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EX-15.1 - REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - MERCURY GENERAL CORPd326437dex151.htm
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EX-32.2 - SECTION 906 CERTIFICATION OF CHIEF FINANCIAL OFFICER - MERCURY GENERAL CORPd326437dex322.htm
EX-15.2 - AWARENESS LETTER OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - MERCURY GENERAL CORPd326437dex152.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended March 31, 2012

Commission File No. 001-12257

 

 

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

California   95-2211612

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

4484 Wilshire Boulevard, Los Angeles, California   90010
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (323) 937-1060

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

Non-accelerated filer

 

¨  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

Indicate by check mark whether the Registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At April 26, 2012, the Registrant had issued and outstanding an aggregate of 54,882,677 shares of its Common Stock.

 

 

 


Table of Contents

MERCURY GENERAL CORPORATION

INDEX TO FORM 10-Q

 

         Page  

PART I - FINANCIAL INFORMATION

  

Item 1

 

Financial Statements

     3   
 

Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011

     3   
 

Consolidated Statements of Operations and Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2012 and 2011

     4   
 

Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2012 and 2011

     5   
 

Condensed Notes to Consolidated Financial Statements

     6   

Item 2

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     16   

Item 3

 

Quantitative and Qualitative Disclosures about Market Risks

     29   

Item 4

 

Controls and Procedures

     31   

PART II - OTHER INFORMATION

  

Item 1

 

Legal Proceedings

     31   

Item 1A

 

Risk Factors

     32   

Item 2

 

Unregistered Sales of Equity Securities and Use of Proceeds

     32   

Item 3

 

Defaults upon Senior Securities

     32   

Item 4

 

Mine Safety Disclosures

     32   

Item 5

 

Other Information

     32   

Item 6

 

Exhibits

     32   

SIGNATURES

     33   

 

2


Table of Contents

PART I - FINANCIAL INFORMATION

 

Item 1.

Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands)

 

     March 31, 2012      December 31, 2011  
     (unaudited)         
ASSETS      

Investments, at fair value:

     

Fixed maturities trading (amortized cost $2,364,561; $2,345,620)

   $ 2,485,594       $ 2,445,589   

Equity securities trading (cost $385,990; $388,417)

     406,456         380,388   

Short-term investments (cost $227,340; $236,433)

     227,196         236,444   
  

 

 

    

 

 

 

Total investments

     3,119,246         3,062,421   

Cash

     204,701         211,393   

Receivables:

     

Premiums

     309,910         288,799   

Accrued investment income

     33,649         32,541   

Other

     11,565         11,320   
  

 

 

    

 

 

 

Total receivables

     355,124         332,660   

Deferred policy acquisition costs

     175,392         171,430   

Fixed assets, net

     172,422         177,760   

Deferred income taxes

     0         6,511   

Goodwill

     42,850         42,850   

Other intangible assets, net

     52,201         53,749   

Other assets

     14,843         11,232   
  

 

 

    

 

 

 

Total assets

   $ 4,136,779       $ 4,070,006   
  

 

 

    

 

 

 
LIABILITIES AND SHAREHOLDERS’ EQUITY      

Losses and loss adjustment expenses

   $ 954,386       $ 985,279   

Unearned premiums

     865,982         843,427   

Notes payable

     140,000         140,000   

Accounts payable and accrued expenses

     99,420         94,743   

Current income taxes

     5,292         67   

Deferred income taxes

     9,915         0   

Other liabilities

     163,224         149,007   
  

 

 

    

 

 

 

Total liabilities

     2,238,219         2,212,523   
  

 

 

    

 

 

 

Commitments and contingencies

     

Shareholders’ equity:

     

Common stock without par value or stated value:
Authorized 70,000 shares; issued and outstanding 54,883; 54,856

     77,833         76,634   

Additional paid-in capital

     538         538   

Retained earnings

     1,820,189         1,780,311   
  

 

 

    

 

 

 

Total shareholders’ equity

     1,898,560         1,857,483   
  

 

 

    

 

 

 

Total liabilities and shareholders’ equity

   $ 4,136,779       $ 4,070,006   
  

 

 

    

 

 

 

See accompanying Condensed Notes to Consolidated Financial Statements.

 

3


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

     Three Months Ended March 31,  
     2012      2011  

Revenues:

     

Net premiums earned

   $ 635,812       $ 638,487   

Net investment income

     31,486         35,096   

Net realized investment gains

     52,663         28,690   

Other

     2,714         3,270   
  

 

 

    

 

 

 

Total revenues

     722,675         705,543   
  

 

 

    

 

 

 

Expenses:

     

Losses and loss adjustment expenses

     449,916         446,461   

Policy acquisition costs

     117,430         121,804   

Other operating expenses

     52,925         58,672   

Interest

     410         1,695   
  

 

 

    

 

 

 

Total expenses

     620,681         628,632   
  

 

 

    

 

 

 

Income before income taxes

     101,994         76,911   

Income tax expense

     28,638         18,685   
  

 

 

    

 

 

 

Net income

   $ 73,356       $ 58,226   
  

 

 

    

 

 

 

Net income per share:

     

Basic

   $ 1.34       $ 1.06   

Diluted

   $ 1.34       $ 1.06   

Weighted average shares outstanding:

     

Basic

     54,877         54,809   

Diluted

     54,908         54,831   

Dividends paid per share

   $ 0.61       $ 0.60   

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Three Months Ended March 31,  
     2012      2011  

Net Income

   $ 73,356       $ 58,226   

Other comprehensive income, before tax:

     

Gains on hedging instrument

     0         143   
  

 

 

    

 

 

 

Other comprehensive income, before tax:

     0         143   

Income tax expense related to gains on hedging instrument

     0         (50
  

 

 

    

 

 

 

Other comprehensive income, net of tax:

     0         93   
  

 

 

    

 

 

 

Comprehensive income

   $ 73,356       $ 58,319   
  

 

 

    

 

 

 

See accompanying Condensed Notes to Consolidated Financial Statements.

 

4


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Three Months Ended March 31,  
     2012     2011  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 73,356      $ 58,226   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     9,516        10,420   

Net realized investment gains

     (52,663     (28,690

Bond amortization, net

     1,545        1,277   

Excess tax benefit from exercise of stock options

     (32     (20

Increase in premiums receivables

     (21,111     (15,341

Change in current and deferred income taxes

     21,683        18,277   

Increase in deferred policy acquisition costs

     (3,962     (66

Decrease in unpaid losses and loss adjustment expenses

     (30,893     (43,486

Increase in unearned premiums

     22,555        19,735   

Increase (decrease) in accounts payable and accrued expenses

     6,017        (5,411

Share-based compensation

     95        116   

Increase in other payables

     3,548        9,195   

Other, net

     5,029        11,344   
  

 

 

   

 

 

 

Net cash provided by operating activities

     34,683        35,576   

CASH FLOWS FROM INVESTING ACTIVITIES

    

Fixed maturities available-for-sale in nature:

    

Purchases

     (129,573     (57,182

Sales

     35,816        96,707   

Calls or maturities

     73,292        82,925   

Equity securities available-for-sale in nature:

    

Purchases

     (40,344     (125,551

Sales

     43,869        125,673   

Calls

     923        0   

Net increase (decrease) in payable for securities

     275        (3,264

Net decrease in short-term investments

     9,056        31,760   

Purchase of fixed assets

     (4,152     (5,956

Sale of fixed assets

     833        554   

Other, net

     1,004        4,033   
  

 

 

   

 

 

 

Net cash (used in) provided by investing activities

     (9,001     149,699   

CASH FLOWS FROM FINANCING ACTIVITIES

    

Dividends paid to shareholders

     (33,478     (32,891

Excess tax benefit from exercise of stock options

     32        20   

Proceeds from stock options exercised

     1,072        498   
  

 

 

   

 

 

 

Net cash used in financing activities

     (32,374     (32,373
  

 

 

   

 

 

 

Net (decrease) increase in cash

     (6,692     152,902   

Cash:

    

Beginning of the year

     211,393        181,388   
  

 

 

   

 

 

 

End of period

   $ 204,701      $ 334,290   
  

 

 

   

 

 

 

SUPPLEMENTAL CASH FLOW DISCLOSURE

    

Interest paid

   $ 539      $ 2,129   

Income taxes paid

   $ 6,954      $ 409   

See accompanying Condensed Notes to Consolidated Financial Statements.

 

5


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. General

Consolidation and Basis of Presentation

The condensed consolidated financial statements include the accounts of Mercury General Corporation and its subsidiaries (referred to herein collectively as the Company). For the list of the Company’s subsidiaries, see Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions and balances have been eliminated.

The financial data of the Company included herein has been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature have been made to present fairly the Company’s financial position at March 31, 2012 and the results of operations, comprehensive income, and cash flows for the periods presented. Operating results and cash flows for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

Use of Estimates

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 revenues 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 (See Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011).

Earnings per Share

Potentially dilutive securities representing approximately 62,000 and 102,000 shares of common stock for the three months ended March 31, 2012 and 2011, respectively, were excluded from the computation of diluted earnings per common share for these periods because their effect would have been anti-dilutive.

Deferred Policy Acquisition Costs

In October 2010, the Financial Accounting Standards Board (“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. 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. As of March 31, 2012, deferred policy acquisition costs were $175.4 million, but would have been $176.6 million had the previous policy been applied. Deferred policy acquisition cost amortization was $117.4 million and $121.8 million for the three months ended March 31, 2012 and 2011, respectively. The Company does not defer advertising expenses but expenses them as incurred. The Company recorded net advertising expenses of approximately $5 million and $6 million for the three months ended March 31, 2012 and 2011, respectively.

 

 

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Table of Contents

2. Recently Issued Accounting Standards

In June 2011, the FASB issued a new standard which revises the manner in which entities present comprehensive income in their financial statements. The new standard removes the presentation options and requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. The new standard does not change the items that must be reported in other comprehensive income. The Company adopted the new standard which became effective for the interim period ended March 31, 2012. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements. In December 2011, the FASB issued a new standard which indefinitely defers certain provisions of this standard that revised the manner in which entities present comprehensive income in financial statements. One of this standard’s provisions required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. Accordingly, this requirement is indefinitely deferred and will be further deliberated by the FASB at a future date. The new standard is effective for the interim period ended March 31, 2012.

In May 2011, the FASB issued a new standard which develops a single and converged guidance on how to measure fair value and on required disclosures about fair value measurements. While the new standard is largely consistent with existing fair value measurement principles, it expands existing disclosure requirements for fair value measurements and makes other amendments. The Company adopted the new standard which became effective for the interim period ended March 31, 2012. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.

3. Fair Value of Financial Instruments

The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured notes payable. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values and are classified as Level 3 in the fair value hierarchy as defined in Note 5. The following table presents the estimated fair values of financial instruments at March 31, 2012 and December 31, 2011.

 

     March 31, 2012      December 31, 2011  
     (Amounts in thousands)  

Assets

     

Investments

   $ 3,119,246       $ 3,062,421   

Liabilities

     

Interest rate swap agreements

   $ 546       $ 670   

Equity contracts

   $ 405       $ 655   

Secured notes payable

   $ 140,000       $ 140,000   

Methods and assumptions used in estimating fair values are as follows:

Investments

The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time the eligible item is first recognized. The cost of investments sold is determined in accordance with first-in and first-out method and realized gains and losses are included in net realized investment gains. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Interest rate swap agreements

The fair value of interest rate swap agreements reflects the estimated amounts that the Company would pay at March 31, 2012 and December 31, 2011 in order to terminate the contracts based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract. For additional disclosures regarding methods and assumptions used in estimating fair values of interest rate swap agreements, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Equity contracts

The fair value of equity contracts is based on quoted prices for identical instruments in active markets. For additional disclosures regarding methods and assumptions used in estimating fair values of equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Secured notes payable

The fair value of the Company’s $120 million and $20 million secured notes, classified as Level 2 in the fair value hierarchy defined in Note 5, is estimated based on assumptions and inputs, such as reset rates and the market value of underlying collateral, for similarly termed notes that are observable in the market.

 

7


Table of Contents

4. Fair Value Option

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 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.

The following table presents gains and losses due to changes in fair value of investments that are measured at fair value pursuant to application of the fair value option:

 

     Three Months Ended March 31,  
     2012     2011  
     (Amounts in thousands)  

Fixed maturity securities

   $ 21,003      $ (9,503

Equity securities

     28,496        30,388   

Short-term investments

     (156     19   
  

 

 

   

 

 

 

Total

   $ 49,343      $ 20,904   
  

 

 

   

 

 

 

5. Fair Value Measurement

The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount 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 using the exit price. Accordingly, when market observable data is not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value are categorized based on the level of judgment associated with inputs used to measure their fair value and the level of market price observability, as follows:

 

Level 1

  

Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.

Level 2

  

Pricing inputs are other than quoted prices in active markets, which are based on the following:

 

•     Quoted prices for similar assets or liabilities in active markets;

 

•     Quoted prices for identical or similar assets or liabilities in non-active markets; or

 

•     Either directly or indirectly observable inputs as of the reporting date.

 

Level 3

  

Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.

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.

The Company uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3. The Company recognizes transfers between levels at either the actual date of the event or a change in circumstances that caused the transfer.

Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities

The Company’s fair value measurements are based on the market approach. The market approach utilizes market transaction data for the same or similar instruments.

 

8


Table of Contents

The Company obtained unadjusted fair values on approximately 98% of its portfolio from an independent pricing service. For approximately 2% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, less significantly, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of March 31, 2012.

Level 1 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure that reasonable fair values are used in pricing the investment portfolio.

U.S. government bonds and agencies: Valued using unadjusted quoted market prices for identical assets in active markets.

Common stock: Comprised of actively traded, exchange listed U.S. and international equity securities and valued based on unadjusted quoted prices for identical assets in active markets.

Money market instruments: Valued based on unadjusted quoted prices for identical assets.

Equity contracts: Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.

Level 2 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.

Municipal securities: Valued based on models or matrices using inputs such as quoted prices for identical or similar assets in active markets.

Mortgage-backed securities: Comprised of securities that are collateralized by residential mortgage loans and valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. At March 31, 2012 and December 31, 2011, the Company had no holdings in commercial mortgage-backed securities.

Corporate securities/Short-term bonds: Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.

Non-redeemable preferred stock: Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.

Interest rate swap agreements: Valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.

Level 3 Measurements - Fair values of financial assets are based on inputs that are both unobservable and significant to the overall fair value measurement, including any items in which the evaluated prices obtained elsewhere were deemed to be of a distressed trading level.

Collateralized debt obligations/Partnership interest in a private credit fund: Valued based on underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.

The Company’s total financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment gains in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.

 

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Table of Contents

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2012 and December 31, 2011, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:

 

     March 31, 2012  
     Level 1      Level 2      Level 3      Total  
     (Amounts in thousands)  

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 14,181       $ 0       $ 0       $ 14,181   

Municipal securities

     0         2,289,120         0         2,289,120   

Mortgage-backed securities

     0         34,914         0         34,914   

Corporate securities

     0         94,396         0         94,396   

Collateralized debt obligations

     0         0         52,983         52,983   

Equity securities:

           

Common stock:

           

Public utilities

     29,369         0         0         29,369   

Banks, trusts and insurance companies

     19,431         0         0         19,431   

Industrial and other

     336,171         0         0         336,171   

Non-redeemable preferred stock

     0         10,975         0         10,975   

Partnership interest in a private credit fund

     0         0         10,510         10,510   

Short-term bonds

     0         31,754         0         31,754   

Money market instruments

     195,442         0         0         195,442   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets at fair value

   $ 594,594       $ 2,461,159       $ 63,493       $ 3,119,246   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Equity contracts

   $ 405       $ 0       $ 0       $ 405   

Interest rate swap agreements

     0         546         0         546   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities at fair value

   $ 405       $ 546       $ 0       $ 951   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     December 31, 2011  
     Level 1      Level 2      Level 3      Total  
     (Amounts in thousands)  

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 14,298       $ 0       $ 0       $ 14,298   

Municipal securities

     0         2,271,275         0         2,271,275   

Mortgage-backed securities

     0         37,371         0         37,371   

Corporate securities

     0         75,142         0         75,142   

Collateralized debt obligations

     0         0         47,503         47,503   

Equity securities:

           

Common stock:

           

Public utilities

     26,342         0         0         26,342   

Banks, trusts and insurance companies

     16,027         0         0         16,027   

Industrial and other

     316,592         0         0         316,592   

Non-redeemable preferred stock

     0         11,419         0         11,419   

Partnership interest in a private credit fund

     0         0         10,008         10,008   

Short-term bonds

     0         9,011         0         9,011   

Money market instruments

     227,433         0         0         227,433   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets at fair value

   $ 600,692       $ 2,404,218       $ 57,511       $ 3,062,421   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Equity contracts

   $ 655       $ 0       $ 0       $ 655   

Interest rate swap agreements

     0         670         0         670   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities at fair value

   $ 655       $ 670       $ 0       $ 1,325   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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The following tables present a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at March 31, 2012 and 2011.

 

     Three Months Ended March 31,  
     2012      2011  
     Municipal
Securities
     Collateralized
Debt Obligations
     Partnership
Interest in a
Private Credit
Fund
     Municipal
Securities
    Collateralized
Debt Obligations
 
     (Amounts in thousands)  

Beginning Balance

   $ 0       $ 47,503       $ 10,008       $ 1,624      $ 55,692   

Realized gains included in earnings

     0         5,480         502         39        2,716   

Sales

     0         0         0         (1,663     0   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Ending Balance

   $ 0       $ 52,983       $ 10,510       $ 0      $ 58,408   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The amount of total gains for the period included in earnings attributable to assets still held at March 31

   $ 0       $ 5,480       $ 502       $ 0      $ 2,716   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the three months ended March 31, 2012 and 2011.

At March 31, 2012, the Company did not have any nonrecurring measurements of nonfinancial assets or nonfinancial liabilities.

6. Derivative Financial Instruments

The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts 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 the interest rate risk associated with the Company’s debts with fixed or floating rates.

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 became 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 $0.5 million and $0.7 million as of March 31, 2012 and December 31, 2011, respectively. The swap terminates on March 1, 2013.

 

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Fair value amounts, and gains and losses on derivative instruments

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:

 

    Liability Derivatives  
    March 31, 2012     December 31, 2011  
    (Amount in thousands)  

Non-hedging derivatives

   

Interest rate swap agreements - Other
liabilities

  $ 546      $ 670   

Equity contracts - Short-term investments
(Other liabilities)

    405        655   
 

 

 

   

 

 

 

Total derivatives

  $ 951      $ 1,325   
 

 

 

   

 

 

 

The Effect of Derivative Instruments on the Consolidated Statements of Operations

 

     Gain Recognized in Other
Comprehensive Income
 
     Three Months Ended March 31,  

Derivatives Contracts for Cash Flow Hedges

   2012      2011  
     (Amounts in thousands)  

Interest rate swap agreements - Other comprehensive income

   $     0       $  143   

 

     Gain Recognized in Income  
     Three Months Ended March 31,  

Derivatives Not Designated as Hedging Instruments

   2012      2011  
     (Amounts in thousands)  

Interest rate swap agreements - Other revenue

   $ 124       $ 431   

Equity contracts - Net realized investment gains

     1,217         2,472   
  

 

 

    

 

 

 

Total

   $ 1,341       $ 2,903   
  

 

 

    

 

 

 

Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy that is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset diversification throughout various industries. For additional disclosures regarding equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

7. Goodwill and Other Intangible Assets

There were no changes in the carrying amount of goodwill for the three months ended March 31, 2012. 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.

 

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The following table presents the components of other intangible assets as of March 31, 2012 and December 31, 2011.

 

     Gross Carrying
Amount
     Accumulated
Amortization
    Net Carrying
Amount
     Useful Lives  
     (Amounts in thousands)      (in years)  

As of March 31, 2012:

          

Customer relationships

   $ 51,755       $ (15,903   $ 35,852         11   

Trade names

     15,400         (2,085     13,315         24   

Software

     550         (550     0         2   

Technology

     4,300         (1,398     2,902         10   

Favorable leases

     1,725         (1,593     132         3   
  

 

 

    

 

 

   

 

 

    

Total intangible assets, net

   $ 73,730       $ (21,529   $ 52,201      
  

 

 

    

 

 

   

 

 

    

As of December 31, 2011:

          

Customer relationships

   $ 51,755       $ (14,676   $ 37,079         11   

Trade names

     15,400         (1,925     13,475         24   

Software

     550         (550     0         2   

Technology

     4,300         (1,290     3,010         10   

Favorable leases

     1,725         (1,540     185         3   
  

 

 

    

 

 

   

 

 

    

Total intangible assets, net

   $ 73,730       $ (19,981   $ 53,749      
  

 

 

    

 

 

   

 

 

    

Intangible assets are amortized on a straight-line basis over their useful lives. Intangible assets amortization expense was $1.5 million and $1.6 million for the three months ended March 31, 2012 and 2011, respectively. The following table presents the estimated future amortization expense related to intangible assets as of March 31, 2012:

 

Year Ending December 31,

   Amortization Expense  
     (Amounts in thousands)  

Remainder of 2012

   $ 4,612   

2013

     5,986   

2014

     5,980   

2015

     5,980   

2016

     5,980   

Thereafter

     23,663   
  

 

 

 

Total

   $ 52,201   
  

 

 

 

8. Share-Based Compensation

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, and is 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 inputs for grant-date assumptions and weighted-average fair values.

 

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Under its 2005 Equity Participation Plan (the “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:

 

     Grant Year  
     2012      2011      2010  

Three-year performance period ending December 31,

     2014         2013         2012   

Vesting shares, target (1)

     92,000         80,000         55,000   

Vesting shares, maximum (1)

     207,000         120,000         55,000   

 

(1)

2010 grant includes 10,000 shares of restricted stock.

The restricted stock units vest at the end of a three-year performance period beginning with the year of the grant, and then only if, and to the extent that, the Company’s cumulative underwriting income, and with respect to the 2012 grants only, target level of growth in net premiums written, during such three-year period achieves the threshold performance levels established by the Compensation Committee.

The fair value of each restricted share grant is determined based on the market price on the grant date. Compensation cost is recognized based on management’s best estimate that performance goals will be achieved. If such goals are not met, no compensation cost is recognized and any recognized compensation cost would be reversed. For the 2010 grant, the achievement of the performance condition set by the Compensation Committee was no longer considered probable, and previously recognized compensation cost was reversed as of December 31, 2011.

9. Income Taxes

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 percent 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 the three months ended March 31, 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.

 

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Table of Contents

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 2010 for federal taxes and 2003 through 2010 for California state taxes. Tax years 2005 through 2010 are currently under examination by the Internal Revenue Service. The Company is currently under examination by the California Franchise Tax Board (“FTB”) for tax years 2003 through 2010. The FTB has issued Notices of Proposed Assessments to the Company for tax years 2003 through 2006. The Company has filed protests with the FTB in response to these assessments and presented its case in a hearing before the FTB. No assessments have been received for tax years 2007 through 2010. Management believes that the resolution of these examinations and assessments will not have a material impact on the condensed consolidated financial statements.

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. 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.

At March 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 realizability 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 nature within the carryback and carryforward periods available under the tax law. Management considers the scheduled 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.

10. Contingencies

The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

 

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Table of Contents

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statements

Certain statements in this Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q and from those that may be expressed or implied by the forward-looking statements contained in this Quarterly Report on Form 10-Q and in other reports or public statements made by the Company.

Factors that could cause or contribute to such differences include, among others: the competition currently existing in the automobile insurance markets in California and the other states in which the Company operates; the cyclical and generally competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserves or other estimates; the accuracy and adequacy of the Company’s pricing methodologies; the Company’s success in managing its business in states outside of California; the impact of potential third party “bad-faith” legislation, changes in laws, regulations or new interpretation of existing laws and regulations, tax position challenges by the FTB, and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in states where the Company operates; the Company’s reliance on independent agents to market and distribute its policies; the investment yields the Company is able to obtain with its investments in comparison to recent yields and the market risks associated with the Company’s investment portfolio; the effect government policies may have on market interest rates; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters in the markets served by the Company; the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives; the Company’s ability to realize current deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other uncertainties, all of which are difficult to predict and many of which are beyond the Company’s control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods.

The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report, or statement. Investors should also understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company’s forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements. Any forward-looking statements should also be considered in light of the information provided in “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 and in Item 1A. Risk Factors in Part II - Other Information of this Quarterly Report on Form 10-Q.

OVERVIEW

A. General

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 weather and natural disasters on losses, general economic conditions, the general regulatory environment in 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 property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the Company’s ability to grow and retain business.

This section discusses some of the relevant factors that management considers in evaluating the Company’s performance, prospects, and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of management’s discussion and analysis, the Company’s condensed consolidated financial statements and notes thereto, and all other items contained within this Quarterly Report on Form 10-Q.

 

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Table of Contents

B. Business

The Company is primarily engaged in writing personal automobile insurance through 13 insurance subsidiaries (“Insurance Companies”). The Company also writes homeowners, commercial automobile and property, mechanical breakdown, fire, and umbrella insurance. These policies are mostly sold through independent agents who receive a commission for selling policies. The Company believes that it has thorough underwriting and claims handling processes that provide the Company with advantages over its competitors. The Company views its agent relationships and its underwriting and claims handling processes as its primary competitive advantages because they allow the Company to charge lower prices while realizing better margins than many competitors.

The Company operates primarily in the state of California, the only state in which it operated prior to 1990. The Company has since expanded its operations into the following states: Georgia and Illinois (1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001), New Jersey (2003), and Arizona, Pennsylvania, Michigan, and Nevada (2004). The direct premiums written during the three months ended March 31, 2012 and 2011 by state and line of business were:

Three Months Ended March 31, 2012

(Amounts in thousands)

 

     Private
Passenger Auto
    Homeowners     Commercial
Auto
    Other Lines     Total        

California

   $ 421,209      $ 56,736      $ 9,743      $ 14,930      $ 502,618        76.3

Florida

     41,717        (107     3,524        2,028        47,162        7.2

Texas

     16,169        1,387        2,131        6,026        25,713        3.9

New Jersey

     19,375        654        —          73        20,102        3.0

Other states

     45,409        10,432        1,792        5,879        63,512        9.6
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 543,879      $ 69,102      $ 17,190      $ 28,936      $ 659,107        100.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     82.5     10.5     2.6     4.4     100.0  

Three Months Ended March 31, 2011

(Amounts in thousands)

 

     Private
Passenger Auto
    Homeowners     Commercial
Auto
    Other Lines     Total        

California

   $ 414,237      $ 52,506      $ 19,368      $ 13,404      $ 499,515        75.8

Florida

     44,469        2,069        3,622        2,396        52,556        8.0

Texas

     16,499        269        1,263        4,490        22,521        3.4

New Jersey

     22,497        385        —          87        22,969        3.5

Other states

     47,310        7,631        1,628        4,984        61,553        9.3
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 545,012      $ 62,860      $ 25,881      $ 25,361      $ 659,114        100.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     82.7     9.5     3.9     3.9     100.0  

 

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Table of Contents

C. Regulatory and Litigation Matters

The Department of Insurance (“DOI”) in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies in their states. Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing, and other practices. The following table presents a summary of current financial and market conduct examinations:

 

State

  

Exam Type

  

Period Under Review

  

Status

NV   

Market Conduct

   Jan 2009 to Dec 2011   

Received an examination notice

GA   

Financial

   2007 to 2010   

Received final report in May 2012.

OK   

Market Conduct

   2008 to 2010   

Received final report in March 2012.

CA   

Financial

   2008 to 2010   

Received final report in January 2012.

IL   

Market Conduct

   Jul 2009 to Jun 2010   

Fieldwork completed. Awaiting final report.

OK   

Financial

   2008 to 2010   

Fieldwork began in May 2011.

During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company and none of the findings reported to date is expected to be material to the Company’s financial position.

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 California DOI has recently advised the Company that it is continuing to review this matter and it continues to question certain past practices. No final determination has been made by the California DOI on how it will proceed going forward. The Company anticipates that it will be advised by the California DOI in the near future as to how the California DOI intends to proceed. The Company denies the allegations in the 2010 NNC and believes that it has done nothing to warrant the penalties cited in the 2010 NNC.

In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. The California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee, which the California DOI contends is the use of an unapproved rate, rating plan or rating system. Further, the California DOI seeks to impose a penalty for each and every date on which the Company allegedly used a misleading advertisement alleged in the 2004 NNC. Finally, based upon the conduct alleged, the California DOI also contends that the Company acted fraudulently in violation of Section 704(a) of the California Insurance Code, which permits the California Commissioner of Insurance to suspend certificates of authority for a period of one year. The Company filed a Notice of Defense in response to the 2004 NNC. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company, denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. This matter was the subject of multiple continuations since the original Notice of Non-Compliance was issued in 2004. On June 7, 2011, the Company filed a number of motions, including motions designed to dispose of the 2004 NNC or to substantially pare it down. On January 31, 2012, the administrative law judge bifurcated the 2004 NNC, ordering separate hearings on (a) the California DOI’s order to show cause, in which the California DOI asserts false advertising allegations against the Company, and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI alleges that the Company used unlawful rates. On February 3, 2012, the administrative law judge submitted a proposed decision that dismissed the California DOI’s allegations that the Company used unlawful rates and recommended its adoption as the decision of the Insurance Commissioner. On March 30, 2012, the proposed decision was rejected by the Insurance Commissioner. The Company has challenged the rejection of the administrative law judge’s proposed decision in Los Angeles Superior Court. The hearing regarding the California DOI’s order to show cause and accusation has not been scheduled.

In the 2004 and 2010 NNC matters, the Company believes that no monetary penalties are warranted and intends to defend the issues vigorously. The Company has been subject to fines and penalties by the California DOI in the past due to alleged violations of the California Insurance Code. The largest and most recent of these was settled in 2008 for $300,000. However, prior settlement

 

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amounts are not necessarily indicative of the potential results in the current Notice of Non-Compliance matters. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the 2004 and 2010 NNC matters will be material to the Company’s financial position. The Company has accrued a liability for the estimated cost to defend itself in the regulatory matters described above.

The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

D. Critical Accounting Policies and Estimates

Reserves

Preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves. 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.

The Company also engages an independent actuarial consultant to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultant for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count, and average severity methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves as part of its reserve analysis. When deciding which method to use in estimating its reserves, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.

 

 

 

The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of business which have a long operating history.

 

 

 

The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.

 

 

 

The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company uses this method for losses and loss adjustment expenses.

 

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At March 31, 2012, the Company recorded its point estimate of $954.4 million in losses and loss adjustment expenses liabilities which include $344.9 million of incurred but not reported (“IBNR”) loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to March 31, 2012, 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.

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 the three months ended March 31, 2012, the Company reported unfavorable development of approximately $6 million on the 2011 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2011 totaled approximately $1 billion. The unfavorable development in 2012 is largely the result of re-estimates of California bodily injury losses which have experienced both higher average severities and more late reported claims (claim count development) than originally estimated at December 31, 2011.

For a further discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

Premiums

The Company’s insurance premiums are recognized as income ratably over the term of the policies and in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the consolidated 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 partially offset by investment income to related unearned premiums. To the extent that any of the Company’s lines of business become unprofitable, a premium deficiency reserve may be required. The remaining premium deficiency reserve for Florida homeowners operations was $1.2 million at March 31, 2012. The Company expects to complete its withdrawal from the Florida homeowners market by September 2012.

Investments

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-redeemable preferred stocks, is actively traded on national exchanges or trading markets, and is valued at the last transaction price on the balance sheet dates.

Fair Value of Financial Instruments

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 3 of Condensed 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, corporate equity securities, and exchange traded funds. Approximately 98% of the fair value of the financial instruments held at March 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 across different financial instruments. 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 for periods of 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 otherwise is not actively quoted.

 

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Income Taxes

At March 31, 2012, the Company’s deferred income taxes were in a net liability position materially due to deferred tax liabilities attributable to tax basis differences in the Company’s investment portfolio. These liabilities were partially offset by deferred tax assets related to unearned premiums, expense accruals, loss reserve discounting, deferred capital losses, and 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 that represent sources of future ordinary taxable income.

Management’s recoverability assessment with regard to its capital deferred tax assets is based on estimates of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of which would contribute to the realization of deferred tax benefits. The Company expects to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a portion of the unrealized loss positions at period end, are fully realizable at maturity. The Company has a long-term horizon for holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The Company also has significant unrealized gains in its investment portfolio which could be realized through asset dispositions, at management’s discretion. Further, the Company has the capability to generate additional realized capital gains by entering into a sale-leaseback transaction using one or more of its appreciated real estate holdings.

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 actions, 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.

The Company’s effective income tax rate for the year could be different from the effective tax rate for the three months ended March 31, 2012 and will be dependent on the Company’s profitability for the remainder of the year. The Company’s effective income tax rate can be affected by several factors. These generally include tax exempt investment income, other non-deductible expenses, investment gains and losses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate for the three months ended March 31, 2012 was 28.1%, compared to 24.3% for the same period in 2011. The increase in the effective tax rate is mainly due to an increase in taxable income relative to tax exempt investment income. The Company’s effective tax rate for the three months ended March 31, 2012 was lower than the statutory tax rate primarily as a result of tax exempt investment income earned. However, the effective tax rate for the entire year could differ from the rate for the three months.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets arise from 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 and other intangible assets for impairment. 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 its implied fair value. As of December 31, 2011, the fair value of the Company’s reporting units exceeded their carrying value. There are no triggering events indicating the carrying amount of goodwill exceeds its implied fair value as of March 31, 2012.

Contingent Liabilities

The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them and/or discloses them in the condensed notes to consolidated financial statements where required. The Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

 

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RESULTS OF OPERATIONS

Three Months Ended March 31, 2012 compared to Three Months Ended March 31, 2011

Revenue

Net premiums written for the three months ended March 31, 2012 were essentially the same as the corresponding period in 2011, while net premiums earned decreased by approximately $3 million from the corresponding period in 2011.

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure 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:

 

     Three Months Ended March 31,  
     2012     2011  
     (Amounts in thousands)  

Net premiums written

   $ 658,287      $ 658,217   

Change in unearned premium

     (22,475     (19,730
  

 

 

   

 

 

 

Net premiums earned

   $ 635,812      $ 638,487   
  

 

 

   

 

 

 

Expenses

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies’ loss ratio, expense ratio, and combined ratio determined in accordance with GAAP:

 

     Three Months Ended March 31,  
     2012     2011  

Loss ratio

     70.8     69.9

Expense ratio

     26.8     28.3
  

 

 

   

 

 

 

Combined ratio

     97.6     98.2
  

 

 

   

 

 

 

Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio was affected by unfavorable development of approximately $6 million and $1 million on prior accident years’ losses and loss adjustment expense reserves for the three months ended March 31, 2012 and 2011, respectively. Excluding the effect of estimated prior periods’ loss development, the loss ratio was 69.8% for each of the three month periods ended March 31, 2012 and 2011, respectively.

Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The improvement in the expense ratio in 2012 was mainly due to ongoing cost reduction efforts.

Combined ratio is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results.

Income tax expense was $28.6 million and $18.7 million for the three month periods ended March 31, 2012 and 2011, respectively. The increase resulted primarily from the increased income before income taxes compared to the corresponding period in 2011.

 

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Investments

The following table presents the investment results of the Company:

 

     Three Months Ended March 31,  
     2012     2011  
     (Amounts in thousands)  

Average invested assets at cost (1)

   $ 2,984,903      $ 3,033,779   

Net investment income(2)

    

Before income taxes

   $ 31,486      $ 35,096   

After income taxes

   $ 28,037      $ 31,214   

Average annual yield on investments(2)

    

Before income taxes

     4.2     4.6

After income taxes

     3.8     4.1

Net realized investment gains

   $ 52,663      $ 28,690   

 

(1)

Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

(2)

Net investment income and average annual yield decreased primarily due to the maturity and replacement of higher yielding investments, purchased when market interest rates were higher, with lower yielding investments purchased during the current low interest rate environment.

Included in net income are net realized investment gains of $52.7 million and $28.7 million for the three months ended March 31, 2012 and 2011, respectively. Net realized investment gains include gains of $49.3 million and $20.9 million for the three months ended March 31, 2012 and 2011, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net gains for the three months ended March 31, 2012 arose primarily from a $28.5 million increase in the market value of the Company’s equity securities and a $21.0 million increase in the market value of the Company’s fixed maturity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for the three months ended March 31, 2012. The primary cause of the gains on the Company’s equity securities was the overall improvement in the equity markets for the three months ended March 31, 2012.

Net Income

Net income was $73.4 million or $1.34 per diluted share and $58.2 million or $1.06 per diluted share in the three months ended March 31, 2012 and 2011, respectively. Diluted per share results were based on a weighted average of 54.9 million and 54.8 million shares in the three months ended March 31, 2012 and 2011, respectively. Basic per share results were $1.34 and $1.06 in the three months ended March 31, 2012 and 2011, respectively. Included in net income per share were net realized investment gains, net of income taxes, of $0.62 and $0.34 per share (basic and diluted) in the three months ended March 31, 2012 and 2011, respectively.

LIQUIDITY AND CAPITAL RESOURCES

A. Cash Flows

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 $431.9 million at March 31, 2012, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. 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 or for 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 the three months ended March 31, 2012 was essentially the same as the corresponding period in 2011. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders.

 

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The following table presents the estimated fair value of fixed maturity securities at March 31, 2012 by contractual maturity in the next five years:

 

     Fixed Maturities  
     (Amounts in thousands)  

Due in one year or less

   $ 59,866   

Due after one year through two years

     120,410   

Due after two years through three years

     53,799   

Due after three years through four years

     81,427   

Due after four years through five years

     79,410   
  

 

 

 
   $ 394,912   
  

 

 

 

B. Invested Assets

Portfolio Composition

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.

 

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The following table presents the composition of the total investment portfolio of the Company at March 31, 2012:

 

     Cost (1)      Fair Value  
     (Amounts in thousands)  

Fixed maturity securities:

     

U.S. government bonds and agencies

   $ 14,012       $ 14,181   

Municipal securities

     2,189,334         2,289,120   

Mortgage-backed securities

     31,247         34,914   

Corporate securities

     90,721         94,396   

Collateralized debt obligations

     39,247         52,983   
  

 

 

    

 

 

 
     2,364,561         2,485,594   
  

 

 

    

 

 

 

Equity securities:

     

Common stock:

     

Public utilities

     26,379         29,369   

Banks, trusts and insurance companies

     17,234         19,431   

Industrial and other

     321,482         336,171   

Non-redeemable preferred stock

     10,895         10,975   

Partnership interest in a private credit fund

     10,000         10,510   
  

 

 

    

 

 

 
     385,990         406,456   
  

 

 

    

 

 

 

Short-term investments

     227,340         227,196   
  

 

 

    

 

 

 

Total investments

   $ 2,977,891       $ 3,119,246   
  

 

 

    

 

 

 

 

(1)

Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

At March 31, 2012, 73.2% of the Company’s total investment portfolio at fair value and 91.8% 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, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. At March 31, 2012, 86.0% 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 equity investment in subprime lenders.

During the three months ended March 31, 2012, the Company recognized $52.7 million in net realized investment gains, which mainly include gains of $30.5 million related to equity securities and $21.1 million related to fixed maturity securities. Included in the gains were $28.5 million in gains due to changes in the fair value of the Company’s equity security portfolio and $21.0 million in gains due to changes in the fair value of the Company’s fixed maturity security portfolio, as a result of applying the fair value option.

Fixed maturity securities

Fixed maturity securities include debt securities, 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 maturity of the overall bond portfolio was 11.8 years (10.9 years including short-term instruments) at March 31, 2012. 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 maturity of the overall bond portfolio was 4.3 years (4.0 years including short-term instruments) at March 31, 2012, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified duration of the overall bond portfolio reflecting anticipated early calls was 3.5 years (3.2 years including short-term instruments) at March 31, 2012, including collateralized mortgage obligations with a modified duration of 2.4 years 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 rate, modified duration is considered a better indicator of price volatility than simple maturity alone.

 

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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 the average rating at December 31, 2011. To calculate the weighted-average credit quality ratings as disclosed throughout this Quarterly Report on Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Tax-exempt bond holdings are broadly diversified geographically. Taxable holdings consist principally of investment grade issues. At March 31, 2012, fixed maturity holdings rated below investment grade and non-rated bonds totaled $95.8 million and $13.3 million, respectively, at fair value, and represented 3.9% and 0.5%, respectively, of total fixed maturity securities. At December 31, 2011, fixed maturity holdings rated below investment grade and non-rated fixed maturity bonds totaled $95.8 million and $17.2 million, respectively, and represented 3.9% and 0.7%, respectively, of total fixed maturity securities.

The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at March 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 during the three months ended March 31, 2012, with 94.3% of fixed maturity securities at fair value experiencing no change in their overall rating. 4.1% of fixed maturity securities at fair value experienced downgrades during the period, partially offset by 1.6% in credit upgrades. The majority of the downgrades were slight and still within the investment grade portfolio, except for approximately $2.7 million at fair value that were downgraded to below investment grade during the quarter.

 

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     March 31, 2012  
     (Amounts in thousands)  
     AAA     AA(1)     A(1)     BBB(1)     Non-Rated/Other     Total
Fair
Value
 

U.S. government bonds and agencies:

            

Treasuries

   $ 8,698      $ —        $ —        $ —        $ —        $ 8,698   

Government agency

     5,483        —          —          —          —          5,483   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     14,181        —          —          —          —          14,181   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     100.0             100.0

Municipal securities:

            

Insured

     4,873        525,861        616,490        153,309        16,884        1,317,417   

Uninsured

     163,608        322,303        343,640        131,262        10,890        971,703   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     168,481        848,164        960,130        284,571        27,774        2,289,120   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     7.4     37.1     41.9     12.4     1.2     100.0

Mortgage-backed securities:

            

Agencies

     16,372        —          —          —          —          16,372   

Non-agencies:

            

Prime

     3,481        637        1,141        381        3,550        9,190   

Alt-A

     —          1,797        1,232        1,491        4,832        9,352   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     19,853        2,434        2,373        1,872        8,382        34,914   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     56.9     7.0     6.8     5.3     24.0     100.0

Corporate securities:

            

Communications

     —          —          —          6,773        —          6,773   

Consumer - cyclical

     —          —          —          —          100        100   

Consumer -non cyclical

     —          —          —          6,199        —          6,199   

Energy

     —          —          —          18,672        —          18,672   

Basic materials

     —          —          —          4,664        —          4,664   

Financial

     —          19,797        22,970        2,024        8,013        52,804   

Technology

     —          —          1,628        —          —          1,628   

Utilities

     —          —          —          3,122        434        3,556   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     —          19,797        24,598        41,454        8,547        94,396   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     0.0     21.0     26.1     43.9     9.0     100.0

Collateralized debt obligations:

            

Corporate - hybrid

     —          —          —          —          52,983        52,983   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     —          —          —          —          52,983        52,983   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
             100.0     100.0

Total

   $ 202,515      $ 870,395      $ 987,101      $ 327,897      $ 97,686      $ 2,485,594   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     8.1     35.0     39.7     13.2     4.0     100.0

 

(1)

Intermediate ratings are offered at each level (e.g., AA includes AA+, AA and AA-).

At March 31, 2012, the Company had $30.6 million, 1.2% of its fixed maturity portfolio, at fair value in U.S. government bonds and agencies and mortgage-backed securities (agencies). In August 2011, Standard and Poor’s downgraded the U.S. government’s long-term sovereign credit rating from AAA to AA+. This downgrade has triggered significant volatility in prices for a variety of investments. While Moody’s and Fitch affirmed their AAA ratings, they placed a negative outlook in November 2011 and warned of a potential downgrade if no long-term deficit agreement was reached over the next two years. The negative outlook reflects these rating agencies’ declining confidence that timely fiscal measures will be forthcoming to place U.S. public finances on a sustainable path and secure the AAA ratings. Standard and Poor’s affirmed the U.S. Treasury’s short-term credit rating of AAA indicating that the short-term capacity of the U.S. to meet its financial commitment on its outstanding obligations is strong. The Company understands that market participants continue to use rates of return on U.S. government debt as a risk-free rate. In addition, in the period after the downgrade, market participants continued to invest in U.S. Treasury securities and push the yield on U.S. Treasury securities even lower than before the downgrade.

 

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(1) Municipal Securities

The Company had $2.3 billion at fair value ($2.2 billion at amortized cost) in municipal bonds at March 31, 2012, of which $1.3 billion were insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was A+ at March 31, 2012.

At March 31, 2012, the bond insurers providing credit enhancement were Assured Guaranty Corporation and National Public Finance Guarantee Corporation, which covered 14.3% 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 BBB+. Most of the insured bonds’ ratings were investment grade and reflected the credit of underlying issuer. The remaining insured bonds’ credit ratings, which covered 1.5% of the insured municipal securities, were 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 estimated fair value of municipal bonds.

(2) Mortgage-Backed Securities

The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for $9.4 million and $9.8 million ($8.2 million and $8.3 million at amortized cost) of Alt-A mortgages at March 31, 2012 and December 31, 2011, 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 March 31, 2012, the Company had no holdings in commercial mortgage-backed securities.

The weighted-average rating of the Company’s Alt-A mortgage-backed securities was BB+ and the weighted-average rating of the entire mortgage-backed securities portfolio was A+ at March 31, 2012.

(3) Corporate Securities

Included in fixed maturity securities are $94.4 million of fixed rate corporate securities with a weighted-average rating of BBB+ and a duration of 3.0 years at March 31, 2012.

(4) Collateralized Debt Obligations

Included in fixed maturities securities are collateralized debt obligations of $53.0 million, which represent 1.7% of the total investment portfolio and had a duration of 0.9 years at March 31, 2012.

Equity securities

Equity holdings consist of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. The net gains due to changes in fair value of the Company’s equity portfolio during the three months ended March 31, 2012 were $28.5 million. The primary cause of the gains on the Company’s equity securities was the overall improvement in the equity markets.

The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At March 31, 2012, 13.0% of the total investment portfolio at fair value was held in equity securities, compared to 12.4% at December 31, 2011.

Short-term investments

At March 31, 2012, short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities and redeemable within one year.

C. Debt

Both a $120 million credit facility and a $20 million bank loan contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk based capital ratio. The Company is in compliance with all of its loan covenants.

 

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D. Regulatory Capital Requirement

Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to statutory policyholders’ surplus should not exceed 3.0 to 1. Based on the combined surplus of all the Insurance Companies of $1.5 billion at March 31, 2012, and net premiums written for the three months ended on that date of $2.6 billion, the ratio of premium writings to surplus was 1.7 to 1.

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risks

The Company is subject to various market risk exposures primarily due to its investing and borrowing activities. Primary market risk exposures are changes in interest rates, equity prices, and credit risk. Adverse changes to these rates and prices may occur due to changes in the liquidity of a market, or to changes in market perceptions of creditworthiness and risk tolerance. The following disclosure reflects estimates of future performance and economic conditions. Actual results may differ.

Overview

The Company’s investment policies define the overall framework for managing market and investment risks, including accountability and controls over risk management activities, and specify the investment limits and strategies that are appropriate given the liquidity, surplus, product profile, and regulatory requirements of the subsidiaries. Executive oversight of investment activities is conducted primarily through the Company’s investment committee. The Company’s investment committee focuses on strategies to enhance after-tax yields, mitigate market risks, and optimize capital to improve profitability and returns.

The Company manages exposures to market risk through the use of asset allocation, duration, and credit ratings. Asset allocation limits place restrictions on the total funds that may be invested within an asset class. Duration limits on the fixed maturities portfolio place restrictions on the amount of interest rate risk that may be taken. Comprehensive day-to-day management of market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon the acceptable boundaries established by investment policies.

 

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Credit risk

Credit risk is due to uncertainty in a counterparty’s ability to meet its obligations. Credit risk is managed by maintaining a high credit quality fixed maturities portfolio. As of March 31, 2012, the estimated weighted-average credit quality rating of the fixed maturities portfolio was AA-, at fair value, consistent with the average rating at December 31, 2011. Historically, the ten-year default rate per Moody’s for AA rated municipal bonds has been less than 1%. The Company’s municipal bond holdings, which represent 92.1% of its fixed maturity portfolio at March 31, 2012, at fair value, are broadly diversified geographically. 99.7% of municipal bond holdings are tax-exempt. The following table presents municipal bond holdings by state in descending order of holdings at fair value at March 31, 2012:

 

States

   Fair Value      Average
Rating
     (Amounts in thousands)       

Texas

   $ 339,771       AA-

California

     304,780       A

Florida

     189,046       A+

Illinois

     160,710       A

Washington

     124,146       AA-

Other states

     1,170,667       A+
  

 

 

    

Total

   $ 2,289,120      
  

 

 

    

The portfolio is broadly diversified among the states and the largest holdings are in populous states such as Texas and California. These holdings are further diversified primarily among cities, counties, schools, public works, hospitals, and state general obligations. Credit risk is addressed by limiting exposure to any particular issuer to ensure diversification.

Taxable fixed maturity securities represent 8.2% of the Company’s fixed maturity portfolio. 15.0% of the Company’s taxable fixed maturity securities were comprised of U.S. government bonds and agencies and mortgage-backed securities (agencies), which were rated AAA at March 31, 2012. 34.4% of the Company’s taxable fixed maturity securities, representing 2.8% of the total fixed maturity portfolio, were rated below investment grade. Below investment grade issues are considered “watch list” items by the Company, and their status is evaluated within the context of the Company’s overall portfolio and its investment policy on an aggregate risk management basis, as well as their ability to recover their investment on an individual issue basis.

Equity price risk

Equity price risk is the risk that the Company will incur losses due to adverse changes in the general levels of the equity markets.

At March 31, 2012, the Company’s primary objective for common equity investments is current income. The fair value of the equity investments consists of $385.0 million in common stocks and $11.0 million in non-redeemable preferred stocks, and $10.5 million in a partnership interest in a private credit fund. Common stock equity assets are typically valued for future economic prospects as perceived by the market. The Company invests more in the energy and utility sector relative to the S&P 500 Index.

Common stocks represent 12.3% of total investments at fair value. Beta is a measure of a security’s systematic (non-diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in the return of the market. The average Beta for the Company’s common stock holdings was 1.15 at March 31, 2012. Based on a hypothetical 25% or 50% reduction in the overall value of the stock market, the Company estimates that the fair value of the common stock portfolio would decrease by $110.7 million or $221.4 million, respectively.

Interest rate risk

Interest rate risk is the risk that the Company will incur a loss due to adverse changes in interest rates relative to the interest rate characteristics of interest bearing assets and liabilities. This risk arises from many of its primary activities, as the Company invests substantial funds in interest sensitive assets and issues interest sensitive liabilities. Interest rate risk includes risks related to changes in U.S. Treasury yields and other key benchmarks, as well as changes in interest rates resulting from the widening credit spreads and credit exposure to collateralized securities.

The value of the fixed maturity portfolio, which represents 79.7% of total investments at fair value, is subject to interest rate risk. As market interest rates decrease, the value of the portfolio increases and vice versa. A common measure of the interest

 

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sensitivity of fixed maturity assets is modified duration, a calculation that utilizes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate fluctuations.

The Company has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy resulted in a portfolio with a moderate duration. Bond investments made by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The decrease in municipal bond credit spreads in 2012 caused overall interest rates to decrease, which resulted in the decrease in the duration of the Company’s portfolio. Consequently, the modified duration of the bond portfolio reflecting anticipated early calls was 3.5 years at March 31, 2012 compared to 3.7 years at December 31, 2010. Given a hypothetical parallel increase of 100 basis or 200 basis points in interest rates, the Company estimates that the fair value of the bond portfolio at March 31, 2012 would decrease by $88.1 million or $176.2 million, respectively.

 

Item 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

As required by Securities and Exchange Commission Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this Quarterly Report on Form 10-Q. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company’s process for evaluating controls and procedures is continuous and encompasses constant improvement of the design and effectiveness of established controls and procedures and the remediation of any deficiencies which may be identified during this process.

PART II - OTHER INFORMATION

 

Item 1.

Legal Proceedings

The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.

There are no environmental proceedings arising under federal, state, or local laws or regulations to be discussed.

 

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Table of Contents

Item 1A.

Risk Factors

The Company’s business, results of operations, and financial condition are subject to various risks. These risks are described elsewhere in this Quarterly Report on Form 10-Q and in its other filings with the United States Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The risk factors identified in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 have not changed in any material respect.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

None

 

Item 3.

Defaults Upon Senior Securities

None

 

Item 4.

Mine Safety Disclosure

Not applicable.

 

Item 5.

Other Information

None

 

Item 6.

Exhibits

 

15.1

  

Report of Independent Registered Public Accounting Firm

15.2

  

Awareness Letter of Independent Registered Public Accounting Firm

31.1

  

Certification of Registrant’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

  

Certification of Registrant’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

  

Certification of Registrant’s Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.

32.2

  

Certification of Registrant’s Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.

101

  

The following financial information from the Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 2012, formatted in XBRL (Extensible Business Reporting Language) and furnished electronically herewith: (i) the Consolidated Balance Sheets; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Cash Flows; and (v) the Condensed Notes to the Consolidated Financial Statements.

 

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Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

MERCURY GENERAL CORPORATION

Date: May 2, 2012

 

By:

 

/s/ Gabriel Tirador

   

Gabriel Tirador

   

President and Chief Executive Officer

Date: May 2, 2012

 

By:

 

/s/ Theodore Stalick

   

Theodore Stalick

   

Vice President and Chief Financial Officer

 

33