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. In addition, the Company owns a 4.2 acre parcel of land in Brea, California for future expansion. 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 Company’s properties are well maintained, adequately meet its needs, and are being utilized for their intended purposes.
Certain statements in this Annual Report on Form 10-K or in other materials the Company has filed or will file with the SEC (as well as information included in oral statements or other written statements made or to be made by the Company) contain or may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results, and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause the Company’s actual business, prospects and results of operations to differ materially from the historical information contained in this Annual Report on Form 10-K and from those that may be expressed or implied by the forward-looking statements contained in this Annual Report on Form 10-K and in other reports or public statements made by the Company.
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of natural disasters on losses, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates, changes in fair value of investments, and other factors such as changes in tax laws.
The Company expects to continue its growth by expanding into new states in future years with the objective of achieving greater geographic diversification. There are 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 2011.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $92 million and $189 million in 2010 and 2009, respectively. Cash flow from operations has been used to pay shareholder dividends and to help support growth.
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 premium growth in excess of 20% during hard markets. Premium growth rates in soft markets have ranged from slightly positive to negative and were negative 2.2% in 2010. Many in the industry have experienced declining profitability since 2007. Since 2009, many of the Company’s largest competitors have increased rates on both private passenger auto insurance and homeowners insurance. Rate increases generally indicate that the market is hardening.
The NextGen system is designed to be a multi-state, multi-line system. NextGen serves as the primary platform for all underwriting, billing, claims, and commission functions supporting the private passenger auto line in seven states (Virginia, New York, Florida, California, Georgia, Illinois, and Texas). During 2010, the Company launched Guidewire, a commercially available software solution, for the Nevada homeowners line of business to replace legacy platforms. The Company plans to implement Guidewire in other states during 2011.
During 2010, the Company received written approval from the California DOI for a private passenger automobile rate filing that was originally made in July 2008. That rate filing was required by a 2006 regulation that effectively reduced the weight that insurers can place on a person’s residence when establishing automobile
On April 9, 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to MIC, MCC, and CAIC based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI on February 18, 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. On April 30, 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. The Company denies the allegations in the 2010 NNC and believes it has done nothing to warrant the monetary penalties cited in the 2010 NNC.
The Company supported Proposition 17, a California initiative on the June 2010 ballot which did not pass. It would have provided for a portable persistency discount, allowing insurance companies to offer new customers discounts based on having continuous insurance coverage from any insurance company. Currently, the California DOI allows insurance companies to provide persistency discounts based on continuous coverage only with existing customers. The Company made financial contributions of $12.1 million and $3.5 million in 2010 and 2009, respectively, related to this initiative. The Company continues to offer a competitive product in California.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous similar catastrophes.
Material damage (MD) reserves, including collision and comprehensive property damage-approximately 20% of total reserves
Beginning late in 2008 and continuing through the end of 2009, the Company changed its claims handling procedures and discontinued the practice of providing small settlement offers to BI claimants at the inception of the claim. This had the effect of increasing loss severity and decreasing loss frequency for the 2009 accident year. The prior practice was reinstated in 2010, which resulted in decreased loss severity and increased loss frequency in 2010 compared to 2009. As a result, the loss severity comparisons from 2008 through 2010 are skewed, with 2009 showing much higher severities than had been the trend and 2010 showing a negative inflation trend when compared to 2009. Consequently, the Company believes that inflation trend comparison between 2010 and 2008, when the same claims handling process was practiced, is more indicative of the actual severity trend. This comparison indicates an annualized inflation trend of 2.1%.
The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 10%, 5%, and 3% for 2010, 2009, and 2008, respectively. For example, at December 31, 2010, the loss severity for the amounts recorded at December 31, 2009 decreased by 2.6%, 0.8% and 0.1% for the 2009, 2008, and 2007 accident years, respectively. Comparatively, at December 31, 2009, the loss severity decreased for the amount recorded at December 31, 2008 by 8.5%, 3.1%, and 0.1% for the 2008, 2007, and 2006 accident years, respectively. The following table presents the effects on the 2010, 2009, and 2008 accident year California BI loss reserves based on possible variations in the severity recorded, however, the variation could be more or less than these amounts.
(a) The increase and decrease in the total number of claims expected in 2010 and 2009, respectively, is reflective of the change in claims handling process noted above. It may also be impacted by declining numbers of insured exposures, partially offset by catastrophe losses from heavy rainstorms in California in December 2010. The number of claims expected excludes those claims that were closed without any payment.
(b) The change in the implied inflation rate in 2010 and 2009 is skewed by the change in claims handling process noted above. The Company believes the comparison between 2010 and 2008 is more indicative of the actual severity trend. This results in an annualized implied inflation rate of 2.1%.
The Company generally estimates ultimate claim counts for an accident period based on development of claim counts in prior accident periods. For California automobile BI claims, the Company has experienced that approximately 2% to 7% additional claims will be reported in the year subsequent to an accident year. However, such late reported claims could be more or less than the Company’s expectations. Typically, almost every claim is reported within one year following the end of an accident year and at that point the Company has a high degree of certainty as to what the ultimate claim count will be. The following table presents the number of BI claims reported at the end of the accident period and one year later:
At December 31, 2010, there were 28,182 BI claims reported for the 2010 accident year and the Company estimates that these are expected to ultimately grow by 2.5%. The Company believes that while actual development in recent years has ranged between approximately 2% and 7%, 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, 2010:
Unexpected large losses are generally not provided for in the current 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, regulation extending claims reporting periods, assumption of unexpected or unknown risks, adverse court decisions as well as many unknown factors.
Unexpected large losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this specific 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, or that the Company will experience additional development on these reserves.
At December 31, 2010 and 2009, the Company recorded its point estimate of approximately $1,034 million and $1,053 million, respectively, in losses and loss adjustment expenses liabilities which include approximately $308 million and $340 million, respectively, of IBNR loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs which may differ from case estimates, unreported claims which occurred on or prior to December 31, 2010 and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
In December 2010, the Insurance Services Office officially designated California winter storms occurring between December 17, 2010 and December 22, 2010 as a catastrophe. These storms established precipitation records across the state with some mountain areas receiving over 200 inches of snow and many lower elevation locations receiving in excess of 15 inches of rain. The Company experienced a large increase in homeowners and automobile claims as a result of these storms. The Company estimates that total losses from these storms are approximately $25 million.
The Company’s insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs to related unearned premiums, net of investment income. To the extent that any of the Company’s lines of business become substantially unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business except Florida homeowners. At December 31, 2010, the Company established a premium deficiency reserve for its Florida homeowners operations of $6 million.
All of the Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-sinking fund preferred stocks, are actively traded on national exchanges or trading markets, and are valued at the last transaction price on the balance sheet date.
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. The
Certain financial instruments that the Company holds or acquires may lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced at times during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise is not actively quoted. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.
At December 31, 2010, the Company’s deferred income taxes were in a net asset position materially due to unearned premiums, expense accruals, loss reserve discounting, tax credit carryforward, and deferred tax recognition of capital losses. 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.
Company has an established history of generating capital gain premiums earned through its common stock call option program. Based on the continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and the Company’s favorable track record in generating net capital gains from this program in both upward and downward markets, management believes it will be able to generate sufficient amounts of capital gains from this program, if necessary, to recover recorded capital deferred tax assets.
Goodwill and other intangible assets arise as a result of business acquisitions and consist of the excess of the cost of the acquisitions over the tangible and intangible assets acquired and liabilities assumed and identifiable intangible assets acquired. The Company annually evaluates goodwill for impairment using widely accepted valuation techniques to estimate the fair value of its reporting units. The Company also reviews its goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed the implied fair value. As of December 31, 2010, the fair value of the Company’s reporting units exceeds their carrying value.
designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by favorable development of approximately $13 million and $58 million on prior accident years’ losses and loss adjustment expenses reserves for the year ended December 31, 2010 and 2009, respectively. The favorable development in 2010 is largely the result of re-estimates of accident year 2009 California BI losses which have experienced both lower average severities and fewer late reported claims (claim count development) than were originally estimated at December 31, 2009. Excluding the effect of prior accident years’ loss development, the loss ratios were 71.6% and 70.0% in 2010 and 2009, respectively. The increase is primarily due to catastrophe losses in California from heavy rainstorms in December 2010, and to sinkhole claims in Florida.
Net premiums earned and net premiums written in 2009 decreased 6.5% and 5.8%, respectively, from 2008. Net premiums written by the Company’s California operations were approximately $2 billion in 2009, a 6.9% decrease from 2008. Net premiums written by the Company’s non-California operations were approximately $578 million in 2009, a 1.9% decrease from 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.
The following is a reconciliation of total net premiums written to net premiums earned:
Income tax expense (benefit) for 2009 and 2008 was $168.5 million and $(208.7) million, respectively. The increase in expense resulted primarily from changes in the fair value of the investment portfolio.
The slight increase in after-tax yield is due to an increase in tax exempt allocations relative to taxable issues.
Net income (loss) was $403.1 million or $7.32 per diluted share and $(242.1) million or $(4.42) per diluted share in 2009 and 2008, respectively. Diluted per share results were based on a weighted average of 55.1 million shares and 54.9 million shares in 2009 and 2008, respectively. Basic per share results were $7.36 and $(4.42) in 2009 and 2008, respectively. Included in net income (loss) per share were net realized investment gains (losses), net of income taxes, of $4.11 and $(6.54) per basic share, and $4.09 and $(6.54) per diluted share in 2009 and 2008, respectively.
The Company is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay ordinary dividends of approximately $31.9 million in 2011 to Mercury General. Actual ordinary dividends paid from the Insurance Companies to Mercury General during 2010 were $130 million. On December 16, 2010, the California DOI notified the Company that MCC was authorized to pay a $270 million extraordinary dividend to Mercury General in 2011. Mercury General intends to use the proceeds from the dividend to repay the $125 million senior notes and to fund shareholder dividends. As of December 31, 2010, Mercury General also had approximately $63 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 after-tax income. With combined cash and short-term investments of $324.8 million at December 31, 2010, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
Net cash provided by operating activities in 2010 was $91.8 million, a decrease of $97.3 million over 2009. The decrease was primarily due to the increased payment of accrued expenses, decreased premiums collected, and the contributions related to Proposition 17 in 2010 compared with 2009. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders and the purchase and development of information technology. Funds derived from the sale, redemption or maturity of fixed maturity investments of $490.0 million were primarily reinvested by the Company in high grade fixed maturity securities.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2010:
At December 31, 2010, 77.0% of the Company’s total investment portfolio at fair value and 91.6% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks and dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction. At December 31, 2010, 88.1% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any direct investment in subprime lenders.
During 2009, the Company recognized approximately $346.4 million in net realized investment gains, which include approximately $255.2 million and $83.5 million related to fixed maturity securities and equity securities, respectively. Included in the gains were $261.9 million and $133.6 million in gains due to changes in the fair value of the Company’s fixed maturity portfolio and equity security portfolio, respectively, as a result of applying the fair value option. Partially offsetting these gains were approximately $6.7 million and $50.1 million in losses from the sale of fixed maturity securities and equity securities, respectively.
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, 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. 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 11.8 years and 12.8 years (11.3 years and 12.2 years including all short-term instruments) at December 31, 2010 and 2009, 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 6.3 years and 7.2 years (6.0 years and 6.8 years including all short-term instruments) at December 31, 2010 and 2009, 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 4.7 years and 5.4 years, (4.5 years and 5.1 years including all short-term instruments), including collateralized mortgage obligations with
a modified duration of 2.2 years and 1.8 years at December 31, 2010 and 2009, 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.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-, at fair value, consistent with December 31, 2009. To calculate the weighted-average credit quality ratings as disclosed throughout this Annual Report on Form 10-K, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At December 31, 2010, fixed maturity holdings rated below investment grade and non-rated bonds totaled $139.4 million and $34.9 million, respectively, at fair value, and represented approximately 5.3% and 1.3%, respectively, of total fixed maturity securities. At December 31, 2009, fixed maturity holdings rated below investment grade and non-rated bonds totaled $92.0 million and $109.9 million, respectively at fair value, and represented approximately 3.4% and 4.1%, respectively, of total fixed maturity securities.
(2) Intermediate ratings are offered at each level (e.g., AA includes AA+, AA and AA-).
The following table presents the Company’s insured municipal bond portfolio by bond insurer at December 31, 2010 and 2009:
(1) Management’s estimate of average of ratings issued by Standard & Poor’s, Moody’s, and Fitch.
The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for $11.5 million and $14.0 million ($10.7 million and $13.2 million at amortized cost) of Alt-A mortgages at December 31, 2010 and 2009, respectively. Alt-A mortgage backed securities are at fixed or variable rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles than sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. At December 31, 2010, the Company had no holdings in commercial mortgage-backed securities.
Included in the fixed maturity securities are $95.2 million and $91.6 million of fixed rate corporate securities, which have durations of 4.1 and 4.7 years, at December 31, 2010 and 2009, respectively. The weighted-average rating is BBB+ for 2010 and A- for 2009.
Included in fixed maturities securities are collateralized debt obligations of $55.7 million and $47.5 million, which represent approximately 1.8% and 1.5% of the total investment portfolio and have durations of 2.0 years and 2.9 years, at December 31, 2010 and 2009, respectively.
Equity holdings consist of non-redeemable preferred stocks and common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction. The net gains due to changes in fair value of the Company’s equity portfolio were $45.7 million. The primary cause of the gains in the Company’s equity securities was the overall improvement in the equity markets. The Company’s large holdings of energy related stocks also experienced growth in value during 2010, in excess of the 12.8% growth in the S&P 500 Index.
The Company has $125 million of senior notes, which are unsecured, senior obligations with a 7.25% annual coupon payable on August 15 and February 15 each year. These notes mature on August 15, 2011. On December 16, 2010, the California DOI notified the Company that MCC was authorized to pay a $270 million extraordinary dividend to Mercury General in 2011. Mercury General intends to use a portion of the proceeds from the dividend to repay the senior notes.
The $120 million credit facility matures on January 1, 2012. The Company expects to either extend the credit facility, refinance the outstanding amount, or retire the debt using cash on hand and funds generated by operations or by selling securities in the investment portfolio.
As of December 31, 2010, the Company had no off-balance sheet arrangements as defined under Regulation S-K 303(a)(4) and the instructions thereto.
The Company’s significant contractual obligations at December 31, 2010 are summarized as follows:
(1) 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, 2010 because the debt amounts above include interest.
(2) The Company is obligated under various non-cancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2019.
(3) Reserve for losses and loss adjustment expenses is an estimate of amounts necessary to settle all outstanding claims, including IBNR as of December 31, 2010. 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.
(4) The table excludes liabilities of $3 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing of related future payments.
Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2010
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010. 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.
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, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
In our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010, and our report dated February 14, 2011 expressed an unqualified opinion on those consolidated financial statements.
Certain items presented in the receivables section of the consolidated balance sheets as of December 31, 2009 have been combined within the receivables section in the consolidated balance sheets as of December 31, 2010.
The Company applies the fair value option to all fixed maturities and equity securities and short-term investments as of the time the eligible item is first recognized. 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 (losses) in the Company’s consolidated statements of operations. 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 expansion of use of fair value measurement 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 and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, 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.
Short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities redeemable within one year.
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 $2.8 million and $1.0 million were included in other liabilities at December 31, 2010 and 2009, 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. During the years ended December 31, 2010, 2009, and 2008, the Company recorded no impairment charges.
No independent agent or broker accounted for more than 2% of the Company’s direct premiums written during 2010 and 2009. However, AIS produced approximately 15% of the Company’s direct premiums written during 2008 prior to the AIS acquisition.
The Company accounts for all derivative instruments, other than those that meet the normal purchases and sales exception, as either an asset or liability measured at fair value, which is based on information obtained from
independent parties. In addition, changes in fair value are recognized in earnings unless specific hedge accounting criteria are met. The Company’s derivative instruments include interest rate swap agreements and are used to hedge the exposure to:
The annual direct premiums written attributable to private passenger automobile, commercial automobile, homeowners, and other lines of insurance were as follows:
The Company accounts for share-based compensation using the modified prospective transition method. Under this method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the estimated grant-date fair value. Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the estimated grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of four or five years for options granted prior to 2008 and four years for options granted subsequent to January 1, 2008, for only those shares expected to vest. The fair value of stock option awards is estimated using the Black-Scholes option pricing model with the grant-date assumptions and weighted-average fair values, as discussed in Note 15.
The fair value of the restricted share grant was determined based on the market price on the date of grant. Compensation cost has been recognized based on management’s best estimate that performance goals will be achieved. If such goals are not met, no compensation cost would be recognized and any recognized compensation cost would be reversed. See Note 15 for additional disclosures.
In December 2010, the Financial Accounting Standards Board (“FASB”) issued a new standard which modifies step 1 of the goodwill impairment test for entities with a zero or negative carrying value to require entities to assess, considering qualitative factors, whether it is more likely than not that a goodwill impairment exists. If an entity concludes that it is more likely than not that goodwill impairment exists, the entity must perform step 2 of the goodwill impairment test. The new standard allows an entity to use either the equity or the enterprise valuation premise to determine the carrying amount of a reporting unit. The new standard will be effective for impairment tests performed during fiscal years and interim periods within those years that begin after December 15, 2010. The adoption of the new standard will not have a material impact on the Company’s consolidated financial statements.
The Company applies the fair value option to all fixed maturity securities and equity securities and short-term investments as of the time the eligible item is first recognized. 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 (losses) in the Company’s consolidated statements of operations. 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.
At December 31, 2010, fixed maturity holdings rated below investment grade and non-rated comprised 5.5% 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, 2010 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.
Either directly or indirectly observable inputs as of the reporting date and fair value is determined through the use of models or other valuation
Collateralized debt obligations: Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.
There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy in 2010. There was a $47.5 million increase in Level 3 financial assets in 2009 related to collateralized debt obligations, which include the use of unobservable inputs related to liquidity assumptions.
At December 31, 2010, the Company did not have any nonrecurring measurements of nonfinancial assets or nonfinancial liabilities.
In February 2008, the Company acquired an 88,300 square foot office building in Folsom, California for approximately $18.4 million. The Company financed the transaction through an $18 million bank loan that is secured by municipal bonds held as collateral. The loan matures on March 1, 2013 with interest payable quarterly at an annual floating rate of LIBOR plus 50 basis points.
The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by derivative instruments are equity price risk and interest rate risk. Equity contracts on various equity securities are intended to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are intended to manage interest rate risk associated with the Company’s loans with fixed or floating rates.
There were no gains or losses on derivative instruments designated as cash flow hedges reclassified from accumulated other comprehensive income into earnings for the years ended December 31, 2010, 2009, and 2008.
Goodwill of $37.6 million arising from the acquisition consists largely of the efficiencies and economies of scale expected from combining the operations of the Company and AIS, and is expected to be fully deductible for income tax purposes.
The fair value of the financial assets acquired includes cash, prepaid expenses, and receivables from customers. The acquired receivables of $6.6 million at fair value were fully collected during the three-month period ended March 31, 2009. The fair value of the liabilities assumed includes accounts payable and other accrued liabilities. The following table reflects the amount of revenue and net income of AIS, which are included in the Company’s consolidated statements of operations for the years ended December 31, 2010 and 2009, and the revenue of the combined entity for the year ended December 31, 2008, had the acquisition date been January 1, 2008.
(3) 2008 pro forma net income for the combined entity is not available as AIS was previously consolidated into its parent company and separate financial statements were not available.
There were no changes in the carrying amount of goodwill for the year ended December 31, 2010. Goodwill is reviewed for impairment on an annual basis and more frequently if potential impairment indicators exist. No impairment indications were identified during any of the periods presented.
The following table presents the components of other intangible assets as of December 31, 2010 and 2009.
Intangible assets are amortized on a straight-line basis over their useful lives. The amortization periods for intangible assets with definite lives, by asset class, are: 24 years for trade names, 11 years for customer relationships, 10 years for technology, 2 years for software, and 3 years for lease agreements. Intangible assets amortization expenses were $6.8 million for each of the years ended December 31, 2010 and 2009. There were no intangible assets as of December 31, 2008. 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, 2010:
On July 1, 2008, the California Superior Court ruled in favor of the Company in a case filed against the FTB for tax years 1993 through 1996, entitling the Company to a tax refund of $24.5 million, including interest. The time period for appeal of the decision has passed and the Company received the full amount on August 15, 2008. After providing for federal taxes, the Company recognized a net tax benefit of $17.5 million in the third quarter 2008.
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2005 through 2009 for federal taxes and 2001 through 2009 for California state taxes. Tax years 2005 through 2009 are currently under examination by the Internal Revenue Service.
The Company is currently under examination by the FTB for tax years 2001 through 2005. The taxing authority has proposed adjustments to the Company’s California tax liabilities which have been accounted for as unrecognized tax benefits. Management believes that the resolution will not have a material impact on the consolidated financial statements.
The Company experienced estimated pre-tax catastrophe losses of $25 million, $0, and $26 million in 2010, 2009, and 2008, respectively. The losses in 2010 primarily related to catastrophe losses in California from heavy rainstorms. The losses in 2008 were $20 million related to wildfires in Southern California and $6 million related to Hurricane Ike in Texas.
On December 16, 2010, the California DOI notified the Company that MCC was authorized to pay a $270 million extraordinary dividend to Mercury General in 2011. Mercury General intends to use the proceeds from the dividend to repay the $125 million senior notes and to fund shareholder dividends.
The Insurance Companies prepare their statutory-basis financial statements in conformity with accounting practices prescribed or permitted by the insurance departments of the applicable states of domicile. Prescribed statutory accounting practices primarily include those published as statements of SAP by the NAIC, as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2010, there were no material permitted statutory accounting practices utilized by the Insurance Companies.
The following table presents the statutory net income and capital and surplus of the Insurance Companies, as reported to regulatory authorities:
(2) The decrease in statutory capital and surplus in 2010 was primarily due to a $270 million extraordinary intercompany dividend declared by MCC in the fourth quarter of 2010. The dividend is payable to Mercury General in 2011.
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 $6,976,000, $3,080,000, and $6,802,000 for 2010, 2009, and 2008, respectively. Substantially reduced contributions were made during 2009 to improve the Company’s profitability as a part of a cost reduction program implemented in 2009.
The Plan also includes an employee stock ownership plan (“ESOP”) that covers substantially all employees. The Board of Directors authorized the Plan to purchase $1.2 million, $1.2 million, and $0 of the Company’s common stock in the open market for allocation to the Plan participants in 2010, 2009, and 2008, respectively. Accordingly, the Company recognized compensation expense equal to such amounts.
In May 1995, the Company adopted the 1995 Equity Participation Plan (the “1995 Plan”) which succeeded a prior plan. In May 2005, the Company adopted the 2005 Plan which succeeded the 1995 Plan. Share-based compensation awards may only be granted under the 2005 Plan. A combined total of 4,937,000 shares of common stock under the 1995 Plan and 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. The maximum number of shares that may be issued under the 2005 Plan is 4,937,000. As of December 31, 2010, 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 $733,000, $393,000, and $1,286,000 during 2010, 2009, and 2008, respectively. The excess tax benefit realized for the tax deduction from option exercises of the share-based payment awards totaled $60,000, $5,000, and $121,000 during 2010, 2009, and 2008, respectively.
The fair value of the restricted stock grant was determined based on the market price on the date of grant. Compensation cost has been recognized based on management’s best estimates that performance goals will be achieved. If such goals are not met as of the end of the three-year performance period, no compensation cost would be recognized and any recognized compensation cost would be reversed. In 2010, total compensation cost was $161,000, and the corresponding income tax benefit recognized in the income statement was $57,000. As of December 31, 2010, there was $977,000 of unrecognized compensation cost that is expected to be recognized over next 2 years. A summary of the restricted stock and restricted stock units activity as of December 31, 2010, and changes during the year then ended is as follows:
The anti-dilutive impact of incremental shares is excluded from loss position in 2008 in accordance with GAAP.
The diluted weighted shares exclude incremental shares of 448,000, 685,000, and 305,000 for 2010, 2009, and 2008, respectively. These shares are excluded due to their anti-dilutive effect.
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 through the CEA. The Company receives a small fee for placing business with the CEA, which is recorded as other income in the consolidated statements of operations. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 1, 2010, the most recent date at which information was available, was approximately $55.6 million. There was no assessment made in 2010.
On April 9, 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to MIC, MCC, and CAIC based on a Report of Examination of the Rating and Underwriting Practices of such companies issued by the California DOI on February 18, 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. On April 30, 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. 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. The Company denies the allegations in the 2010 NNC and believes it has done nothing to warrant the monetary penalties cited in the 2010 NNC.
The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages, which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. Additionally, from time to time, regulators may take actions to challenge the Company’s business practices. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s results of operations in the period of such ruling, however, none is expected to be material to the Company’s financial position.
The Company is taking steps to align expenses with declining revenues, however, not all expenses can be effectively reduced and continued declines in premium volumes could lead to higher expense ratios. The impact from the recession would also affect the capital and surplus of the Insurance Companies, which could indirectly impact the ability and capacity to pay shareholder dividends.
Summarized quarterly financial data for 2010 and 2009 are as follows:
During January 2011, the Company announced a workforce reduction of approximately 165 employees, primarily located in California. Approximately $4 million of severance related expense will be recognized during the first quarter of 2011.