ultimate losses utilizing historical reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI 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 becomes a higher degree of certainty for the reserves established for that accident year. Consequently, there is a decreasing likelihood of reserve development on any particular accident year, as those periods age. The Company believes that the accident years that are most likely to develop are the 2006 through 2008 accident years; however it is also possible that older accident years could develop as well.
At December 31, 2008, there were 29,647 BI claims reported for the 2008 accident year and the Company estimates that these are expected to ultimately grow by 7.0% to approximately 31,737 claims. The Company believes that while actual development in recent years has ranged between roughly 5% and 10%, it is reasonable to expect that the range could be as great as to be between 3% and 12%. Actual development may be more or less than the expected range.
The following table shows the effect should the actual amount of claims reported develop differently within the broader reasonably possible range than what the Company recorded at December 31, 2008:
In 2008, it became apparent that the Company results were turning out differently than estimates derived by the industry results. In particular, loss severities for the PIP coverage were developing into larger amounts than the industry data suggested. With the passage of 2008, the loss data began to mature and the Company began utilizing its own historical loss patterns to determine the reserves. While management believes that this has led to a more reliable reserve estimate, there is still a great deal of potential variability in the reserves. This is particularly true with PIP and BI losses which often take years to settle.
At December 31, 2008 the Company estimates that in New Jersey, for every 10% increase on recorded BI and PIP loss severities for the 2006, 2007 and 2008 accident years, an additional loss reserve of approximately $20 million would be required, with the converse holding true if the loss severities recorded were reduced. As these accident years continue to mature, there is likely to be additional development, however, it is uncertain whether this development will be positive or negative.
One instance when there were large unanticipated losses arising from older accident periods was in 2006 from extra-contractual losses in Florida. Typically, extra-contractual claims are those that settle for more than the policy limits because the original claim was denied, thus exposing the Company to losses greater than the policy limits. Claims may be denied for various reasons, including material misrepresentations made by the insured on the policy application or insureds that have violated prohibitions in the insurance contract or when there is fraud involved. These types of losses are fairly infrequent but can amount to millions of dollars per claim, especially if the injured party sustained a serious physical injury. Consequently, these claims can have a large impact on the Company’s losses. During 2006, the Company had extra-contractual losses that settled for amounts much greater than the policy limits and much greater than expected. As a result of these settlements, the Company, during the second quarter of 2006, reevaluated its exposure to extra-contractual claims in Florida and increased its reserve estimates for prior accident years.
To mitigate this specific risk, during 2006 the Company established new claims handling and review procedures in Florida, as well as in other states, that are intended to reduce the risk of receiving extra-contractual claims. Consequently, the Company does not expect that Florida extra-contractual claims will continue to have a significant impact on the financial statements or reserves in the future. However, it is possible that these procedures will not prove entirely effective and the Company may continue to have material extra-contractual losses. It is also possible that the Company has not identified and established a sufficient reserve for all of the extra-contractual losses occurring in the older accident years, even though a comprehensive claims file review was undertaken, or that the Company will experience additional development on these reserves.
Discussion of loss reserves and prior period loss development at December 31, 2008
For 2008, the Company had negative development of approximately $89 million on the 2007 and prior accident years’ loss and loss adjustment expense reserves which at December 31, 2007 totaled approximately $1,104 million.
(1) The estimates for California Bodily Injury Severities and California Defense and Cost Containment reserves established at December 31, 2007 were too low causing adverse development of approximately $45 million. During the year, the Company experienced a lengthening of the pay-out period for claims that are settled after the first year and a large increase in the average amounts paid on closed claims. The Company believes that the lengthening of the pay-out periods may be attributable to a law passed in California several years ago that extended the statute for filing claims from one year to two years. Initial indications, when the law was passed, were that the law would have little impact on development patterns and therefore it was not factored into the Company’s reserve estimates. In hindsight, claims payouts 2 to 4 years after the period-end have increased thereby affecting the loss reserve estimates. The Company believes that this trend was factored into its reserve estimate at year-end 2008.
(2) The Company had approximately $30 million of adverse development on its New Jersey reserves established at December 31, 2007. Due to short operating history and rapid growth in that state, the Company had limited internal historical claims information to estimate BI, PIP and related loss adjustment expense reserves as of December 31, 2007. Consequently, the Company relied substantially on industry data to help set these reserves. During 2008, the reserve indications using the Company’s own historical data rather than industry data led to increases in estimates for both PIP losses and loss adjustment expenses. In particular, loss severities experienced by the Company data for the PIP coverage developed into amounts larger than industry data suggested. The Company is now using its own historical data, rather than industry data to set New Jersey loss reserves. Management believes that, over time this will lead to less variation in reserve estimates.
Certain financial instruments that the Company holds or may acquire may lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise is not actively quoted. For a further discussion, see Note 2 of Notes to Consolidated Financial Statements-Investments and Investment Income-Fair Value of Investments in 2008.
Management's position is supported based on the Company's steady history of generating positive cash flow from operations, as well as its reasonable expectation that its cash flow needs can be met in future periods without the forced sale of its investments. This capability will enable management to use its discretion in controlling the timing and amount of realized losses it generates during future periods. Thus, although realization is not assured, management believes it is more likely than not that the Company's deferred tax assets will be realized.
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned:
Investment income was $151.3 million and $158.9 million in 2008 and 2007, respectively. The after-tax yield on average investments (fixed maturities, equities and short-term investments valued at cost) was 3.9% and 4.0% in 2008 and 2007, respectively, on average invested assets of $3.5 billion for each period. The slight decrease in after-tax yield is due to a decrease in short-term interest rates.
Included in net (loss) income are net realized investment losses of $550.5 million in 2008 compared to net realized investment gains of $20.8 million in 2007. Net realized investment losses of $550.5 million in 2008 include losses of $525.7 million due to changes in the fair value of total investments measured at fair value pursuant to SFAS No. 159. These losses, primarily in fixed maturity securities, arise from the market value declines on the Company’s holdings during 2008 resulting from ongoing downgrades of municipal bond insurers, widening credit spreads, economic downturn impacting municipalities and the lack of liquidity in the market.
Operating income for 2008 was $115.7 million, down 48% from the prior year largely due to a decrease in premiums earned reflecting the continuing soft market conditions, higher losses as a result of inflation and higher other operating expenses. In addition, a decrease in net investment income resulting from lower investment yields and lower invested assets contributed to the decrease in operating income. Partially offsetting this was a $17.5 million net tax benefit realized from the tax case victory over the California FTB.
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any effects of reinsurance. Net premiums written is a statutory measure used to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of premiums written that are recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned:
The loss ratio (GAAP basis) (loss and loss adjustment expenses related to premiums earned) was 68.0% and 67.5% in 2007 and 2006, respectively. There was negative development of approximately $20 million on prior accident years’ loss reserves in both 2007 and 2006. Excluding the effect of prior accident years’ loss development, the loss ratio was 67.4% and 66.8% in 2007 and 2006, respectively. The Southern California fire storms negatively impacted the loss ratio by approximately 0.8% in 2007.
The expense ratio (GAAP basis) (policy acquisition costs and other operating expenses related to premiums earned) was 27.4% and 27.5% in 2007 and 2006, respectively. The majority of expenses vary directly with premiums.
The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 95.4% and 95.0% in 2007 and 2006, respectively.
Net realized investment gains were $20.8 million and $15.4 million in 2007 and 2006, respectively. Included in the net realized investment gains were investment write-downs of $22.7 million and $2.0 million in 2007 and 2006, respectively, that the Company considered to be other-than-temporarily impaired. In addition, net realized investment gains included approximately $1.4 million loss and $0 in 2007 and 2006, respectively, related to the change in the fair value of hybrid financial instruments, and approximately $2.0 million gain and $0 in 2007 and 2006, respectively, related to the change in the fair value of trading securities.
The income tax provision for 2006 of $97.6 million was impacted significantly by a $15 million income tax charge relating to the Notices of Proposed Assessments for the tax years 1993 through 1996 (the “NPAs”) that were upheld by the California State Board of Equalization. Excluding the effect of this income tax charge resulted in an effective tax rate of 24.5% and 26.4% in 2007 and 2006, respectively. The lower rate in 2007 was primarily attributable to an increased proportion of tax-exempt investment income including tax sheltered dividend income, in contrast to taxable investment income and underwriting income.
Net income was $237.8 million or $4.34 per share (diluted) and $214.8 million or $3.92 per share (diluted) in 2007 and 2006, respectively. Diluted per share results were based on a weighted average of 54.8 million shares and 54.8 million shares in 2007 and 2006, respectively. Basic per share results were $4.35 and $3.93 in 2007 and 2006, respectively. Included in net income were net realized investment gains, net of income tax expense, of $0.25 and $0.18 per share (diluted and basic) in 2007 and 2006, respectively.
The Company is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay, without extraordinary approval, ordinary dividends of approximately $136.7 million in 2009. Extraordinary dividends, as defined by the DOI, require DOI extraordinary approval. Actual ordinary dividends paid from the Insurance Companies to Mercury General during 2008 were $140 million. As of December 31, 2008, Mercury General also had approximately $67 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
* Insured municipal bonds based on underlying ratings: AAA: $7,611, AA: $361,438, A: $581,533, BBB: $73,645, Non rated/Other: $171,744
MBIA, FSA, AMBAC, ASSURED GTY and RADIAN maintained investment grade ratings at December 31, 2008 while XLCA, CIFG and FGIC were downgraded to below investment grade during 2008. Many FGIC-insured bonds were reinsured by MBIA. Based on the uncertainty surrounding the financial condition of these insurers, it is possible that there will be additional downgrades to below investment grade ratings by the rating agencies in the future, and such downgrades could impact the estimated fair value of municipal bonds. The following table shows the Company’s insured municipal bond portfolio by bond insurer at December 31, 2008:
Included in the fixed maturity securities are $65.7 million of fixed rate corporate securities which have a duration of 4.2 years and an overall credit quality rating of A.
Included in fixed maturities securities are redeemable preferred stock, which represents less than 1% of the total investment portfolio at December 31, 2008, and had an overall credit quality rating less than investment grade.
At December 31, 2008, short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities redeemable on a daily or weekly basis.
In February 2008, the Company acquired an 88,300 square foot office building in Folsom, California for approximately $18.4 million. The Company financed the transaction through an $18 million secured bank loan. The loan matures on March 1, 2013 with interest payable quarterly at an annual floating rate of LIBOR plus 50 basis points. On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate plus 50 basis points on the loan for a fixed rate of 4.25%. The swap agreement terminates on March 1, 2013. The swap is designated as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). Changes in fair value of the swap are recorded as a component of accumulated other comprehensive income.
The Company has no direct investment in real estate that it does not utilize for operations. In February 2008, the Company acquired an 88,300 square foot office building in Folsom, California for approximately $18.4 million. Since January 2009, when a lease on previously occupied space expired, the building has been occupied by the Company’s Northern California employees. The Company financed the transaction through an $18 million secured bank loan.
The NextGen project began in 2002 and total capital investment has been approximately $41 million as of December 31, 2008. The Mercury First project began in 2006 and the total capital investment has been approximately $24 million as of December 31, 2008. Although the majority of the related software development costs have been expended, there will be some Mercury First development and implementation costs and NextGen implementation costs in the future.
The Company has obligations to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2008, certain long-term aggregate contractual obligations and credit-related commitments are summarized as follows:
The Company’s outstanding 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 thereunder.
The table excludes the contingent consideration arrangement related to the AIS acquisition.
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 $1,371.1 million at December 31, 2008, and net premiums written of $2,750.2 million, the ratio of premium writings to surplus was 2.0 to 1.
Consolidated Statements of Shareholders' Equity for Each of the Years in the Three-Year Period
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We have audited Mercury General Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercury General Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
The consolidated financial statements include the accounts of Mercury General and its directly and indirectly wholly owned insurance and non-insurance subsidiaries. The insurance subsidiaries are MCC, MIC, CAIC, CGU, MIC IL, MIC GA, MID GA, MNIC, AMI, AML, MCM, MIC FL and MID AM. The non-insurance subsidiaries are MSMC, AMMGA, Concord, MIS LLC and MGI. AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact, MSMC. MCM is not owned by the Company, but is controlled through a management contract and therefore its results are included in the consolidated financial statements. The consolidated financial statements have been prepared in conformity with GAAP, which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.
Short-term investments include money market accounts, options and short-term bonds expected to mature within one year. Prior to the adoption of SFAS No. 159, short-term bonds were carried at cost, which approximated fair value. Effective January 1, 2008, short-term investments are reported at fair value. As of December 31, 2008, liabilities for covered call options of $2.8 million and short sales of $2.5 million were included in other liabilities.
As discussed above, all investments, including short-term investments, are carried on the balance sheet at fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 of Notes to Consolidated Financial Statements and were drawn from standard trade data sources such as market and broker quotes, with the exception of $3 million of fixed maturities, at fair value at December 31, 2008, for which management determined fair value estimates using discounted cash flow models. The carrying value of receivables, accounts payable and accrued expenses and other liabilities is equivalent to the estimated fair value of those items.
Insurance premiums are recognized as income ratably over the term of the policies in proportion to the amount of insurance protection provided. Unearned premiums are computed on a monthly pro rata basis. Unearned premiums are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets and other receivables. Net premiums of $2.75 billion, $2.98 billion, and $3.04 billion were written in 2008, 2007 and 2006, respectively.
Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials or labor rates can impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the occurrence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail property damage claims tend to be more reasonably predictable than long-tail liability 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. Since the provisions for loss reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company analyzes loss reserves quarterly primarily using the incurred loss development, average severity and claim count development methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves and industry claims data as part of its reserve analysis. When deciding which method to use in estimating its reserves, the Company and its actuaries evaluate the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on one method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
The Company accounts for derivative financial instruments in accordance with SFAS No. 133, as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Hedging Activities,” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133 establishes accounting and reporting standards requiring that all derivative instruments, other than those that meet the normal purchases and sales exception, be recorded on the balance sheet as either an asset or liability measured at fair value which is generally based on information obtained from independent parties. SFAS No. 133 also requires that changes in fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The Company’s derivative instruments include interest rate swap agreements and are used to hedge the exposure to:
• Changes in fair value of an asset or liability (fair value hedge);
• Variable cash flows of a forecasted transaction (cash flow hedge).
At December 31, 2008, the Company held one fair value hedge and one cash flow hedge, compared to one fair value hedge at December 31, 2007.
Derivatives designated as hedges are evaluated based on established criteria to determine the effectiveness of their correlation to, and ability to reduce the designated risk of specific securities or transactions. Effectiveness is reassessed on a quarterly basis. Hedges that are deemed to be effective are accounted for as follows:
If a hedge is deemed to become ineffective, it is accounted for as follows:
• Cash flow hedge: changes in fair value of the hedging instrument are reported in earnings for the current period. If it is determined that a hedging instrument no longer meets the Company’s risk reduction and correlation criteria, or if the hedging instrument expires, any accumulated balance in other comprehensive income is recognized in earnings in the period of determination.
Earnings per share is presented in accordance with the provisions of SFAS No. 128, “Earnings per Share,” which requires presentation of basic and diluted earnings per share for all publicly traded companies. Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average number of common and dilutive potential common shares outstanding. At December 31, 2008, potential dilutive common shares consist of outstanding stock options. Note 13 of Notes to Consolidated Financial Statements contains the required disclosures relating to the calculation of basic and diluted earnings per share.
The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and expected benefits of utilizing net operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled, and reflected in the financial statements in the period enacted. At December 31, 2008, the Company’s deferred income taxes were in a net asset position, compared to a net liability position at December 31, 2007. In assessing the realizability of 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 the generation of sufficient taxable income of the appropriate character within the carryback and carryforward periods available under the tax law. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences.
Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). Under the modified prospective transition method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of five years for options granted prior to 2008 and four years for options granted subsequent to January 1, 2008, for only those shares expected to vest. The fair value of stock option awards was estimated using the Black-Scholes option pricing model with the grant-date assumptions and weighted-average fair values, as discussed in Note 12 of Notes to Consolidated Financial Statements.
The transition adjustment to beginning retained earnings related to the adoption of SFAS No. 159 was a gain of $80.5 million, net of deferred taxes of $43.3 million, all of which related to applying the fair value option to fixed maturity and equity securities available for sale. This adjustment was reflected as a reclassification of accumulated other comprehensive income to retained earnings. Both the fair value and carrying value of such securities were $3.3 billion on January 1, 2008, immediately prior to the adoption of the fair value option.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (“SFAS No. 161”). SFAS No. 161 amends SFAS No. 133 by requiring expanded disclosures about an entity’s derivative instruments and hedging activities, but does not change the scope of accounting of SFAS No. 133. SFAS No. 161 requires increased qualitative disclosures such as how and why an entity is using a derivative instrument; how the entity is accounting for its derivative instrument and hedged items under SFAS No. 133 and its related interpretations; and how the instrument affects the entity’s financial position, financial performance, and cash flows. Quantitative disclosures should include information about the fair value of the derivative instruments, including gains and losses, and should contain more detailed information about the location of the derivative instrument in the entity’s financial statements. Credit-risk disclosures should include information about the existence and nature of credit-risk-related contingent features included in derivative instruments. Credit-risk-related contingent features can be defined as those that require entities, upon the occurrence of a credit event such as a credit rating downgrade, to settle derivative instruments or post collateral. The Company adopted SFAS No. 161 on January 1, 2009. The adoption of SFAS No. 161 is not expected to have a material impact on the Company’s consolidated financial statements.
The following table presents losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option under SFAS No. 159:
Net realized investment gains and losses included investment impairment write-downs of $22.7 million and $2.0 million in 2007 and 2006, respectively. In addition, in 2007, net realized investment gains and losses also included $2.0 million gain and $1.4 million loss related to the change in the fair value of trading securities and hybrid financial instruments, respectively.
Effective January 1, 2008, the Company adopted SFAS No. 159. The gains and losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option were included in net realized investment losses for 2008. A summary of the net increase and decrease in unrealized investment gains and losses less applicable income tax expense or benefit for 2007 and 2006 is as follows:
SFAS No. 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price). Accordingly, when market observable data is not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Financial assets and financial liabilities recorded on the consolidated balance sheets at fair value are categorized based on the reliability of inputs to the valuation techniques as follows:
Level 1 Financial assets and financial liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in active markets that the Company can access.
Level 2 Financial assets and financial liabilities whose values are based on the following:
Level 3 Financial assets and financial liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect the Company’s estimates of the assumptions that market participants would use in valuing the financial assets and financial liabilities.
The Company primarily utilizes independent pricing services to obtain fair values on its portfolio except for 1% of its portfolio at fair value where unadjusted broker quotes are obtained and less than 1% for which management performed discounted cash flow modeling.
Common stock; Other: 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.
Municipal securities: Municipal bonds are valued based on models or matrices using inputs including quoted prices for identical or similar assets in active markets.
Mortgage-backed securities: 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 following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
The following table provides a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at December 31, 2008:
The Company monitors its investments closely. Prior to the adoption of SFAS No. 159 on January 1, 2008, if an unrealized loss was determined to be other than temporary, it was written off as a realized loss through the consolidated statements of operations. The Company’s assessment of other-than-temporary impairments was security-specific as of the balance sheet date and considered various factors including the length of time and the extent to which the fair value had been lower than the cost, the financial condition and the near-term prospects of the issuer, whether the debtor was current on its contractually obligated interest and principal payments, and the Company’s intent and ability to hold the securities until they mature or recover their value. The Company recognized $22.7 million in realized losses as other-than-temporary declines to its investment securities during 2007.
Based upon the Company’s analysis of the securities, which included consideration of the status of debt servicing for fixed maturities and third party analyst estimates for the equity securities, and the Company’s intent and ability to hold the securities until they mature or recover their costs, the Company concluded that the gross unrealized losses of $35.8 million at December 31, 2007 were temporary in nature.
Depreciation expense including amortization of leasehold improvements was $27.0 million, $26.3 million, and $24.3 million during 2008, 2007 and 2006, respectively.
In February 2008, the Company acquired an 88,300 square foot office building in Folsom, California for approximately $18.4 million. The Company financed the transaction through an $18 million bank loan. On January 2, 2009, the loan was secured by municipal bonds pledged as collateral. The loan matures on March 1, 2013 with interest payable quarterly at an annual floating rate of LIBOR plus 50 basis points. On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate on the loan for a fixed rate of 3.75%, resulting in a total fixed rate of 4.25%, which expires on March 1, 2013. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is designated as a cash flow hedge. The fair value of the interest rate swap was negative $1,348,000, pre-tax, at December 31, 2008 and has been recorded as a component of accumulated other comprehensive income and amortized into earnings over the life of the hedged transaction. The interest rate swap was determined to be highly effective and no amount of ineffectiveness was recorded in earnings during 2008.
Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate of LIBOR plus 107 basis points. The swap agreement terminates on August 15, 2011 and includes an early termination option exercisable by either party on the fifth anniversary or each subsequent anniversary by providing sufficient notice, as defined. The swap reduced interest expense in 2006, 2007 and 2008, but does expose the Company to higher interest expense in future periods if LIBOR rates increase. The effective annualized interest rate was 3.3%, 6.4% and 6.6% in 2008, 2007 and 2006, respectively. The swap is designated as a fair value hedge and qualifies for the “shortcut method” under SFAS No. 133, because the hedge is deemed to have no ineffectiveness. The fair value of the interest rate swap was $14,393,000 and $9,218,000 at December 31, 2008 and 2007, respectively, and has been recorded in other assets in the consolidated balance sheets with a corresponding increase in notes payable. The interest rate swap was determined to be highly effective and no amount of ineffectiveness was recorded in earnings during 2008, 2007 and 2006.
The temporary differences that give rise to a significant portion of the deferred tax assets and liabilities relate to the following:
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. The tax years that remain subject to examination by major taxing jurisdictions are 2005 through 2007 for federal taxes and 2001 through 2007 for California state taxes.
The FTB has audited the 1997 through 2002 and 2004 tax returns and accepted the 1997 through 2000 returns to be correct as filed. The Company received a notice of examination for the 2003 tax return from the FTB in January 2008. For the Company’s 2001, 2002, and 2004 tax returns, the FTB has taken exception to the state apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from MIS LLC, a subsidiary of MCC, that are excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. In addition, for the 2004 tax return, the FTB has asserted that a portion of management fee expenses paid by MIS LLC should be disallowed. Based on these assertions, the FTB has issued notices of proposed tax assessments for the 2001, 2002 and 2004 tax years totaling approximately $5 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the California SBE. An unfavorable ruling against the Company may have a material impact on the Company’s results of operations in the period of such ruling. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail on this matter.
As presented above, the balance of unrecognized tax benefits at December 31, 2008 was $5,897,000. Of this total, $4,914,000 represents unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would affect the Company's effective tax rate.
Management anticipates that it is reasonably possible that the Company's total amount of unrecognized tax benefits will increase within the next twelve months by approximately $700,000 to $1,000,000 related to its ongoing California state tax apportionment factor issues.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. During the years ended December 31, 2008, 2007, and 2006, the Company recognized net interest and penalty expense or (refunds) of $(16,672,000), $450,000, and $14,432,000, respectively. The Company carried an accrued interest and penalty balance of $1,334,000 and $710,000 at December 31, 2008 and 2007, respectively.
The increase in the provision for insured events of prior years in 2007 primarily relates to adverse development of approximately $25 million in California mostly resulting from increases in estimates for loss severity and ultimate reported claims on the bodily injury reserves, which was partially offset by positive development of approximately $5 million related to operations outside of California.
In 2008 and 2007, the Company experienced pre-tax catastrophe losses of $26 million and $23 million, respectively. The pre-tax losses in 2008 were $20 million related to Southern California wildfires and $6 million related to Hurricane Ike in Texas. The full $23 million of catastrophe losses in 2007 related to Southern California wildfires.
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. For 2009, the direct insurance subsidiaries of the Company are permitted to pay approximately $136.7 million in dividends to the Company without the prior approval of the DOI of the states of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2008 and 2007, the Insurance Companies paid ordinary dividends to the Company of $140.0 million and $127.0 million, respectively.
A summary of interest, income taxes paid and net realized gains and losses from sale of investments is as follows:
In 2007, the Company issued a promissory note of $4.5 million in connection with the acquisition of a 4.25 acre parcel of land in Brea, California. The note was paid in full in December 2008.
The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices primarily include those published as statements of Statutory Accounting Principles by 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, 2008, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
The following table summarizes the statutory net loss or income and statutory policyholders’ surplus of the Insurance Companies, as reported to regulatory authorities:
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $6,802,000, $5,056,000 and $4,512,000 for 2008, 2007 and 2006, respectively.
The Plan also includes an employee stock ownership plan (“ESOP”) that covers substantially all employees. The Board of Directors authorized the Plan to purchase $1.2 million of the Company’s common stock in the open market for allocation to the Plan participants in 2007 and 2006. Accordingly, the Company recognized $1.2 million compensation expense in those years. The Board of Directors did not authorize the purchase of common stock for the Plan for 2008.
A summary of the stock option activity of the Company’s plans in 2008 is presented below:
The diluted weighted shares exclude incremental shares of 305,000, 88,000 and 107,000 for 2008, 2007 and 2006, respectively. These shares are excluded due to their antidilutive effect.
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 26, 2008, was approximately $74 million.
The Company is taking steps to align expenses with declining revenues, however, not all expenses can be effectively reduced and continued declines in premium volumes could lead to higher expense ratios.
The Company has recorded a deferred tax asset as a result of the fair value declines in the investment portfolio. Should the value of the portfolio continue to decline, additional deferred tax assets would be recorded and it is possible that a valuation allowance would be required if the realization of the deferred tax assets becomes unlikely.
On October 10, 2008, MCC, the primary insurance subsidiary of the Company, entered into the Purchase Agreement with Aon Corporation and Aon Services Group, Inc. Pursuant to the terms of the Purchase Agreement, effective January 1, 2009, MCC acquired all of the membership interests of AIS Management LLC, which is the parent company of AIS and PoliSeek AIS Insurance Solutions, Inc. AIS is a major producer of automobile insurance in the state of California and the Company’s largest independent broker producing over $400 million of direct premiums written, which represented approximately 15% and 14% of the Company’s direct premiums written during 2008 and 2007, respectively. This preexisting relationship did not require measurement at the date of acquisition as there was no settlement of executory contracts between the Company and AIS as part of the acquisition.
The preliminary estimate of goodwill of $36.4 million arising from the acquisition consists largely of the efficiency and economies of scale expected from combining the operations of the Company and AIS. Goodwill in the amount of $37.3 million is expected to be deductible for income tax purposes and exceeds recorded goodwill due to the capitalization of transaction costs for tax purposes.
The expected weighted-average amortization periods for intangible assets with definite lives, by asset class, are: 24 years for trade names, 11 years for customer relationships, 10 years for technology, 2 years for software and 3 years for lease agreements.
A contingent consideration arrangement requires the Company to pay the former owner of AIS up to an undiscounted maximum amount of $34.7 million. The potential undiscounted amount of all future payments that the Company could be required to make under the contingent consideration arrangement is between $0 and $34.7 million. Based on the projected performance of the AIS business over the next two years, the Company does not expect to pay the contingent consideration. That estimate is based on significant inputs that are not observable in the market, including management’s projections of future cash flows, to which SFAS No. 157 refers as Level 3 inputs. Key assumptions in determining the estimated contingent consideration include (a) a discount rate of 10.7% and (b) a decline in revenues ranging from -4% to -5%. As of February 27, 2009, the estimates for the contingent consideration arrangement, the range of outcomes, and the assumptions used to develop the estimates had not changed.
The final purchase price and the valuation of the financial assets acquired and financial liabilities assumed are expected to be completed as soon as practicable, but no later than one year from the date of acquisition. The final purchase price allocation is still under review, specifically related to the determination of the fair value of current assets, current liabilities, fixed assets, identifiable intangible assets and deferred tax balances. The Company believes that any adjustments would not be material to the consolidated financial statements and management expects this review to be completed by April 30, 2009.