In line with the goal of improving operating efficiencies outside California and overall long-term profitability, the Company
The Company believes its thorough underwriting process gives it an advantage over its competitors. The Company’s agent relationships and underwriting and claims processes are its most important competitive advantages.
Economic Conditions-Many businesses are experiencing the effects of uncertain conditions in the global economy and capital markets, reduced consumer spending and confidence, and continued volatility, which could adversely impact the Company’s financial condition, results of operations, and liquidity. Further, volatility in global capital markets could adversely affect the Company’s investment portfolio. The Company is unable to predict the impact of current and future global economic conditions on the United States, and California, where the majority of the Company’s business is produced.
Underwriting Cycle and Competition-The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company has historically seen significant premium growth during hard market conditions. The Company believes that the automobile insurance industry is in a hard market with carriers generally raising rates, although this also depends on individual state profitability and the carriers’ growth appetite.
In January 2019, the California DOI approved a 6.9% rate increase on CAIC's private passenger automobile line of insurance business, which represented approximately 13% of the Company's total net premiums earned in 2018. The Company expects to implement this rate increase in March 2019.
the $27.6 million assessed penalty was paid in March 2015. The Company filed an amended Writ on September 11, 2015, adding an explicit request for a refund of the penalty, with interest.
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 $31.6 million at December 31, 2018, 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.
During the years 2014 through 2018, 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 the California automobile BI loss reserves for the 2018, 2017, and 2016 accident years based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.
Implied inflation rate is calculated by dividing the difference between the current and prior year actual recorded severity
During 2016, the Company implemented a claims strategy that reduced the number of small dollar settlements offered shortly after the claims were reported. This strategy reduced the total number of claims expected, which had the effect of increasing the actual recorded severity across the total claims population. There were fewer small dollar claims in the calculation of actual recorded severity for the 2016 through 2018 accident years compared to prior accident years. Consequently, the implied inflation rate recorded for these years are skewed upward due to this strategy change.
At December 31, 2018, there were 26,978 California automobile BI claims reported for the 2018 accident year and the Company estimates that these are expected to ultimately grow by approximately 7.8%. The Company believes that while actual development in recent years has ranged approximately from 3% to 5%, it is reasonable to expect that the range could be as great as between 0% and 10%. Actual development may be more or less than the expected range.
The following table presents the effects on loss development of different claim count within the broader possible range at December 31, 2018:
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 2018, the Company did not incur any material unexpected losses related to claims from accident periods prior to 2015.
During 2018, the Company recorded catastrophe losses of approximately $289 million ($67 million, net of reinsurance benefits), resulting primarily from wildfires in Northern and Southern California and weather-related catastrophes across several states.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, total return swaps, accounts payable, options sold, and notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried on the consolidated balance sheets at fair value, as described in Note 2. Financial Instruments, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flows from operations and believes that its liquidity needs can be met in future periods without the forced sale of its investments. This capability assists management in controlling the timing and amount of realized losses generated during future periods. By prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability to generate capital gains and minimize tax losses in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.
The Company’s effective income tax rate can be affected by several factors. These generally include large changes in fully-taxable income including net realized investment gains or losses, tax-exempt investment income, nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate was 81.3% for 2018, compared to 13.3% for 2017. The effective tax rate increased despite the reduction in the statutory tax rate from 35% to 21%. Tax-exempt investment income coupled with pre-tax loss caused the effective tax rate for 2018 to increase, while tax-exempt investment income coupled with pre-tax income lowered the effective tax rate for 2017.
As a result of enactment of the Act on December 22, 2017 that is effective for tax years beginning January 1, 2018, the Company made certain tax adjustments for the twelve months ended December 31, 2018 and 2017. For the year ended December 31, 2018, the Company computed its current and deferred income taxes at the new corporate tax rate of 21%, compared to computing only deferred income taxes at 21% and current income taxes at the pre-enactment rate of 35% for the year ended December 31, 2017. Additionally, as a result of recently published guidance in 2018 by the Internal Revenue Service ("IRS"), the amount of deferred income tax liability adjustment recorded at December 31, 2018 resulting from the Act related to loss reserve discounting was based on the information available in the IRS guidance.
The alternative minimum tax (“AMT”) credit, previously classified as deferred tax asset that was included in deferred income taxes in the Company’s consolidated balance sheets, was reclassified during 2017 to current income taxes receivable as a result of the Act. At December 31, 2018, the Company’s AMT credit balance was $66.7 million. The AMT credit will be used to offset future federal tax obligations, and as tax refunds, until its benefits are fully realized by December 31, 2021. The amount of income tax adjustment recorded at December 31, 2018 resulting from the Act related to the AMT credit was based on reasonable estimates of the Company’s tax obligations using the latest information available.
Net premiums earned included ceded premiums earned of $48.9 million and $26.9 million in 2018 and 2017, respectively. Net premiums written included ceded premiums written of $56.0 million and $33.9 million in 2018 and 2017, respectively. Ceded premiums earned and ceded premiums written increased in 2018, largely due to increased coverage and reinsurance rates, as well as increased reinstatement premiums after increased use of reinsurance benefits following the major wildfires in Northern and Southern California in the second half of 2018.
The following is a reconciliation of total net premiums earned to net premiums written:
Net investment income before and after income taxes increased primarily due to higher average invested assets combined with rising market interest rates. Average annual yield on investments before and after income taxes increased primarily due to yield increases in short-term and floating-rate securities resulting from rising market interest rates. Net investment income and average annual yield on investments after income taxes also benefited modestly from the lower tax rate effective January 1, 2018 applied to taxable investment income.
The decreases in fair value of fixed maturity securities during 2018 were primarily due to increases in market interest rates. The increases in fair value in 2017 were primarily due to the overall improvement in the market conditions affecting fixed maturity securities.
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 $54 million and $85 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2017 and 2016, respectively. The unfavorable development in 2017 was primarily attributable to higher than estimated California automobile and property losses, while the unfavorable development in 2016 was primarily from the California and Florida automobile lines of business. The 2017 loss ratio was also negatively impacted by a total of $79 million of catastrophe losses, net of reinsurance benefits, primarily due
to wildfires in Northern and Southern California, severe rainstorms in California, and the impact of hurricanes in Texas, Florida and Georgia. 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. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 72.3% and 71.6% for the years ended December 31, 2017 and 2016, respectively. The increase in the loss ratio was primarily due to higher loss severity, partially offset by higher average premiums per policy.
The increases in fair value of fixed maturity securities during 2017 were primarily due to the overall improvement in the market conditions affecting fixed maturity securities, while the fair value in 2016 was adversely affected by the increases in market interest rates.
A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The Company's portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity securities purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The holdings, that are heavily weighted with high coupon issues, are expected to be called prior to maturity. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a better indicator of price volatility than simple maturity alone.
The following table presents the maturities and durations of the Company's fixed maturity securities and short-term investments:
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, 2018, consistent with the average rating at December 31, 2017. The Company’s municipal bond holdings, of which 97.9% were tax exempt, represented 87.8% of its fixed maturity portfolio at December 31, 2018, at fair value, and are broadly diversified geographically.
The Company had $25.0 million and $13.2 million, or 0.8% and 0.5% of its fixed maturity portfolio, at fair value, in U.S. government bonds at December 31, 2018 and 2017, respectively. At December 31, 2018, Moody's and Fitch ratings for U.S. government issued debt were Aaa and AAA, respectively, although a significant increase in government deficits and debt could
The Company had $2.62 billion and $2.56 billion, or 87.8% and 88.4% of its fixed maturity securities portfolio, at fair value, in municipal securities at December 31, 2018 and 2017, respectively, of which $404.8 million and $480.6 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, 2018 and 2017.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities was BB at December 31, 2018 and 2017. The weighted-average rating of the entire mortgage backed securities portfolio was A+ at December 31, 2018, compared to A- at December 31, 2017. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 4.0 years and 4.9 years at December 31, 2018 and 2017, respectively.
At December 31, 2018 and 2017, respectively, the company had corporate securities of $105.5 million and $137.5 million, or 3.5% and 4.8% of its fixed maturity securities portfolio, at fair value. The weighted-average rating was BBB at December 31, 2018 and 2017. The modified duration reflecting anticipated early calls was 2.4 years and 2.6 years at December 31, 2018 and 2017, respectively.
The Company had collateralized loan obligations of $165.8 million and $105.2 million, which represented 5.6% and 3.6% of its fixed maturity securities portfolio, at fair value, at December 31, 2018 and 2017, respectively. The weighted-average rating was A+ at December 31, 2018 and 2017. The modified duration reflecting anticipated early calls was 5.5 years and 6.2 years at December 31, 2018 and 2017, respectively.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2018, 14.1% of the total investment portfolio, at fair value, was held in equity securities, compared to 14.4% at December 31, 2017.
The following table presents the equity security portfolio by industry sector at December 31, 2018 and 2017:
On March 8, 2017, the Company completed a public debt offering issuing $375 million of senior notes. The notes are unsecured senior obligations of the Company, with a 4.4% annual coupon payable on March 15 and September 15 of each year commencing September 15, 2017. These notes mature on March 15, 2027. The Company used the proceeds from the
notes to pay off the total outstanding balance of $320 million under the existing loan and credit facility agreements and terminated the agreements on March 8, 2017. The remainder of the proceeds from the notes was used for general corporate purposes. The Company incurred debt issuance costs of approximately $3.4 million, inclusive of 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 18.8% at December 31, 2018, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of February 7, 2019, there have been no borrowings under this facility.
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, 2018, 2017 and 2016, 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 300% of the authorized control level RBC as of December 31, 2018, 2017 and 2016. Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
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 $1.47 billion at December 31, 2018 and net premiums written in 2018 of $3.5 billion, the ratio of premiums written to surplus was 2.38 to 1.
The DOI in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies in their states. Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing, and other practices.
The Company’s significant contractual obligations at December 31, 2018 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, 2018 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.
Consolidated Statements of Operations for the Years Ended December 31, 2018, 2017, and 2016
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2018, 2017, and 2016
Consolidated Statements of Cash Flows for the Years Ended December 31, 2018, 2017, and 2016
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial schedules I, II, and IV (collectively, the consolidated financial statements), and our report dated February 13, 2019 expressed an unqualified opinion on those consolidated financial statements.
The consolidated financial statements include the accounts of Mercury General Corporation and its subsidiaries:
The Company did not have other comprehensive income (loss) in 2018, 2017 and 2016.
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, 2018 and 2017, 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.
As required by statute, the Company’s insurance subsidiaries have securities deposited with the departments of insurance or similar governmental agencies in the states in which they are licensed to operate with fair values totaling $15 million and $17 million at December 31, 2018 and 2017, respectively.
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 2018, 2017, and 2016.
Unpaid losses and loss adjustment expenses are determined in amounts estimated to cover incurred losses and loss adjustment expenses and established based upon the Company’s assessment of claims pending and the development of prior years’ loss liabilities. These amounts include liabilities based upon individual case estimates for reported losses and loss adjustment expenses and estimates of such amounts that are incurred but not reported. Changes in the estimated liability are charged or credited to operations as the losses and loss adjustment expenses are re-estimated. The liability is stated net of anticipated salvage and subrogation recoveries, and gross of reinsurance recoverables on unpaid losses.
The Company analyzes loss reserves quarterly primarily using the incurred loss, paid loss, average severity coupled with the claim count development methods, and the generalized linear model ("GLM") described below. When deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of insurance business or coverage within a line of insurance business. The Company may also evaluate qualitative factors such as known changes in laws or legal ruling that could affect claims handling or other external environmental factors or internal factors that could affect the settlement of claims. When establishing the loss reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single 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.
At December 31, 2018, the Company’s deferred income taxes were in a net asset 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.
The Company is party to a Catastrophe Reinsurance Treaty ("Treaty") covering a wide range of perils that is effective through June 30, 2019. The Treaty provides $205 million of coverage on a per occurrence basis after covered catastrophe losses exceed the $10 million Company retention limit. The Treaty specifically excludes coverage for any Florida business and for California earthquake losses on fixed property policies, such as homeowners, but does cover losses from fires following an earthquake.
The fair value of each restricted stock unit ("RSU") grant is determined based on the market price on the grant date for awards classified as equity and on each reporting date for awards classified as liability. Compensation cost is recognized based on management’s best estimate of the performance goals that will be achieved at the end of the performance period, taking into account expected forfeitures. If the minimum performance goals are not expected to be met, no compensation cost is recognized and any recognized compensation cost would be reversed. See Note 15. Share-Based Compensation for additional disclosures.
On January 1, 2018, the Company adopted Topic 606, Revenue from Contracts with Customers, using the modified retrospective transition method. The Company had no cumulative-effect adjustment and its consolidated financial statement line items were not impacted as a result of the adoption, mostly because the accounting for insurance contracts was outside of the scope of Topic 606 and the application of the key aspects of revenue recognition of Topic 606 to the Company's in-scope transactions, such as the timing of recognition of revenue (at a point in time vs. over time) and the estimation of refund liability, resulted in recognition of revenues and related expenses consistent with that under the legacy accounting guide, Topic 605.
The Company's revenue from contracts with customers that are in scope of Topic 606 represents the commission income that the Company's 100% owned insurance agencies, Auto Insurance Specialists LLC ("AIS") and PoliSeek AIS Insurance Solutions, Inc. ("Poliseek"), earned from third-party insurers. The Company's commission income from third-party insurers was approximately $16.0 million and $15.2 million representing approximately 0.5% and 0.4% of the consolidated total revenue, with related expenses of approximately $10.5 million and $10.2 million, for the year ended December 31, 2018 and 2017, respectively. Due to the immateriality of the Company's commission income and its related expenses to the overall consolidated financial statements, the commission income, net of related expenses, is included in other revenues in the Company's consolidated statements of operations, and in other income of the Property and Casualty business segment in the Company's segment reporting in accordance with Topic 280, Segment Reporting (see Note 19. Segment Information).
AIS and PoliSeek are primarily engaged in the marketing and sales of insurance policies in private passenger automobile, commercial automobile and homeowners lines of business. Their revenues primarily consist of commission income received from property and casualty insurers. Approximately 80% of their total revenue is generated from sales of policies issued by the Company's insurance subsidiaries, which are eliminated as intercompany transactions in consolidation, with the remaining from sales of policies issued by third-party property and casualty insurers. The primary performance obligation of AIS and Poliseek in return for the commission income from the insurers is to complete the sale of the policy and deliver the control of the policy to the insurer prior to the policy effective date. In addition, AIS and PoliSeek provide administrative services to the insurer or the policyholder subsequent to the sale of the policy as needed, including processing of endorsements, collection of premiums, and answering general questions concerning the policyholder's account. The administrative services and the costs to perform such services are deemed immaterial in the context of the contract and to the Company's consolidated financial statements, and hence, such services are not identified as a separate performance obligation and the costs to perform such services are not accrued at the time of the sale of the policy but are expensed as incurred as part of the overall operating expenses.
The total revenue from the sale of a policy is recognized when the sale is complete and the policy is effective as all the material aspects of the performance obligation are satisfied and the insurer is deemed to obtain control of the insurance policy at that time. The commission income is constrained such that the revenue is recognized only to the extent that the commission income received is not likely to be returned to the insurers due to policy cancellations. Any commission income not received when the sale is complete is recognized as commission income receivable, which is included in other receivables in the Company's consolidated balance sheets. The commission income receivable at December 31, 2018 and 2017 was approximately $1.2 million .
A refund liability is recorded for the expected amount of the commission income that has to be returned to the insurers based on estimated policy cancellations. The refund liability is computed for the entire portfolio of contracts as a practical expedient, rather than for each contract or performance obligation. The estimated policy cancellations and the resulting refund liability are computed using the expected value method based on all relevant information, including historical data. The refund liability at December 31, 2018 and 2017 was approximately $0.7 million, which was included in other liabilities in the Company's consolidated balance sheets.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326)." The amendments in this ASU replace the "incurred loss" methodology for recognizing credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of information including past events, current conditions and reasonable and supportable forecasts that affect the collectibility of reported amounts of financial assets that are not accounted for at fair value through net income, such as loans, certain debt securities, trade receivables, net investment in leases, off-balance sheet credit exposures and reinsurance receivables. Under the current GAAP incurred loss methodology, recognition of the full amount of credit losses is generally delayed until the loss is probable of occurring. Current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the probability threshold. Subsequently, the FASB has issued an additional ASU on Topic 326 that does not change the core principle of the guidance in ASU 2016-13 but merely clarifies certain aspects of it. ASU 2016-13 and the additional ASU on Topic 326 will be effective for the Company beginning January 1, 2020. While the Company is in the process of evaluating the impact of ASU 2016-13, it does not expect this ASU to have a material impact on its consolidated financial statements and related disclosures as most of its financial instruments with potential exposure to material credit losses are accounted for at fair value through net income.
between the straight-line rent expenses and paid rent amounts under the leases) to operating lease ROU assets from other liabilities at the adoption date. The Company did not have any cumulative-effect adjustment as a result of the adoption. The standard is not expected to materially impact the Company's future consolidated net income or cash flows. The standard will have no impact on its financial covenant compliance under its current unsecured credit facility agreement.
Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, options sold, total return swaps, accounts payable, and notes payable. Due to their short-term maturity, the carrying values of other receivables and accounts payable approximate their fair values. All investments are carried at fair value in the consolidated balance sheets.
The fair values of the total return swaps reflect the estimated amounts that, upon termination of the contracts, would be received for selling an asset or paid to transfer a liability in an orderly transaction at December 31, 2018 and 2017 based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract.
For additional disclosures regarding methods and assumptions used in estimating fair values, see Note 4. Fair Value Measurements.
At December 31, 2018, fixed maturity holdings rated below investment grade and non-rated comprised 3.0% of total investments at fair value. Additionally, the Company owns securities that are credit enhanced by financial guarantors that are subject to uncertainty related to market perception of the guarantors’ ability to perform. Determining the estimated fair value of municipal bonds could become more difficult should markets for these securities become illiquid.
b. Quoted prices for identical or similar assets or liabilities in non-active markets; or
c. Either directly or indirectly observable inputs as of the reporting date.
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 $24.8 million and $19.3 million in commercial mortgage-backed securities at December 31, 2018 and 2017, respectively.
Collateralized loan obligations ("CLOs"): Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets.
Depreciation expense, including amortization of leasehold improvements, was $19.9 million, $21.2 million, and $20.3 million for 2018, 2017, and 2016, respectively.
The unamortized discount and debt issuance costs of approximately $3.3 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.
The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts (options sold) on various equity securities are intended to manage the price risk associated with forecasted purchases or sales of such securities.
The Company also enters into derivative contracts to enhance returns on its investment portfolio.
On February 13, 2014, Fannette Funding LLC ("FFL"), a special purpose investment vehicle, formed by and consolidated into the Company, entered into a total return swap agreement with Citibank. Under the agreement, FFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest on the outstanding notional amount of the underlying obligations. The total return swap is secured by approximately $31 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets. The Company paid interest equal to LIBOR plus 128 basis points prior to the renewal of the agreement in January 2018 and LIBOR plus 120 basis points subsequent to the January 2018 renewal through July 2018, on approximately $100 million of underlying obligations as of December 31, 2018 and 2017. The agreement had an initial term of one year, subject to periodic renewal. In July 2018, the agreement was renewed through January 24, 2020, and the interest rate was changed to LIBOR plus 105 basis points.
On August 9, 2013, Animas Funding LLC ("AFL"), a special purpose investment vehicle, formed and consolidated by the Company, entered into a three-year total return swap agreement with Citibank, which was renewed for an additional one-year term through February 17, 2018. The total portfolio of underlying obligations was liquidated during June 2017, and the total return swap agreement between AFL and Citibank was terminated on July 7, 2017. Under the agreement, AFL received the income equivalent on underlying obligations due to Citibank and paid to Citibank interest on the outstanding notional amount of the underlying obligations. The total return swap was secured by approximately $40 million of U.S. Treasuries as collateral, which were included in short-term investments on the consolidated balance sheets. The Company paid interest, which was equal to LIBOR plus 135 basis points prior to the amendment of the agreement in January 2017 and LIBOR plus 128 basis points subsequent to the amendment until June 2017, on approximately $152 million of underlying obligations as of December 31, 2016.
There were no changes in the carrying amount of goodwill during 2018 and 2017. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2018 and 2017. All of the Company's goodwill is associated with the Property and Casualty business segment (See Note 19. Segment Information for additional information on the reportable business segment).
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during 2018 and 2017.
As a result of the Tax Cuts and Jobs Act of 2017 (the "Act"), the Company’s deferred tax assets and liabilities were measured using the new corporate tax rate of 21% at December 31, 2018 and 2017. For the year ended December 31, 2018, the Company measured its current income taxes using the new corporate tax rate of 21%, rather than the pre-enactment corporate tax rate of 35%. Additionally in 2018, as a result of a determination made by the Office of Management and Budget, the Company reversed the previously recorded provisional 6.6% sequestration reduction to its alternative minimum tax (“AMT”) credit that originally resulted from repeal of the corporate AMT and reclassification of AMT credit carryforwards to current taxes receivable as a refundable credit.
In computing taxable income, property and casualty insurers reduce underwriting income by losses and loss adjustment expenses incurred. The amount of the deduction for losses incurred associated with unpaid losses is discounted at the interest rates and for the loss payment patterns prescribed by the U.S. Treasury. The Act changes the prescribed interest rates to rates based on corporate bond yield curves and extends the applicable time periods for the loss payment pattern. These changes are effective for tax years beginning after 2017 and are subject to a transition rule that spreads the additional tax payments from the amount determined by applying these changes versus the previous calculated amount over the subsequent eight years beginning in 2018. The changes included in the Act related to discounting of unpaid losses are broad and complex. The Securities Exchange Commission has issued rules that would allow for a measurement period of up to one year after the enactment date of the Act to finalize the recording of the related tax impacts. The Company recorded a total deferred tax liability adjustment of approximately $8.6 million at December 31, 2018 related to the changes in discounting of unpaid losses included in the Act based on the guidance published in 2018 by the Internal Revenue Service.
The following table presents a reconciliation of the tax expense (benefit) based on the statutory rate to the Company's actual tax expense (benefit) in the consolidated statements of operations:
There was a $0.9 million increase to the total amount of unrecognized tax benefits related to tax uncertainties during 2018. The increase was the result of tax positions taken regarding state tax apportionment issues based on management’s judgment and latest information available. The Company does not expect any changes in unrecognized tax benefits to have a material impact on its consolidated financial statements within the next 12 months.
The Company and its subsidiaries file income tax returns with the Internal Revenue Service and the taxing authorities of various states. Tax years that remain subject to examination by major taxing jurisdictions are 2015 through 2017 for federal taxes and 2011 through 2017 for California state taxes. For tax years 2003 through 2010, the Company achieved a resolution with the Franchise Tax Board (“FTB”) in December 2017 and paid a $4.6 million negotiated settlement amount in accordance with the settlement agreement provided by the FTB and signed by the Company. The settlement agreement was approved by the California attorney general in 2018. The Company believes that resolution of tax years 2003 through 2010 has the potential to establish guidance for future audit assessments proposed by the FTB for future tax years.
The following is information about incurred and paid claims development as of December 31, 2018, 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.
The following is unaudited supplementary information about average historical claims duration as of December 31, 2018.
On February 1, 2019, the Board of Directors declared a $0.6275 quarterly dividend payable on March 28, 2019 to shareholders of record on March 14, 2019.
The Company’s employees are eligible to become members of the Profit Sharing Plan (the "Plan"). The Company, at the option of the Board of Directors, may make annual contributions to the Plan, and the contributions are not to exceed the greater of the Company’s net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed an amount equal to 15% of the compensation paid or accrued during the year to all participants under the Plan. No contributions were made in the past three years.
In February 2018, the Compensation Committee of the Company's Board of Directors awarded a total of 80,000 stock options to four senior executives under the 2015 Plan which will vest over the four-year requisite service period. The fair values of these stock options were estimated on the date of grant using a closed-form option valuation model (Black-Scholes). No stock options were awarded in 2017 and 2016 under the 2015 Plan.
The following table presents a summary of the stock option activity for the year ended December 31, 2018:
The aggregate intrinsic values in the table above represent the total pre-tax intrinsic value (the difference between the Company’s closing stock price and the stock option exercise price, multiplied by the number of in-the-money stock options) that would have been received by the stock option holders had all stock options been exercised on December 31, 2018. The aggregate intrinsic values of stock options exercised were $42,000, $371,000, and $591,000 for 2018, 2017, and 2016, respectively. The total fair value of stock options vested during 2018, 2017, and 2016 was $0, $142,000, and $142,000, respectively.
The following table presents information regarding stock options outstanding at December 31, 2018:
The following table presents a summary of RSU awards activity, based on target vesting, during the years indicated:
The RSU awards 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. Performance thresholds are based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. As of December 31, 2018, 20,500 target RSUs granted in 2016 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 to the vesting date.
The following table presents future minimum commitments for operating leases as of December 31, 2018:
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 August 7, 2018, the most recent date at which information was available, was approximately $68.3 million. There was no assessment made in 2018.
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 $31.6 million at December 31, 2018, 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.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate.
The Company is also involved in proceedings relating to assessments and rulings made by the FTB. See Note 10. Income Taxes.
The following table presents summarized quarterly financial data for 2018 and 2017:
The Company is primarily engaged in writing personal automobile insurance and provides related property and casualty insurance products to its customers through 14 subsidiaries in 11 states, principally in California.
The Company has one reportable business segment - the Property and Casualty business segment.