On July 14, 2006, the California OAL approved proposed regulations by the California DOI that effectively reduce the weight that insurers can place on a person’s residence when establishing automobile insurance rates. Insurance companies in California are required to file rating plans with the California DOI that comply with the new regulations. There is a two year phase-in period for insurers to fully implement those plans. The Company made a rate filing in August 2006 that reduced the territorial impact of its rates and requested a small overall rate increase. The California DOI approved the August 2006 filing in January 2008, which resulted in a small rate increase for two of the California insurance subsidiaries and a small decrease for a third, for a total net rate reduction of approximately 2.5%. The newly approved rates went into effect in April 2008. In July 2008, the Company made an additional rate filing to bring its rates into full compliance with the new regulations. However, the Company cannot predict whether the California DOI will determine that the Company’s rates are in full compliance with the new regulations as a result of this filing. In general, the Company expects that the regulations will cause rates for urban drivers to decrease and those for non-urban drivers to increase. These rate changes are likely to increase consumer shopping for insurance which could affect the volume and the retention rates of the Company’s business. It is the Company’s intention to maintain its competitive position in the marketplace while complying with the new regulations.
There are many potential factors that can affect the number of claims reported after a period end including changes in weather patterns, a reduction in the amount of litigated files, whether the last day of the year falls on a weekday or a weekend and vehicle safety improvements. However, the Company is unable to determine which, if any, of the factors actually impacted the number of claims reported and, if so, by what magnitude.
Beginning January 1, 2008, all of the Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required by SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), as amended, and SFAS No. 159. Prior to January 1, 2008, the Company’s fixed maturity and equity investment portfolios were classified either as “available for sale” or “trading” and carried at fair value under SFAS No. 115, as amended. The Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”) and SFAS No. 159 as of January 1, 2008. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges or trading markets, and were valued at the last transaction price on the balance sheet date. Changes in fair value of the investments are reflected in net realized investment gains or losses in the consolidated statements of operations as required under SFAS No. 115, as amended, and SFAS No. 159.
The loss ratio (GAAP basis) (loss and loss adjustment expenses related to premiums earned) was 73.3% and 68.0% in 2008 and 2007, respectively. There was negative development of approximately $89 million and $19 million on prior accident years’ loss reserves for 2008 and 2007, respectively. Excluding the effect of prior accident years’ loss development, the loss ratio was 70.4% and 67.4% in 2008 and 2007, respectively. The increase in the loss ratio excluding the effect of prior accident years’ loss development is primarily due to higher severity in the California automobile lines of business which was partially offset by lower frequency in the same lines.
The after-tax yield on average investments (fixed maturities, equities and short-term investments valued at cost) was 4.0% on average invested assets of $3.5 billion and 3.8% on average invested assets of $3.3 billion in 2007 and 2006, respectively.
The entire mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for approximately $16.3 million ($20.0 million amortized cost) of Alt-A mortgages at December 31, 2008. 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.
In our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
No agent or broker accounted for more than 2% of direct premiums written except AIS which produced approximately 15%, 14% and 13% during 2008, 2007, and 2006, respectively, of the Company’s direct premiums written. Effective January 1, 2009, MCC acquired all of the membership interests of AIS Management LLC, a California limited liability company, which is the parent company of AIS and PoliSeek AIS Insurance Solutions, Inc.
At December 31, 2008, bond holdings rated below investment grade or non rated were 3.6% 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 amortized cost and estimated fair value of fixed maturities at December 31, 2008 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.
The Company’s acquisition of AIS was effective January 1, 2009 for $120 million.The acquisition was financed by a $120 million credit facility that is secured by municipal bonds pledged as collateral. The credit facility calls for the minimum amount of collateral pledged multiplied by the bank's “advance rates” to be greater than the loan amount. The collateral requirement is calculated as the fair market value of the municipal bonds pledged multiplied by the advance rates, which vary based on the credit quality and duration of the assets pledged and range between 75% and 100% of the fair value of each bond. The loan matures on January 1, 2012 with interest payable at a floating rate of LIBOR rate plus 125 basis points. On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on the loan for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is not designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change.
The income tax provision reflected in the consolidated statements of operations is reconciled to the federal income tax on (loss) income before income taxes based on a statutory rate of 35% as shown in the table below:
Statutory net income excluded changes in the fair value of the investment portfolio. As a result of the adoption of SFAS No. 159 on January 1, 2008 for GAAP purposes, the change in unrealized gains and losses on all investments is recorded as realized gains and losses on the consolidated statements of operations. During 2008, the Company recognized approximately $525.7 million of losses related to the change in fair value of the total investment portfolio as a result of the adoption of SFAS No. 159.
Cash received from option exercises was $1,286,000, $2,173,000 and $1,943,000 during 2008, 2007 and 2006, respectively. The excess tax benefit realized for the tax deduction from option exercises of the share-based payment awards totaled $121,000, $273,000 and $505,000 during 2008, 2007 and 2006, respectively.
In Marissa Goodman, on her own behalf and on behalf of all others similarly situated v. Mercury Insurance Company (Los Angeles Superior Court), filed June 16, 2002, the Plaintiff is challenging the Company’s use of certain automated database vendors to assist in valuing claims for medical payments alleging that they systematically undervalue medical payment claims to the detriment of insured. The Plaintiff is seeking actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with two other similar cases, and also with ten other cases relating to total loss claims. The Plaintiff sought class action certification of all of the Company’s insureds from 1998 to the present who presented a medical payments claim, had the claim reduced using the computer program and whose claim did not reach the policy limits for medical payments. The Court certified the class on January 11, 2007. The Company appealed the class certification ruling, and the Court of Appeal stayed the case pending their review. The Company and the Plaintiff subsequently agreed to settle the claims for an amount that is immaterial to the Company’s operations and financial position. The settlement was approved by the Court on April 24, 2008, and on January 30, 2009, the Court approved the final distribution of the settlement proceeds.
The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. See Note 6 of Notes to Consolidated Financial Statements.
The Company is affected by the recession, particularly in how it impacts the state of California. The deepening recession with rising unemployment has contributed to declining premium revenues and could lead to further premium revenue declines in the future. The disruption in the capital markets has led to reductions in the fair value of the Company’s investments which led to significant capital losses in 2008. Should the capital markets continue to be strained, it is likely that further capital losses will be realized.