The Company owns the following buildings which are mostly occupied by the Company’s employees. Space not occupied by the Company is leased to independent third party tenants. For future expansion, the Company owns 4.2 acre and 5.9 acre parcels of land in Brea and Rancho Cucamonga, California, respectively. The Company leases all of its other office space for operations. Office location is not crucial to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.
The following selected financial and operating data are derived from the Company’s audited consolidated financial statements. The selected financial and operating data should be read in conjunction with “
The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents in thirteen states. The Company also offers homeowners, commercial automobile and property, mechanical breakdown, fire, and umbrella insurance. Private passenger automobile lines of insurance accounted for 80.6% of the $2.7 billion of the Company’s direct premiums written in 2012. 78.0% of the private passenger automobile premiums were written in California. The Company also operates in Arizona, 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 the future to achieve greater geographic diversification. There are 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 2013.
The Company’s net income for the year ended December 31, 2012 decreased to $116.9 million, or $2.13 per diluted share, from $191.2 million, or $3.49 per diluted share, for the same period in 2011. Approximately $132 million in pre-tax investment income was generated during 2012 on a portfolio of approximately $3.2 billion at fair value at December 31, 2012, compared to $141 million pre-tax investment income during 2011 on a portfolio of approximately $3.1 billion at fair value at December 31, 2011. Included in net income are net realized investment gains of $66.4 million and $58.4 million in 2012 and 2011, respectively. Net realized investment gains include gains of $45.5 million and $31.3 million in 2012 and 2011, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option.
During 2012, the Company continued its marketing efforts to enhance name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation, make the Company very competitive in California and in other states.
The Company believes its thorough underwriting process gives it an advantage over 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 rates yet realize better margins than many competitors.
Economic Conditions-Many businesses are experiencing a slow recovery from the severe economic recession, and economic uncertainty is expected to continue in 2013 due in large part to continuing political disagreements in Washington that may cause businesses and consumers to hold back spending. Further, the sovereign debt crisis in Europe continues to lead to weaker global economic growth, heightened financial vulnerabilities and some negative
rating actions. The Company is unable to predict the duration and severity of current global economic conditions and their impact on the United States, and California, where the majority of the Company’s business is produced. If economic conditions do not show improvement, there could be an adverse impact on the Company’s financial condition, results of operations, and liquidity.
In 2012, the Company continued to enhance its internet agency portal, Mercury First. Mercury First is a single entry point for agents providing a broad suite of capabilities. One of its most powerful tools is a point of sale (POS) system that allows agents to easily obtain and compare quotes and write new business. Mercury First is designed as an easy-to-use agency portal that provides a customized work queue for each agency user showing new business leads, underwriting requests and other pertinent customer information in real time. Agents can also assist customers with processing payments, reporting claims or updating their records. The system enables quick access to documents and forms and empowers the agents with several self-service capabilities.
During 2010, the Company launched Guidewire, a commercially available software solution, to replace legacy platforms and implemented it for the Nevada homeowners line. In 2011, the Company expanded the Guidewire implementation to Texas, Georgia, Illinois, Pennsylvania, and Oklahoma for the homeowners line of business and for the Texas commercial auto line of business. In 2012, the Company continued to expand the Guidewire implementation to California, Oklahoma, Georgia, and Arizona for the commercial auto line and to Michigan and Nevada for the private passenger automobile line. The Company plans to expand Guidewire to other states and lines of business during 2013.
On October 26, 2012, the Company implemented the California DOI approved rate increase of approximately 4% on California private passenger automobile policies. The rate increase has not had a significant impact on the number of new and renewal policies written. In October 2012, the Company filed for a 6.9% rate increase in CAIC's private passenger automobile
In January 2013, the California DOI approved auto body repair regulation to strengthen consumer protection. This regulation builds on existing protection by requiring insurers to settle automobile insurance claims using repair standards described by the regulation and not by the insurers' own standards. The new ruling will become effective in March 2013. The full extent of the impact is currently unknown.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see Note 16 of Notes to Consolidated Financial Statements-Commitments and Contingencies-Litigation.
development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
In general, the Company expects that historical claims trends will continue with costs tending to increase, which is generally consistent with historical data, and therefore the Company believes that it is reasonable to expect inflation to continue. The Company is experiencing inflation at a rate that is higher than in recent years. Many potential factors can affect the BI inflation rate, including changes in: claims handling process, statutes and regulations, the number of litigated files, increased use of medical procedures such as MRIs and epidural injections, general economic factors, timeliness of claims adjudication, vehicle safety, weather patterns, and gasoline prices, among other factors; however, the magnitude of such impact on the inflation rate is unknown.
Implied inflation rate is calculated by dividing the difference between current and prior year actual recorded severity by the prior year actual recorded severity. The change in the implied inflation rate in 2010 and 2009 is skewed by the change in claims handling process noted above. The 10.5% inflation rate estimated for 2012 reflects the consideration of recent trends experienced on 2012 accident year claims that closed in 2012. While these claims represent just 12% of the ultimate dollars expected to be paid, they serve as an early indicator of inflation. The higher inflation may result from an increase in medical procedures and an increased prevalence of large losses.
There are many other potential factors that can affect the number of claims reported after a period end. These factors include changes in weather patterns, a change in the number of litigated files, the number of automobiles insured, and whether the last day of the year falls on a weekday or a weekend. However, the Company is unable to determine which, if any, of the factors actually impact the number of claims reported and, if so, by what magnitude.
At December 31, 2012, there were 26,757 BI claims reported for the 2012 accident year and the Company estimates that these are expected to ultimately grow by approximately 7%. The Company believes that while actual development in recent years has ranged between approximately 2% and 8%, 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 effect on loss development based on different claim count within the broader possible range at December 31, 2012:
Unexpected large losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected large losses in future periods. It is also possible that the Company has not identified and established a sufficient reserve for all unexpected large losses occurring in the older accident years, even though a comprehensive claims file review was undertaken. The Company may experience additional development on these reserves.
During 2012, the Company experienced severe losses due to Hurricane Sandy which made landfall in New Jersey on October 29, 2012 and caused significant damage to large portions of the Northeastern United States. The Company's total losses from Hurricane Sandy are estimated to be approximately $28 million. The Company also recognized catastrophe losses due to wind and hail storms in the Midwest region totaling $10 million.
The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For 2012, the Company reported unfavorable development of approximately $42 million on the 2011 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2011 totaled approximately $985 million. The unfavorable development in 2012 is largely the result of re-estimates of California BI losses that have experienced both higher average severities and more late reported claims (claim count development) than originally estimated at December 31, 2011.
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured 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 receivables and accounts payable approximate their fair market values. All investments are carried on the consolidated balance sheets at fair value, as disclosed in Note 1 of Notes to Consolidated Financial Statements.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange traded funds. Approximately 98% of the fair value of the financial instruments held at December 31, 2012 is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary by financial instrument. Observable market prices and pricing parameters of a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
The Company may hold or acquire financial instruments that 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 from time to 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 are otherwise not actively quoted. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.
At December 31, 2012, the Company’s deferred income taxes were in a net liability position materially due to deferred tax liabilities generated by deferred acquisition costs and unrealized gains on securities held. These deferred tax liabilities were substantially offset by deferred tax assets resulting from unearned premiums, expense accruals, loss reserve discounting, and AMT and other tax credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established. Management’s recoverability assessment of its deferred tax assets which are ordinary in character takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities which represent sources of future ordinary taxable income.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations, as well as the reasonable expectation that its cash flow 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 it generates during future periods. By prudent utilization of some or all of these strategies, management believes that it has the ability and intent 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.
Net premiums earned and net premiums written in 2012 increased 0.3% and 3.0%, respectively, from 2011. Net premiums written by the Company's California operations and non-California operations increased by $73.3 million and $3.1 million, respectively, from 2011. The increase in net premiums written is primarily due to an increase in the number of policies-in-force and slightly higher average premiums per policy. The increase in average premiums per policy partially reflects a modest shift for the California personal automobile line from six-month policies to twelve-month policies. Premiums on twelve-month policies are typically twice that of six-month policies. For 2012, fewer than 5% of California personal automobile policies were written on a twelve-month basis and more than 95% were written on a six-month basis, whereas in 2011, fewer than 1% of the California personal automobile policies were written on a twelve-month basis and over 99% were written on a six-month basis. In addition, the Company increased private passenger automobile insurance rates in twelve states outside California and grew its homeowners business in several states outside of California during 2012.
Net income was $116.9 million or $2.13 per diluted share and $191.2 million or $3.49 per diluted share in 2012 and 2011, respectively. Diluted per share results were based on a weighted average of 54.9 million and 54.8 million shares in 2012 and 2011, respectively. Basic per share results were $2.13 and $3.49 in 2012 and 2011, respectively. Included in net income per share were net realized investment gains, net of income taxes, of $0.79 and $0.69 per share (basic and diluted) in 2012 and 2011, respectively.
The expense ratio for 2010 was impacted by contributions made in support of a California legislative initiative totaling $12.1 million and would have been 29.1% without those financial contributions. The 2011 expense ratio decreased as a result of decreased agent contingent commissions, consulting, advertising, and information technology expenditures.
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 ordinary dividends of approximately $155 million in 2013 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of approximately $145 million during 2012. As of December 31, 2012, Mercury General had approximately $85 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on
Net cash provided by operating activities in 2012 was $148.1 million, a decrease of $10.5 million compared to 2011. The decrease was primarily due to the increased payment of income taxes and losses and lower investment income as a result of the lower interest rate environment, partially offset by increased premiums collected. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $668.7 million were primarily reinvested by the Company in high grade fixed maturity securities.
The following table presents the estimated fair value of fixed maturity securities at December 31, 2012 by contractual maturity in the next five years.
An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company continues to believe that this strategy maintains the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a market risk and consistent asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2012:
During 2011, the Company recognized $58.4 million in net realized investment gains, which included gains of $54.1 million related to fixed maturity securities and losses of $4.9 million related to equity securities. Included in the gains and losses were $62.1 million in gains due to changes in the fair value of the Company’s fixed maturity portfolio and $30.9 million in losses due to changes in the fair value of the Company's equity security portfolio, as a result of applying the fair value option.
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 nominal average maturities of the overall bond portfolio were 12.2 years and 11.8 years (11.0 years and 10.8 years including all short-term instruments) at December 31, 2012 and 2011, respectively. The portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturities of the overall bond portfolio were 3.7 years and 4.5 years (3.3 years
and 4.1 years including all short-term instruments) at December 31, 2012 and 2011, respectively, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio reflecting anticipated early calls were 3.1 years and 3.7 years, (2.8 years and 3.3 years including all short-term instruments), including collateralized mortgage obligations with a modified duration of 3.2 years and 2.4 years at December 31, 2012 and 2011, respectively, and short-term bonds that carry no duration. 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 credit quality ratings of the Company’s fixed maturity portfolio by security type at December 31, 2012 at fair value. The Company’s estimated credit quality ratings are based on the average of ratings assigned by nationally recognized securities rating organizations. Credit ratings for the Company’s fixed maturity portfolio were stable as compared to the prior year, with 81.2% of fixed maturity securities at fair value experiencing no change in their overall rating. 14.2% of fixed maturity securities at fair value experienced upgrades, partially offset by 4.5% in credit downgrades. The majority of the downgrades were slight and still within the investment grade portfolio, except for $8.8 million at fair value that were downgraded to below investment grade during 2012.
At December 31, 2012, the bond insurers providing credit enhancement were Assured Guaranty Corporation and National Public Finance Guarantee Corporation, which covered approximately 18% of the insured municipal securities. The average rating of the Company’s insured municipal bonds by these bond insurers was A+, with an underlying rating of A-. 9.1% of the remaining insured bonds are non-rated or below investment grade, and the Company does not believe that these insurers provide credit enhancement to the municipal bonds that they insure.
The Company considers the strength of the underlying credit as a buffer against potential market value declines which may result from future rating downgrades of the bond insurers. In addition, the Company has a long-term time horizon for its municipal bond holdings which generally allows it to recover the full principal amounts upon maturity and avoid forced sales prior to maturity of bonds that have declined in market value due to the bond insurers’ rating downgrades. 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 fair value of municipal bonds.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2012, 15.0% of the total investment portfolio at fair value was held in equity securities, compared to 12.4% at December 31, 2011. The following table presents the equity security portfolio by industry sector for 2012 and 2011:
Both the $120 million credit facility and the $20 million bank loan contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk based capital ratio. The Company was in compliance with all of its loan covenants at December 31, 2012.
In 2012, the Company made capital expenditures, including capitalized software, of approximately $15 million primarily related to Information Technology.
The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations, and must have adequate reserves for claims. The minimum statutory capital requirements differ by state and are generally based on balances established by statute, a percentage of annualized premiums, a percentage of annualized loss, or RBC requirements. The RBC requirements are based on guidelines established by the NAIC. The RBC formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance 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. At December 31, 2012, each of the Insurance Companies had sufficient capital to exceed the highest level of minimum required capital.
The Company’s significant contractual obligations at December 31, 2012 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 balance presented on the consolidated balance sheets as of December 31, 2012 because the debt amounts above include interest.
The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, and office equipment that expire at various dates through the year 2019.
Reserve for losses and loss adjustment expenses is an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2012. The Company has estimated the timing of these payments based on its historical experience and expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above. The ultimate cost of losses may vary materially from recorded amounts which are the Company’s best estimates.
The table excludes liabilities of $3.5 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments.
Consolidated Statements of Operations and Consolidated Statements of Comprehensive Income for Each of the Years in the Three-Year Period Ended December 31, 2012
Consolidated Statements of Shareholders’ Equity for Each of the Years in the Three-Year Period Ended December 31, 2012
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercury General Corporation’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 11, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Mercury General Corporation’s (the Company) internal control over financial reporting as of December 31, 2012, 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.
Mercury General Corporation and its subsidiaries (referred to herein collectively as the “Company”) are engaged primarily in writing personal automobile insurance through 13 Insurance Companies in a number of states, principally California. The Company also writes homeowners, commercial automobile and property, mechanical breakdown, fire, and umbrella insurance. The private passenger automobile lines of insurance exceeded 80% of the Company’s direct premiums written in 2012, 2011, and 2010, with approximately 78%, 77%, and 77% of the private passenger automobile premiums written in California during 2012, 2011, and 2010, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
The consolidated financial statements include the accounts of Mercury General Corporation and its 100% owned subsidiaries. The subsidiaries are as follows:
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates.
The Company applies the fair value option to all fixed maturities and equity securities and short-term investments at the time an eligible item is first recognized. The cost of investments sold is determined on a first-in and first-out method and realized gains and losses are included in net realized investment gains. Gains and losses due to changes in fair value for items measured at fair value pursuant to application of the fair value option are included in net realized investment gains in the Company’s consolidated statements of operations, while interest and dividend income on the investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as fair value measurement use consistent with the long-term measurement objectives of the FASB for accounting for financial instruments. See Note 2 for additional information regarding the fair value option.
Fixed maturity securities include debt securities, which may have fixed or variable principal payment schedules and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations, or other economic factors. Premiums and discounts on fixed maturities are amortized using first call date and are adjusted for anticipated prepayments. Premiums and discounts on mortgage-backed securities are adjusted for anticipated prepayment using the retrospective method, with the exception of some beneficial interests in securitized financial assets, which are accounted for using the prospective method.
The Company writes covered call options through listed and over-the-counter exchanges. When the Company writes an option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security or currency in determining whether the Company has realized a gain or loss. The Company, as writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option. Liabilities for covered call options of $0.2 million and $0.7 million were included in other liabilities at December 31, 2012 and 2011, respectively.
The Company has securities deposited by the Insurance Companies with various DOIs as required by statute with fair values of approximately $16 million and $18 million at December 31, 2012 and 2011, respectively.
In October 2010, the FASB issued a new standard to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The new standard defines acquisition costs as those related directly to the successful acquisition of new or renewal insurance contracts. Effective January 1, 2012, the Company adopted the new standard using the prospective method. Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses, and the servicing costs that will be incurred as premiums are earned. Under the new standard, the Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements. Deferred policy acquisition cost amortization was $477.8 million, $481.7 million, and $505.6 million during the years ended December 31, 2012, 2011, and 2010, respectively. The Company does not defer advertising expenses but expenses them as incurred. The Company recorded net advertising expenses of approximately $19 million, $21 million, and $30 million during the years ended December 31, 2012, 2011, and 2010, 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 amount 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. The Company recorded no impairment charges during the three years ended December 31, 2012.
premiums are predominantly computed on a monthly pro-rata basis and are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other receivables. Net premiums written, a statutory measure designed to determine production levels, were $2.65 billion, $2.58 billion, and $2.56 billion in 2012, 2011, and 2010, respectively.
No independent agent accounted for more than 2% of the Company’s direct premiums written during 2012, 2011, and 2010.
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 IBNR. Changes in the estimated liability are charged or credited to operations as the losses and loss adjustment expenses are reestimated. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of reinsurance recoverable is included in other receivables.
Estimating loss reserves is a difficult process as many factors 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, and labor rates, among other factors, can impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount could be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims, such as those involving the Company’s BI coverages. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions for loss reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
Fair value hedge: changes in fair value of the hedging instrument, as well as the hedged item, are recognized in earnings in the period of change.
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting basis and the respective tax basis of the Company’s assets and liabilities, and expected benefits of utilizing net operating loss, capital loss, and tax-credit carryforwards. 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 effect on deferred tax assets and liabilities of a change in tax rates or laws is recognized in earnings in the period that includes the enactment date.
At December 31, 2012, the Company’s deferred income taxes were in a net liability position which included a combination of ordinary and capital deferred tax benefits. In assessing the realization 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 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.
Under its 2005 Incentive Award Plan (the “2005 Plan”), the Compensation Committee of the Company’s Board of Directors granted performance vesting restricted stock units to the Company’s senior management and key employees as follows:
At December 31, 2012, fixed maturity holdings rated below investment grade and non-rated comprised 2.8% 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. The estimated fair values at December 31, 2012 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In certain cases, inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3). The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset or liability.
Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy in 2012 and 2011.
At December 31, 2012, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
Depreciation expense including amortization of leasehold improvements was $30.8 million, $34.3 million, and $33.9 million during 2012, 2011, and 2010, respectively.
Notes payable consists of two secured notes of $120 million and $20 million at both December 31, 2012 and 2011.
On October 4, 2011, the Company refinanced its Bank of America $18 million LIBOR plus 50 basis points loan that was scheduled to mature on March 1, 2013 with a Union Bank $20 million LIBOR plus 40 basis points loan that matures on January 2, 2015. The $20 million loan has collateral requirements similar to those of the $120 million credit facility.
The Company retired all of its $125 million 7.25% senior notes on their August 15, 2011 maturity date by using a portion of the proceeds from the extraordinary dividend paid by MCC to Mercury General.
On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on a $120 million credit facility for a fixed rate of 1.93% that matured on January 3, 2012. The purpose of the swap was to offset the variability of cash flows resulting from the variable interest rate. The swap was not designated as a hedge and changes in the fair value were adjusted through the consolidated statement of operations in the period of change.
On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate on the $18 million bank loan for a fixed rate of 4.25%. The swap was designated as a cash flow hedge and the fair market value of the interest rate swap was reported as a component of other comprehensive income and amortized into earnings over the term of the hedged transaction. On October 4, 2011, the Company refinanced its Bank of America $18 million LIBOR plus 50 basis points loan that was scheduled to mature on March 1, 2013 with a Union Bank $20 million LIBOR plus 40 basis points loan that matures on January 2, 2015. The related interest rate swap was deemed to become ineffective and is no longer designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change. The fair market value of the interest rate swap was approximately $103,000 and $670,000 as of December 31, 2012 and 2011, respectively. The swap matures on March 1, 2013.
The following tables present the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains and losses in the consolidated statements of operations:
Intangible assets are amortized on a straight-line basis over their useful lives. Intangible assets amortization expenses were $6.2 million, $6.4 million, and $6.8 million during 2012, 2011, and 2010, respectively. None of the intangible assets are anticipated to have a residual value. The following table presents the estimated future amortization expense related to intangible assets as of December 31, 2012:
The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return once a “more-likely-than-not” threshold has been met. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement is recognized in the financial statements.
There were no material changes to the total amount of unrecognized tax benefits related to tax uncertainties during 2012. The Company does not expect any changes in such unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months.
As presented above, the balances of unrecognized tax benefits were $5.9 million and $4.6 million at December 31, 2012 and 2011, respectively. Of these totals, $3.5 million and $3.6 million represent unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would impact the Company’s effective tax rate.
Management does not expect the Company’s total amount of unrecognized tax benefits to materially increase within the next twelve months related to its ongoing California state tax apportionment factor issues.
The increase in the provision for insured events of prior years in 2011 of approximately $18 million primarily resulted from the re-estimate of accident years 2008 through 2010 California BI losses which have experienced higher average severities than were originally estimated at December 31, 2010. Partially offsetting this increase was favorable development on loss adjustment expenses reflecting cost savings from the transition of a large portion of litigated cases from outside counsel to in-house counsel.
The decrease in the provision for insured events of prior years in 2010 of approximately $13 million primarily resulted from the re-estimate of accident year 2009 California BI losses. In addition, the Company experienced favorable development on New Jersey personal automobile reserves, resulting from more aggressive handling of litigated claims, which includes a high percentage of favorable results in cases brought to trial. The favorable development was partially offset by unfavorable development on Florida reserves, which included approximately $3 million of unfavorable development on the homeowners line of business, primarily related to sinkhole claims.
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 2013, the insurance subsidiaries of the Company are permitted to pay approximately $155 million in dividends to Mercury General without the prior approval of the DOI of domiciliary states. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2012, 2011, and 2010, the Insurance Companies paid the Company ordinary dividends of $145 million, $0, and $128 million, respectively, and extraordinary dividends of $0 million, $270 million, and $0, respectively.
On February 1, 2013, the Board of Directors declared a $0.6125 quarterly dividend payable on March 28, 2013 to shareholders of record on March 14, 2013.
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. The matching contributions, at a rate set by the Board of Directors, totaled $7.2 million, $7.2 million, and $7.0 million for 2012, 2011, and 2010, respectively.
allocation to the Plan participants in 2012, 2011, and 2010, respectively. The Company recognized compensation expense equal to such amounts.
In May 2005, the Company adopted the 2005 Plan which succeeded a prior plan. A maximum of 4,957,250 shares of common stock under the 2005 Plan are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. As of December 31, 2012, only options and restricted stock awards have been granted under these plans. Beginning January 1, 2008, options granted, for which the Company has recognized share-based compensation expense become exercisable at a rate of 25% per year beginning one year from the date granted, are granted at the market price on the date of grant, and expire after 10 years. Prior to January 1, 2008, shares became exercisable at a rate of 20% per year.
Cash received from option exercises was $2,492,000, $1,951,000, and $733,000 during 2012, 2011, and 2010, respectively. Total compensation costs were $168,000, $439,000, and $651,000 during 2012, 2011, and 2010, respectively. The excess tax benefit realized for the tax deduction from option exercises of the share-based payment awards totaled $86,000, $56,000, and $132,000 during 2012, 2011, and 2010, respectively. No stock options were awarded in the past three years.
A summary of the stock option activity under the Company’s plans as of December 31, 2012 and changes during the year then ended is presented below:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all options been exercised on December 31, 2012. The aggregate intrinsic value of stock options exercised was $392,000, $262,000, and $431,000 during 2012, 2011, and 2010, respectively. The total fair value of options vested was $407,000, $467,000, and $498,000 during 2012, 2011, and 2010, respectively.
The following table presents information regarding stock options outstanding at December 31, 2012:
As of December 31, 2012, $42,000 of total unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of 0.4 years.
Incremental shares of 415,000, 504,000, and 448,000 for 2012, 2011, and 2010, respectively, were excluded from the computation of the diluted earnings per common shares due to their anti-dilutive effect. Potentially dilutive securities representing approximately 80,000, 103,000, and 93,000 shares of common stock for 2012, 2011, and 2010, respectively, were also excluded from the computation of diluted earnings per common share because their effect would have been anti-dilutive.
The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, and office equipment that expire at various dates through the year 2019. For leases that contain predetermined escalations of the minimum rentals, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent in other liabilities. This liability amounted to $2.2 million and $1.6 million at December 31, 2012 and 2011, respectively. Total rent expense under these lease agreements was $17.7 million, $18.2 million, and $17.1 million for 2012, 2011, and 2010, respectively.
In April 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to Mercury Insurance Company (“MIC”), Mercury Casualty Company (“MCC”), and California Automobile Insurance Company (“CAIC”) based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI in February 2010. The 2010 NNC includes allegations of 35 instances of noncompliance with applicable California insurance law and seeks to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and may also seek monetary penalties. In April 2010, the Company submitted a Statement of Compliance and Notice of Defense to the 2010 NNC, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each allegation. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense does not establish to the satisfaction of the California DOI that the alleged noncompliance does not exist, and the matters described in the 2010 NNC are not otherwise able to be resolved informally with the California DOI. However, no assurance can be given that efforts to resolve the 2010 NNC informally will be successful.
Summarized quarterly financial data for 2012 and 2011 are as follows:
Net income during 2011 was mainly affected by lower policy acquisition costs and operating expenses, offset by unfavorable development on loss reserves. The lower policy acquisition costs are due to the lower premium deficiency reserve and declines in other underwriting costs including agent contingent commissions. The operating expenses in 2011 decreased as a result of decreased consulting, advertising, and information technology expenditures. The unfavorable development of loss reserves is largely the result of re-estimates of California BI losses. The primary causes of the net loss during the third quarter of 2011 were driven by declines in the fair value of the Company’s equity securities due to the overall decline in the equity markets.
During January 2013, the Company announced a net workforce reduction of approximately 135 employees, representing less than 3% of the total workforce, resulting from the consolidation of its claims and underwriting operations located outside of California into hub locations in Florida, New Jersey, and Texas. Approximately $8 million to $13 million (pre-tax) of office closure costs and severance related expense will be recognized during the first quarter of 2013.