The Company did business only in the state of California until 1990, when it began operations in Georgia and Illinois. In December 1996, the American Fidelity Insurance Group (AFI) was acquired for cash. The results of operations of AFI for the month of December only are included in the Company's consolidated statements of income. AFI writes automobile (approximately 54% of AFI's direct premiums) and other casualty lines of insurance principally in Oklahoma, Texas and Kansas, and is headquartered in Oklahoma City, Oklahoma. Total direct premiums written by AFI in 1996 were $90.4 million; of that amount $5.5 million of premiums were written in December. The Group is licensed in 36 states.
During 1996, approximately 98% of the Company's direct premiums written, excluding AFI, were derived from California.
In February 1994, the Commissioner approved new rates which were designed to improve the Company's competitive position for new insureds. These rate changes, which became effective on May 1, 1994, provided for decreases in premium rates for new insureds. Further rate modifications were approved and made effective on October 15, 1995 and April 15, 1996. The rate changes made over the last three years have been substantially revenue-neutral overall, with physical damage rates being increased and bodily injury liability rates decreased. The rate changes have resulted in a substantial increase in new business being submitted to the Company. Since March 31, 1994, Private Passenger Automobile (PPA) policies in force in California have increased by approximately 190,000 to 494,000 at December 31, 1996, an annual rate of increase of over 20%, compared with an annualized growth rate of 4.1% over the prior fifteen month period.
In September 1996, the California Insurance Commissioner issued new permanent rating factor regulations designed to implement the requirements that automobile insurance rates be determined by (1) driving safety record, (2) years of driving experience, (3) miles driven per year and (4) whatever optional factors are determined by the Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further requires that each of the four factors be applied in decreasing order of importance.
The new permanent regulations replace emergency regulations which have been in use since their issuance in 1989. They require all automobile insurers in California to submit new rating plans complying with the regulations in early 1997. In January 1997, in response to a court ruling on the issue of surcharges imposed on drivers not complying with California's financial responsibility law, the Commissioner amended the regulations to exclude such non-compliance as a rating factor.
The statistical methodology prescribed by the regulations for determining rating factor weightings are technical and complex. The January amendment required the Company to rework its rate filing. The Company submitted its new proposed rating plan on March 11, 1997.
The filings must be reviewed and approved by the Department, and the companies will have ninety days following approval to place their new rates in effect. The Company does not expect the newly filed rating plan, if approved by the Commissioner, to have a material effect on its competitive position or its profitability. However, the Company has not yet been able to review the filings of its competitors.
Premiums earned in 1996 of $754.7 million (including $5.2 million contributed by AFI in December 1996) increased 22.5%, primarily reflecting unit growth. Average premium per policy for the year was substantially unchanged. Net premiums written in 1996 of $795.9 million (including $4.5 million contributed by AFI) increased 25.0% over a year earlier, continuing a growth trend which began in the second quarter of 1993.
The loss ratio in 1996 (loss and loss adjustment expenses related to premiums earned) was 66.5%, compared with 67.6% in 1995. The 1996 and 1995 loss ratios reflect small contributions from favorable loss reserve development from prior periods.
The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 24.4% in 1996 and 1995. The consolidation of one month of operating results of AFI in 1996 had no material effect on either the loss or expense ratios.
Year Ended December 31, 1995 Compared to Year Ended December 31, 1994 ---------------------------------------------------------------------
Total losses and expenses, excluding interest expense of $2.0 million, were $567.4 million, resulting in an underwriting gain for the period of $49.0 million, compared with an underwriting gain of $35.6 million in 1994.
Investment income in 1995 was $63.0 million, compared with $54.6 million in 1994. The after-tax yield on average investments of $827.9 million (fixed maturities at cost, equities at market) was 6.89%, compared with 6.84% on average investments of $727.9 million in 1994. The effective tax rate on investment income was 9.4% in 1995, compared with 8.8% in 1994. The slightly higher tax rate reflects an increase in the proportion of investment income derived from dividend income on equities, principally perpetual preferred stocks, compared to tax-exempt income. The maintenance of above-average yields during a period of declining interest rates is, in part, the result of the bond restructuring program undertaken in 1994 when bonds acquired in lower interest rate environments were sold with proceeds reinvested at significantly higher rates. The redemption of bonds acquired during higher interest periods has been a negative influence on realized yields which will continue in 1996 and 1997. Bonds matured and called in 1995 totaled $71.0 million, compared with $53.4 million in 1994, and approximately $83.1 million of calls and maturities are expected in 1996. Average yields being obtained during the first quarter of 1996 on new investments are some 50-75 basis points lower than the average 1995 portfolio yield.
Year Ended December 31, 1994 Compared to Year Ended December 31, 1993 ---------------------------------------------------------------------
The income tax provision of $16.1 million in 1994 represented an effective tax rate of 19.6%, compared with an effective rate of 23.3%, in 1993. The decrease in the rate is attributable principally to the decrease in fully taxable underwriting income, and the resulting higher proportion of tax exempt investment income.
The market value of all investments held at market as "Available for Sale" exceeded the amortized cost of $1,139.1 million at December 31, 1996 by $29.2 million. That unrealized gain, reflected in shareholders' equity net of applicable tax effects, was $19.0 million at December 31, 1996 compared with an
unrealized gain of $25.2 million at December 31, 1995. The decrease in market values since December 31, 1995 reflects principally the increase in intermediate and long term interest rates during 1996.
Traditionally, it has been the Company's policy not to invest in high yield or "junk" bonds. In 1995, the Company adopted a policy to place a small proportion of its investments in the taxable sector in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1996 bond holdings rated below investment grade totaled $15.2 million at market (cost $14.9 million), or 1.3% of total investments. All but $1.5 million of such holdings were downgraded to their current ratings subsequent to purchase. The average rating of the $789.6 million bond portfolio, excluding AFI, (at amortized cost) was A, while the average effective maturity, giving effect to anticipated early call, approximates 8.7 years. The modified duration of the bond portfolio at year-end, excluding AFI, was 5.9 years, reflecting the heavy weighting of high coupon issues, including housing issues subject to sinking funds, and other issues which are pre-refunded or are expected to be called prior to their maturity. Duration measures the length of time it takes to receive all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is a much better indicator of price volatility than simple maturity alone. Bond holdings are broadly diversified geographically, and, within the tax-exempt sector, consist largely of high coupon revenue issues, many of which have been pre-refunded and escrowed with U.S. Treasuries. General obligation bonds of the large eastern cities have generally been avoided.
Equity holdings of $148.1 million at market (cost $148.3 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 23.1% of total shareholders' equity.
In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been 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. The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1996. Each of the companies' policyholders' surplus exceeded the highest level of recommended capital requirements.
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 of the licensed insurance subsidiaries of $594.8 million at December 31, 1996, and net written premiums for the twelve months ended on that date of $795.9 million, the ratio of writings to surplus was approximately 1.3 to 1.
Summarized quarterly financial data for 1996 and 1995 is as follows (in thousands except per share data):
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996, in conformity with generally accepted accounting principles.
One agent produced direct premiums written of approximately 17%, 15% and 13% of the Company's total direct premiums written during 1996, 1995 and 1994, respectively.
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 are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
Earnings per share are computed by dividing earnings by the weighted average number of common shares outstanding of 27,397,173 for 1996, 27,311,707 for 1995, and 27,273,192 for 1994.
The balance sheet of AFI at acquisition date included the following assets: investments of $75,310,000, cash of $1,362,000, receivables of $44,418,000 and other assets of $31,124,000. Liabilities assumed in the acquisition included unearned premiums of $50,199,000, loss and loss adjustment expense reserves of $47,039,000 and other liabilities of $19,985,000.
A summary of the net increase (decrease) in unrealized investment gains (losses) less applicable income tax expense (benefit), is as follows:
Traditionally, it has been the Company's policy not to invest in high yield or non-investment grade bonds. In 1995, the Company adopted a policy allowing a small percentage of its investments to be placed in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1996 bond holdings rated below investment grade totaled approximately 1.3% of total investments. All but $1.5 million of such holdings were downgraded subsequent to purchase. The average Standard and Poor's rating of the bond portfolio is A.
The terms of the loan agreement include certain affirmative and negative covenants, all of which are met by the Company at December 31, 1996.
The following unaudited proforma consolidated results of operations for 1996 and 1995 give effect to the acquisition as though it had occurred at the beginning of each year presented:
The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 1996, there were no material permitted statutory accounting practices utilized by the Insurance Companies. The NAIC is working on a project to codify statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. When complete, that project will most likely change the definition of prescribed versus permitted statutory accounting practices and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements.
The Insurance Companies' statutory net income, as reported to regulatory authorities, was $97,979,000, $86,210,000, and $62,861,000 for the years ended December 31, 1996, 1995 and 1994, respectively. The statutory policyholders' surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 1996 and 1995 was $594,799,000 and $479,114,000, respectively.
The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2002. Total rent expense under these lease agreements, all of which are operating leases, was $1,583,000, $1,461,000 and $1,492,000 for the years ended December 31, 1996, 1995 and 1994, respectively. Mercury Casualty
The Company, at the option of the Board of Directors, may make annual contributions to an employee profit sharing plan. 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. The annual contribution was $1,000,000 for each of the plan years ended December 31, 1996, 1995 and 1994.
The Profit Sharing Plan also includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $955,000, $773,000, and $762,000 for the plan years ended December 31, 1996, 1995 and 1994.
Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan (ESOP) that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends received by the ESOP. Dividends received by the ESOP on
unallocated shares are used to pay debt service and the ESOP shares serve as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the debt of the ESOP, which was $3,000,000, $4,000,000 and $5,000,000 at December 31, 1996, 1995 and 1994, respectively, is recorded in the balance sheet as other liabilities. The shares pledged as collateral are reported as unearned ESOP compensation in the shareholders' equity section of the balance sheet. As shares are committed to be released from collateral, the Company reports compensation expense equal to the current market price of the shares, and reduces unearned ESOP compensation by the original cost of the shares. The difference between the market price and cost of the shares is charged to common stock. As shares are committed to be released from collateral, the shares become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of accrued interest. ESOP compensation expense was $1,509,000, $1,145,000 and $919,000 in 1996, 1995 and 1994, respectively. The ESOP shares as of December 31 were as follows:
As explained in Note 1, the Company applies APB Opinion No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Statements of Income. Had compensation cost for the Company's Plans been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's net income would have been reduced by $295,000 and $116,000 in 1996 and 1995, respectively, and earnings per share would have been reduced by $.01 in each year. Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1996 and 1995: dividend yield of 2.0 percent for both years, expected volatility of 30 percent for both years and expected lives of 7 years for both years. The risk-free interest rates used were 5.5 and 6.4 percent for the options granted during 1996 and 7.4 and 6.4 percent for the options granted during 1995.
A summary of the status of the Company's plans as of December 31, 1994, 1995 and 1996 and changes during the years ending on those dates is presented below: