Form 10-Q

 

 

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 June 30, 2009

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  ¨    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 July 31, 2009, the Registrant had issued and outstanding an aggregate of 54,769,713 shares of its Common Stock.

 

 

 


PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

 

     June 30,
2009
    December 31,
2008
 
ASSETS     

Investments:

    

Fixed maturities trading, at fair value (amortized cost $2,724,175; $2,728,471)

   $ 2,624,812      $ 2,481,673   

Equity securities trading, at fair value (cost $348,285; $403,773)

     258,813        247,391   

Short-term investments, at fair value (cost $94,574; $208,278)

     94,557        204,756   
                

Total investments

     2,978,182        2,933,820   

Cash

     194,710        35,396   

Receivables:

    

Premiums receivable

     256,004        268,227   

Premium notes

     27,410        25,699   

Accrued investment income

     36,634        36,540   

Other

     8,343        9,526   
                

Total receivables

     328,391        339,992   

Deferred policy acquisition costs

     181,132        200,005   

Fixed assets, net

     201,987        191,777   

Current income taxes

     —          43,378   

Deferred income taxes

     119,988        171,025   

Goodwill

     42,850        5,206   

Other intangible assets

     70,229        —     

Other assets

     24,402        29,596   
                

Total assets

   $ 4,141,871      $ 3,950,195   
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

Losses and loss adjustment expenses

   $ 1,070,003      $ 1,133,508   

Unearned premiums

     862,706        879,651   

Notes payable

     273,426        158,625   

Accounts payable and accrued expenses

     118,766        93,864   

Current income taxes

     9,576        —     

Other liabilities

     164,848        190,496   
                

Total liabilities

     2,499,325        2,456,144   
                

Commitments and contingencies

    

Shareholders’ equity:

    

Common stock without par value or stated value:

    

Authorized 70,000,000 shares; issued and outstanding 54,769,713 in 2009 and 54,763,713 shares in 2008

     72,030        71,428   

Accumulated other comprehensive loss

     (550     (876

Retained earnings

     1,571,066        1,423,499   
                

Total shareholders’ equity

     1,642,546        1,494,051   
                

Total liabilities and shareholders’ equity

   $ 4,141,871      $ 3,950,195   
                

See accompanying Notes to Consolidated Financial Statements.

 

2


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

 

     Three Months Ended June 30,
             2009                    2008        

Revenues:

     

Net premiums earned

   $ 659,211    $ 711,204

Net investment income

     36,212      38,995

Net realized investment gains

     99,862      36,496

Other

     694      1,202
             

Total revenues

     795,979      787,897
             

Expenses:

     

Losses and loss adjustment expenses

     445,463      489,545

Policy acquisition costs

     136,359      157,441

Other operating expenses

     51,364      43,169

Interest

     1,879      1,486
             

Total expenses

     635,065      691,641
             

Income before income taxes

     160,914      96,256

Income tax expense

     46,467      25,530
             

Net income

   $ 114,447    $ 70,726
             

Basic earnings per share (weighted average shares outstanding 54,769,713 in 2009 and 54,733,880 in 2008)

   $ 2.09    $ 1.29
             

Diluted earnings per share (weighted average shares 55,319,836 as adjusted by 550,123 for the dilutive effect of options in 2009 and 54,997,272 as adjusted by 263,392 for the dilutive effect of options in 2008)

   $ 2.07    $ 1.29
             

Dividends declared per share

   $ 0.58    $ 0.58
             

See accompanying Notes to Consolidated Financial Statements.

 

3


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

 

     Six Months Ended June 30,  
             2009                    2008          

Revenues:

     

Net premiums earned

   $ 1,325,274    $ 1,432,120   

Net investment income

     74,126      78,294   

Net realized investment gains (losses)

     181,176      (55,641

Other

     2,361      2,496   
               

Total revenues

     1,582,937      1,457,269   
               

Expenses:

     

Losses and loss adjustment expenses

     889,755      973,018   

Policy acquisition costs

     283,890      317,582   

Other operating expenses

     104,850      87,484   

Interest

     3,425      1,996   
               

Total expenses

     1,281,920      1,380,080   
               

Income before income taxes

     301,017      77,189   

Income tax expense

     89,917      10,424   
               

Net income

   $ 211,100    $ 66,765   
               

Basic earnings per share (weighted average shares outstanding 54,768,520 in 2009 and 54,731,897 in 2008)

   $ 3.85    $ 1.22   
               

Diluted earnings per share (weighted average shares 55,166,115 as adjusted by 397,595 for the dilutive effect of options in 2009 and 54,894,590 as adjusted by 162,693 for the dilutive effect of options in 2008)

   $ 3.83    $ 1.22   
               

Dividends declared per share

   $ 1.16    $ 1.16   
               

See accompanying Notes to Consolidated Financial Statements.

 

4


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Three Months Ended June 30,
             2009                    2008        

Net income

   $ 114,447    $ 70,726

Other comprehensive income, before tax:

     

Gains on hedging instrument

     490      713
             

Other comprehensive income, before tax

     490      713

Income tax expense related to gains on hedging instrument

     172      249
             

Comprehensive income, net of tax

   $ 114,765    $ 71,190
             

See accompanying Notes to Consolidated Financial Statements.

 

5


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Six Months Ended June 30,
             2009                    2008        

Net income

   $ 211,100    $ 66,765

Other comprehensive income, before tax:

     

Gains on hedging instrument

     502      269
             

Other comprehensive income, before tax

     502      269

Income tax expense related to gains on hedging instrument

     176      94
             

Comprehensive income, net of tax

   $ 211,426    $ 66,940
             

See accompanying Notes to Consolidated Financial Statements.

 

6


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Six Months Ended June 30,  
             2009                     2008          

Cash flows from operating activities:

    

Net income

   $ 211,100      $ 66,765   

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

    

Depreciation and amortization

     17,418        13,075   

Net realized investment (gains) losses

     (181,176     55,641   

Bond amortization, net

     2,218        3,643   

Excess tax benefit from exercise of stock options

     (3     (59

Decease in premiums receivable

     12,223        15,185   

Increase in premiums notes receivable

     (1,711     (2,088

Decrease in deferred policy acquisition costs

     18,873        3,851   

Decrease in unpaid losses and loss adjustment expenses

     (63,505     (82,983

Decrease in unearned premiums

     (16,945     (18,748

Decrease (increase) in income taxes

     103,818        (26,832

Increase (decrease) in accounts payable and accrued expenses

     19,119        (6,353

Decrease in trading securities in nature, net of realized gains and losses

     3,209        1,792   

Share-based compensation

     367        327   

Decrease in other payables

     (12,840     (9,265

Other, net

     (5,802     (1,018
                

Net cash provided by operating activities

     106,363        12,933   

Cash flows from investing activities:

    

Fixed maturities available for sale in nature:

    

Purchases

     (232,116     (412,022

Sales

     123,275        329,915   

Calls or maturities

     111,710        124,949   

Equity securities available for sale in nature:

    

Purchases

     (143,665     (238,349

Sales

     155,652        176,757   

Net increase in payable for securities

     4,127        14,335   

Net decrease in short-term investments

     110,268        53,481   

Purchase of fixed assets

     (20,656     (29,757

Sale of fixed assets

     357        776   

Business acquisition, net of cash acquired

     (115,488     —     

Other, net

     2,784        6,913   
                

Net cash (used in) provided by investing activities

     (3,752     26,998   

Cash flows from financing activities:

    

Dividends paid to shareholders

     (63,533     (63,491

Excess tax benefit from exercise of stock options

     3        59   

Proceeds from stock options exercised

     233        495   

Proceeds from bank loan

     120,000        18,000   
                

Net cash provided by (used in) financing activities

     56,703        (44,937
                

Net increase (decrease) in cash

     159,314        (5,006

Cash:

    

Beginning of the period

     35,396        48,245   
                

End of the period

   $ 194,710      $ 43,239   
                

Supplemental disclosures of cash flow information:

    

Interest paid during the period

   $ 3,689      $ 2,769   

Income taxes (received) paid during the period

   $ (13,903   $ 37,061   

Net realized (losses) gains from sale of investments

   $ (42,877   $ 15,007   

See accompanying Notes to Consolidated Financial Statements.

 

7


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of Presentation

The consolidated financial statements include the accounts of Mercury General Corporation (“Mercury General”) and its directly and indirectly wholly owned insurance and non-insurance subsidiaries (collectively, the “Company”). The insurance subsidiaries are: Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Mercury Insurance Company of Illinois, Mercury Insurance Company of Georgia, Mercury Indemnity Company of Georgia, Mercury National Insurance Company, American Mercury Insurance Company, American Mercury Lloyds Insurance Company (“AML”), Mercury County Mutual Insurance Company (“MCM”), Mercury Insurance Company of Florida and Mercury Indemnity Company of America. The non-insurance subsidiaries are: Mercury Select Management Company, Inc. (“MSMC”), American Mercury MGA, Inc., Concord Insurance Services, Inc., Mercury Insurance Services, LLC, Mercury Group, Inc., AIS Management LLC, Auto Insurance Specialists, LLC (“AIS”) and PoliSeek AIS Insurance Solutions, Inc. (“PoliSeek”). AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact, MSMC. MCM is not owned by the Company, but is controlled through a management contract and therefore its results are included in the consolidated financial statements. The 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 significant intercompany balances and transactions have been eliminated.

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 and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates and assumptions in the preparation of these consolidated financial statements relate to losses and loss adjustment expenses and evaluation of the recoverability of deferred tax assets. Actual results could differ materially from those estimates (See Note 1 “Significant Accounting Policies” of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008).

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 necessary to present fairly the Company’s financial position at June 30, 2009 and the results of operations, comprehensive income and cash flows for the periods presented have been made. Operating results and cash flows for the six-month period ended June 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

Certain reclassifications have been made to the prior-period balances to conform to the current-period presentation.

2. Recently Adopted Accounting Standards

Effective January 1, 2009, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141(R)”). While SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141, “Business Combinations” (“SFAS No. 141”), that the acquisition method (referred to as the purchase method in SFAS No. 141) be used for all business combinations and for an acquirer to be identified for each business combination, SFAS No. 141(R) significantly changes the accounting for business combinations in a number of areas including the treatment of contingent consideration, contingencies, and acquisition costs. SFAS No. 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. This replaces the cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. Additionally, SFAS No. 141(R) requires costs incurred to effect the acquisition to be recognized separately from the acquisition rather than included in the cost allocated to the assets acquired and liabilities assumed. SFAS No. 141(R) requires the acquirer to recognize goodwill as of the acquisition date, measured as a residual, which in most types of business combinations will result in measuring goodwill as the excess of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree at the acquisition date over the fair values of the identifiable net assets acquired. In addition, under SFAS No. 141(R), changes in deferred tax asset valuation allowances and acquired income tax uncertainties in a business combination after the measurement period impact income tax expense. Effective January 1, 2009, MCC acquired all of the membership interests of AIS Management LLC, a California limited liability company, which is the parent company of AIS and PoliSeek. The acquisition was accounted for in accordance with SFAS No. 141(R). The adoption of SFAS No. 141(R) did not have a material impact on the Company’s consolidated financial statements.

In March 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (“SFAS No. 161”). SFAS No. 161 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”) by requiring expanded disclosures about

 

8


an entity’s derivative instruments and hedging activities, but does not change the scope of accounting of SFAS No. 133. SFAS No. 161 requires increased qualitative disclosures such as how and why an entity is using a derivative instrument; how the entity is accounting for its derivative instrument and hedged item under SFAS No. 133 and its related interpretations; and how the instrument affects the entity’s financial position, financial performance, and cash flows. Quantitative disclosures should include information about the fair value of the derivative instrument, including gains and losses, and should contain more detailed information about the location of the derivative instrument in the entity’s financial statements. Credit-risk disclosures should include information about the existence and nature of credit-risk-related contingent features included in derivative instruments. Credit-risk-related contingent features can be defined as those that require entities, upon the occurrence of a credit event such as a credit rating downgrade, to settle derivative instruments or post collateral. The Company adopted SFAS No. 161 on January 1, 2009. The adoption of SFAS No. 161 did not have a material impact on the Company’s consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position Financial Accounting Standard 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No.142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 is effective for fiscal years beginning after December 15, 2008. The Company adopted FSP FAS 142-3 on January 1, 2009. The adoption of FSP FAS 142-3 did not have a material impact on the Company’s consolidated financial statements.

On April 1, 2009, the FASB issued FASB Staff Position Financial Accounting Standard 141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies” (“FSP FAS 141(R)-1”). Under FSP FAS 141(R)-1, an acquirer is required to recognize at fair value an asset acquired or liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be determined during the measurement period. The Company adopted FSP FAS 141(R)-1 on January 1, 2009. The adoption of FSP FAS 141(R)-1 did not have a material impact on the Company’s consolidated financial statements.

Effective for the interim reporting period ending June 30, 2009, the Company adopted FASB Staff Position Financial Accounting Standard 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP FAS 157-4”). FSP FAS 157-4 clarifies that when there has been a significant decrease in the volume and level of activity for an asset or liability, some transactions may not be orderly. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for an asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). The adoption of FSP FAS 157-4 did not have a material impact on the Company’s consolidated financial statements.

Effective for the interim reporting period ending June 30, 2009, the Company adopted FASB Staff Position Financial Accounting Standard 107-1 and Accounting Principles Board (“APB”) 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP FAS 107-1 and APB 28-1”). FSP FAS 107-1 and APB 28-1 amends SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. FSP FAS 107-1 and APB 28-1 also amends APB Opinion No. 28, “Interim Financial Reporting,” to require related disclosures in summarized financial information at interim reporting periods. FSP FAS 107-1 and APB 28-1 is effective for the interim reporting period ending June 30, 2009. The adoption of FSP FAS 107-1 and APB 28-1 did not have a material impact on the Company’s consolidated financial statements.

Effective for the interim reporting period ended June 30, 2009, the Company adopted SFAS No. 165, “Subsequent Events” (“SFAS No. 165”). SFAS No. 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The adoption of SFAS No. 165 did not have a material impact on the Company’s consolidated financial statements.

 

9


3. Financial Instruments

The financial instruments recorded in the consolidated balance sheet include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. Due to their short-term maturity, the carrying amounts of receivables and accounts payable approximate their fair market values. The following table sets forth the carrying amounts and estimated fair values of other financial instruments at June 30, 2009 and December 31, 2008.

 

     June 30, 2009    December 31, 2008
     Carrying
Value
   Fair
Value
   Carrying
Value
   Fair
Value
     (Amounts in thousands)

Assets

           

Investments

   $ 2,978,182    $ 2,978,182    $ 2,933,820    $ 2,933,820

Interest rate swap agreements

   $ 10,523    $ 10,523    $ 14,394    $ 14,394

Liabilities

           

Interest rate swap agreements

   $ 1,509    $ 1,509    $ 1,348    $ 1,348

Equity contracts

   $ 1,779    $ 1,779    $ 2,803    $ 2,803

Secured notes

   $ 138,000    $ 138,000    $ —      $ —  

Unsecured note

   $ 135,426    $ 130,620    $ 158,625    $ 146,758

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

Investments

Effective January 1, 2008, the Company adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”) and elected to apply the fair value option to all investments (available for sale fixed maturity and equity securities, and short-term investments) existing at the time of adoption and similar securities acquired subsequently. Therefore, these securities are carried at fair value. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5 of Notes to Consolidated Financial Statements.

Interest rate swap agreements and equity contracts

The fair value of interest rate swap agreements reflects the estimated amounts that the Company would pay or receive at June 30, 2009 and December 31, 2008 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 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 Notes to Consolidated Financial Statements.

Secured notes

The fair value of the Company’s $120 million and $18 million secured notes is estimated based on assumptions and inputs, such as reset rates, for similar termed notes. The carrying amounts of the Company’s secured notes approximate their fair market value.

Unsecured note

The fair value of the Company’s publicly traded $125 million unsecured notes is based on the unadjusted quoted price for identical notes in active markets.

4. Fair Value of Financial Instruments

Gains and losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option are included in net realized investment gains (losses) in the Company’s consolidated statements of operations, while interest and dividend income on the investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as 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 reflects gains (losses) due to changes in fair value for items measured at fair value pursuant to election of the fair value option under SFAS No. 159:

 

     Three Months ended June 30,     Six Months ended June 30,  
             2009                    2008                     2009                     2008          
     (Amounts in thousands)  

Fixed maturity securities

   $ 46,419    $ 51      $ 147,434      $ (313

Equity securities

     77,198      (13,554     66,919        (69,857

Short-term investments

     —        36,077        (3     (543
                               

Total

   $ 123,617    $ 22,574      $ 214,350      $ (70,713
                               

 

10


In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”). SFAS No. 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to irrevocably be accounted for at fair value, with changes in fair value recognized in the statement of operations. The Company adopted SFAS No. 155 on January 1, 2007. As SFAS No. 159 incorporates accounting and disclosure requirements that are similar to those of SFAS No. 155; effective January 1, 2008, SFAS No. 159 rather than SFAS No. 155 is applied to the Company’s fair value elections for hybrid financial instruments.

5. Fair Value Measurement

SFAS No. 157 establishes 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 (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. Financial assets and financial liabilities recorded on the consolidated balance sheets at fair value are categorized based on the reliability of inputs to the valuation techniques as follows:

Level 1 Financial assets and financial liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in active markets that the Company can access.

Level 2 Financial assets and financial liabilities whose values are based on the following:

a) Quoted prices for similar assets or liabilities in active markets;

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

c) Valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability.

Level 3 Financial assets and financial liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect the Company’s estimates of the assumptions that market participants would use in valuing the financial assets and financial liabilities.

The availability of observable inputs varies by instrument. In situations where fair value is based on internally developed pricing models or inputs that are unobservable in the market, the determination of fair value requires more judgment. The degree of judgment exercised by the Company in determining fair value is typically greatest for instruments categorized in Level 3. In certain cases, the 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. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers 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.

Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities

The Company obtained unadjusted fair values on approximately 99% of its portfolio from an independent pricing service. For less than 1% of its portfolio, the Company obtained specific unadjusted broker quotes generally from one knowledgeable outside security broker to determine the fair value of each security. For 0.1% of its portfolio, where the Company was not able to obtain fair values from the independent pricing service or outside security brokers, management performed discounted cash flow price modeling.

 

11


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 realistic fair values are used in pricing the investment portfolio.

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

Common stock; Other: 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.

Short-term bonds/Money market accounts: 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 realistic fair values are used in pricing the investment portfolio.

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

Mortgage-backed securities: Comprised of securities that are collateralized by residential mortgage loans. 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 June 30, 2009 and December 31, 2008, the Company had no holdings in commercial mortgage-backed securities.

Corporate securities: 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.

Collateralized debt obligations: Valued based on observable inputs, such as underlying debt instruments and their appropriate benchmark spread, for identical or similar assets in active markets.

Redeemable and 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 discounted cash flow price modeling performed by management with 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.

Municipal securities: Comprised of certain distressed municipal securities for which valuation is based on models that are widely accepted in the financial services industry and require projections of future cash flows that are not market observable. Included in this category are $2.9 million of auction rate securities (“ARS”). ARS are valued based on a discounted cash flow model with certain inputs that are significant to the valuation, but are not market observable.

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 and losses in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.

 

12


Assets Measured at Fair Value

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2009, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:

 

     June 30, 2009
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Balance as of
June 30, 2009
     (Amounts in thousands)

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 10,099    $ —      $ —      $ 10,099

Municipal securities

     —        2,343,571      2,856      2,346,427

Mortgage-backed securities

     —        148,167      —        148,167

Corporate securities

     —        86,281      —        86,281

Redeemable preferred stock

     —        444         444

Collateralized debt obligations

     —        33,394         33,394

Equity securities:

           

Common stock:

           

Public utilities

     35,726      —        —        35,726

Banks, trusts and insurance companies

     13,291      —        —        13,291

Industrial and other

     197,922      —        —        197,922

Non-redeemable preferred stock

     —        11,874      —        11,874

Short-term bonds/Money market accounts

     94,535      —        —        94,535

Equity contracts

     22      —        —        22

Interest rate swap agreements

     —        10,523      —        10,523
                           

Total assets at fair value

   $ 351,595    $ 2,634,254    $ 2,856    $ 2,988,705
                           

Liabilities

           

Equity contracts

   $ 1,779    $ —      $ —      $ 1,779

Interest rate swap agreements

     —        1,509      —        1,509
                           

Total liabilities at fair value

   $ 1,779    $ 1,509    $ —      $ 3,288
                           

 

13


The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:

 

     December 31, 2008
     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Other
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Balance as of
December 31, 2008
     (Amounts in thousands)

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 9,898    $ —      $ —      $ 9,898

Municipal securities

     —        2,184,684      2,984      2,187,668

Mortgage-backed securities

     —        202,326      —        202,326

Corporate securities

     —        65,727      —        65,727

Collateralized debt obligations

        13,120         13,120

Redeemable preferred stock

     —        2,934      —        2,934

Equity securities:

           

Common stock:

           

Public utilities

     39,148      —        —        39,148

Banks, trusts and insurance companies

     11,328      —        —        11,328

Industrial and other

     186,294      —        —        186,294

Non-redeemable preferred stock

     —        10,621      —        10,621

Short-term bonds/Money market accounts

     204,678      —        —        204,678

Equity contracts

     78      —        —        78

Interest rate swap agreements

     —        14,394      —        14,394
                           

Total assets at fair value

   $ 451,424    $ 2,493,806    $ 2,984    $ 2,948,214
                           

Liabilities

           

Equity contracts

   $ 2,803    $ —      $ —      $ 2,803

Interest rate swap agreements

     —        1,348      —        1,348

Other

     2,492      —        —        2,492
                           

Total liabilities at fair value

   $ 5,295    $ 1,348    $ —      $ 6,643
                           

As required by SFAS No. 157, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is 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).

 

14


The following table provides a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at June 30, 2009. There were no Level 3 financial assets and financial liabilities held at June 30, 2008.

 

     Three Months Ended
June 30, 2009
 
     Fixed Maturities  
     (Amounts in thousands)  

Fair value at March 31, 2009

   $ 3,264   

Realized losses included in net realized investment gains

     (408
        

Fair value at June 30, 2009

   $ 2,856   
        

The amount of total losses for the period included in earnings attributable to assets held at June 30, 2009

   $ (408
        
     Six Months Ended
June 30, 2009
 
     Fixed Maturities  
     (Amounts in thousands)  

Fair value at December 31, 2008

   $ 2,984   

Realized losses included in net realized investment gains

     (128
        

Fair value at June 30, 2009

   $ 2,856   
        

The amount of total losses for the period included in earnings attributable to assets held at June 30, 2009

   $ (128
        

On January 1, 2009, the Company adopted SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities measured on a nonrecurring basis. At June 30, 2009, the Company had no applicable nonrecurring measurements of nonfinancial assets and 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 entered into to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are entered into to manage interest rate risk associated with the Company’s loans with fixed or floating rates.

Fair value hedge

Effective January 2, 2002, the Company entered into an interest rate swap of a 7.25% fixed rate obligation on a $125 million senior note for a floating rate of LIBOR plus 107 basis points. The swap is designated as a fair value hedge and qualifies for the shortcut method under SFAS No. 133. In accordance with SFAS No. 133, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in current earnings. The Company includes the gain or loss on the hedged item in the same line item—interest expense—as the offsetting loss or gain on the related interest rate swaps as follows:

 

     Three Months Ended
June 30, 2009
   Six Months Ended
June 30, 2009

Income Statement Classification

   Gains/(Losses)
on Swap
    Gains/(Losses)
on Loan
   Gains/(Losses)
on Swap
    Gains/(Losses)
on Loan
     (Amounts in thousands)

Other revenue

   $ (2,472   $ 2,472    $ (3,871   $ 3,871

As of June 30, 2009, the total fair market value of the Company’s interest rate swap designated as a fair value hedge was $10.5 million.

 

15


Cash flow hedge

On March 3, 2008, the Company entered into an interest rate swap of a floating LIBOR rate on an $18 million bank loan for a fixed rate of 3.75%. The swap is designated as a cash flow hedge and qualifies for the shortcut method under SFAS No. 133. In accordance with SFAS No. 133, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income (“OCI”) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.

As of June 30, 2009, the total fair market value of the Company’s interest rate swap designated as a cash flow hedge was $(0.8) million.

Fair value amounts, and gains and losses on derivative instruments

The following tables provide the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains and losses in the consolidated statements of operations:

Fair Values of Derivative Instruments

 

     Asset Derivatives    Liability Derivatives
     June 30, 2009    December 31, 2008    June 30, 2009    December 31, 2008
     (Amounts in thousands)
     Balance Sheet
Location
   Fair
Values
   Balance Sheet
Location
   Fair
Values
   Balance Sheet
Location
   Fair
Values
   Balance Sheet
Location
   Fair
Values

Derivatives designated as hedging instruments under SFAS No. 133

                       

Interest rate contracts

   Other assets    $ 10,523    Other assets    $ 14,394    Other liabilities    $ 846    Other liabilities    $ 1,348
                                       

Total derivatives designated as hedging instruments under SFAS No. 133

      $ 10,523       $ 14,394       $ 846       $ 1,348
                                       

Derivatives not designated as hedging instruments under SFAS No. 133

                       

Interest rate contract

               Other liabilities    $ 663      

Equity contracts

   Investments    $ 22    Investments    $ 78    Other liabilities      1,779    Other liabilities    $ 2,803
                                       

Total derivatives not designated as hedging instruments under SFAS No. 133

      $ 22       $ 78       $ 2,442       $ 2,803
                                       

Total derivatives

      $ 10,545       $ 14,472       $ 3,288       $ 4,151
                                       

The Effect of Derivative Instruments on the Statements of Operations

for Three Months and Six Months Ended June 30, 2009 and 2008

 

Derivatives in SFAS No. 133 Fair Value
Hedging Relationships

   Location of Gain or (Loss)
Recognized in Income on
Derivatives
   Amount of Gain or (Loss) Recognized in Income on Derivatives
      Three Months Ended June 30,    Six Months Ended June 30,
              2009                    2008                    2009                    2008        
          (Amounts in thousands)

Interest rate contracts

   Interest expense    $ 1,629    $ 1,024    $ 3,348    $ 2,890

 

Derivatives in SFAS No. 133
Cash Flow Hedging
Relationships

   Amount of Gain or (Loss)
Recognized in OCI on Derivatives
   Location of Gain or (Loss)
Reclassified from Accumulated
OCI
into Income
   Amount of Gain or (Loss)
Reclassified from Accumulated OCI
into Income
   Three Months
Ended June 30,
   Six Months
Ended June 30,
      Three Months
Ended June 30,
   Six Months
Ended June 30,
   2009    2008    2009    2008       2009    2008    2009    2008
     (Amounts in thousands)         (Amounts in thousands)

Interest rate contracts

   $ 490    $ 713    $ 502    $ 269    Other revenue    $ —      $ —      $ —      $ —  

 

16


Derivatives Not Designated as
Hedging Instruments under
SFAS No. 133

   Location of Gain or (Loss)
Recognized in Income on Derivatives
   Amount of Gain or (Loss)
Recognized in Income on
Derivatives
      Three Months
Ended June 30,
   Six Months
Ended June 30,
      2009    2008    2009     2008
          (Amounts in thousands)

Interest rate contract

   Other revenue    $ 1,469    $ —      $ (663   $ —  

Equity contracts

   Net realized investment gains      2,971      4,247      6,409        8,176
                               

Total

      $ 4,440    $ 4,247    $ 5,746      $ 8,176
                               

The interest rate contract not designated as hedging instrument under SFAS No. 133 is an interest rate swap that the Company entered into on February 6, 2009. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate of a $120 million credit facility which was used for the acquisition of AIS.

Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy. This 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 allocation throughout various industries.

For additional disclosures regarding equity contracts, see Note 5 of Notes to Consolidated Financial Statements.

7. Acquisition

Effective January 1, 2009, the Company acquired all of the membership interests of AIS Management LLC, a California limited liability company, which is the parent company of AIS and PoliSeek. AIS is a major producer of automobile insurance in the state of California and was the Company’s largest independent broker. This preexisting relationship did not require measurement at the date of acquisition as there was no settlement of executory contracts between the Company and AIS as part of the acquisition.

Goodwill of $38 million arising from the acquisition consists largely of the efficiencies and economies of scale expected from combining the operations of the Company and AIS, and is expected to be fully deductible for income tax purposes in 2009 and future years.

The total cost of the acquisition has been allocated to the assets acquired and the liabilities assumed based upon estimates of their fair values at the acquisition date. The following table summarizes the consideration paid for AIS and the allocation of the purchase price.

 

     January 1, 2009  
     (Amounts in thousands)  

Consideration

  

Cash

   $ 120,000   
        

Fair value of total consideration transferred

   $ 120,000   
        

Acquisition-related costs

   $ 2,000   
        

Recognized amounts of identifiable assets acquired and liabilities assumed

  

Financial assets

   $ 12,875   

Property, plant, and equipment

     2,915   

Favorable leases

     1,725   

Trade names

     15,400   

Customer relationships

     51,200   

Software & technology

     4,850   

Liabilities assumed

     (6,608
        

Total identifiable net assets

     82,357   

Goodwill

     37,643   
        

Total

   $ 120,000   
        

 

17


The weighted-average amortization periods for intangible assets with definite lives, by asset class, are: 24 years for trade names, 11 years for customer relationships, 10 years for technology, 2 years for software and 3 years for lease agreements.

A contingent consideration arrangement requires the Company to pay the former owner of AIS up to an undiscounted maximum amount of $34.7 million. The potential undiscounted amount of all future payments that the Company could be required to make under the contingent consideration arrangement is between $0 and $34.7 million. Based on the projected performance of the AIS business over the next two years, the Company does not expect to pay the contingent consideration. That estimate is based on significant inputs that are not observable in the market, including management’s projections of future cash flows, which SFAS No. 157 refers as Level 3 inputs. Key assumptions in determining the estimated contingent consideration include (a) a discount rate of 10.7% and (b) a decline in revenues ranging from 4% to 5%. As of August 4, 2009, the estimates for the contingent consideration arrangement, the range of outcomes, and the assumptions used to develop the estimates have not changed.

The fair value of the financial assets acquired includes cash, prepaid expenses and receivables from customers. The acquired receivables of $6.6 million at fair value were fully collected during the three-month period ended March 31, 2009. The fair value of the liabilities assumed includes accounts payable and other accrued liabilities.

The following table reflects the amount of revenue and net income of AIS, which are included in the Company’s consolidated statement of operations for the three-month and six-month periods ended June 30, 2009, and the revenue of the combined entity for the three-month and six-month periods ended June 30, 2008, had the acquisition date been January 1, 2008.

 

     Three Months ended June 30,
2008 (pro forma)
   Six Months ended June 30,
2008 (pro forma)
     (Amounts in thousands)

Combined entity

     

Revenues (2)

   $ 791,004    $ 1,463,009

Net income (1)

     N/A      N/A
     Three Months ended June 30,
2009
   Six Months ended June 30,
2009
     (Amounts in thousands)

AIS

     

Revenues (3)

   $ 3,201    $ 5,956

Net income (3)

   $ 530    $ 673
 
  (1) 2008 pro forma net income for the combined entity is not available, as AIS was previously consolidated into its parent company and separate financial statements were not available.

 

  (2) Includes net premiums earned, net investment income, net realized investment gains/losses and commission revenues.

 

  (3) Excludes intercompany transactions with the Company’s insurance subsidiaries.

8. Intangible Assets

The following table reflects the components of intangible assets:

 

     June 30, 2009    December 31, 2008
     Gross Carrying
Amount
   Accumulated
Amortization
    Net Carrying
Amount
   Gross Carrying
Amount
   Accumulated
Amortization
   Net Carrying
Amount
     (Amounts in thousands)    (Amounts in thousands)

Customer relationships

   $ 51,640    $ (2,426   $ 49,214    $ —      $ —      $ —  

Trade names

     15,400      (321     15,079      —        —        —  

Software and technology

     4,850      (353     4,497      —        —        —  

Favorable leases

     1,725      (286     1,439      —        —        —  
                                          
   $ 73,615    $ (3,386   $ 70,229    $ —      $ —      $ —  
                                          

 

18


Intangible assets are amortized on a straight-line basis over their weighted average lives. Intangible assets amortization expense was $1.7 million for the three-month period ended June 30, 2009 and $3.4 million for the six-month period ended June 30, 2009. The following table outlines the estimated future amortization expense related to intangible assets as of June 30, 2009:

 

Year Ended December 31,

   (Amounts in thousands)

2009

   $ 3,406

2010

     6,812

2011

     6,358

2012

     6,144

2013

     5,969

Thereafter

     41,540

9. Goodwill

There are no changes in the carrying amount of goodwill for the three-month period ended June 30, 2009. The changes in the carrying amount of goodwill for the six-month period ended June 30, 2009 are as follows:

 

     Six Months ended June 30, 2009
     Balance as of
January 1, 2009
   Acquisitions    Purchase
price
adjustments
   Balance as of
June 30, 2009
     (Amounts in thousands)

Goodwill

   $ 41,557    $ —      $ 1,293    $ 42,850

The purchase price adjustments are the result of additional information obtained in conjunction with the finalization of the purchase price allocation as of March 31, 2009. Goodwill is reviewed for impairment on an annual basis and between annual tests if indicators of potential impairment exist. No indications of impairment were identified during any of the periods presented.

10. Share-Based Compensation

The Company accounts for share-based compensation in accordance with SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), using the modified prospective transition method. Under this transition method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). 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 only those shares expected to vest. The fair value of stock option awards is estimated using the Black-Scholes option pricing model.

11. Income Taxes

The Company accounts for uncertainty in income taxes in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 provides guidance on financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return related to uncertainties in income taxes. FIN No. 48 prescribes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. 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.

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 2008 for federal taxes and 2001 through 2008 for California state taxes.

There were no material changes to the total amount of unrecognized tax benefits related to tax uncertainties during the six months ended June 30, 2009. The Company does not expect any changes in such unrecognized tax benefits to have any significant impact on its consolidated financial statements within the next 12 months. The Company recognizes interest and assessed penalties related to unrecognized tax benefits as part of income taxes.

 

19


The Company is under examination by the California Franchise Tax Board for tax years 2001 through 2005. The taxing authority has proposed significant adjustments to the Company’s California tax liabilities. Management does not believe that the ultimate outcome of this examination will have a material impact on the Company’s financial position. However, an unfavorable outcome may have a material impact on the Company’s results of operations in the period of such resolution.

The Company accounts for current and deferred income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recorded with respect to temporary differences in the accounting treatment of items for financial reporting purposes and for income tax purposes. Where, in management’s judgment and based on the weight of all available evidence, it is more likely than not that some amount of recorded deferred tax assets will not be realized, a valuation allowance is established for the portion that is not realizable.

At June 30, 2009, the Company’s deferred income taxes were in a net asset position primarily as a result of the fair value declines in the investment portfolio during 2008, which resulted from extreme volatility in the capital markets and a widening of credit spreads beyond historic norms. Realization of deferred tax assets is dependent on generating sufficient taxable income of an appropriate nature to offset tax losses. 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 avoid losing the full benefits of its deferred tax assets. As a result of significant increases in the value of the Company’s securities portfolio during the three months ended June 30, 2009, the Company reversed a valuation allowance of $2.2 million recognized at March 31, 2009. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.

12. Contingencies

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages, which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations; however, none is expected to be material to the Company’s financial position. For a discussion of the Company’s pending material litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

13. Recently Issued Accounting Standards

In April 2009, the FASB issued Staff Position Financial Accounting Standard 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2 and FAS 124-2”). FSP FAS 115-2 and FAS 124-2 amends the other-than-temporary impairment guidance in U.S. GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. As the Company adopted SFAS No. 159 and elected to apply the fair value option to all available for sale investments, FSP FAS 115-2 and FAS 124-2 is not applicable to the Company.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 168”). SFAS No. 168 establishes the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the Securities and Exchange Commission under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. SFAS No. 168 is effective for the interim reporting period ending September 30, 2009. The Company is assessing the impact of adopting SFAS No. 168 on the Company’s consolidated financial statements.

14. Subsequent Events

The Company evaluated subsequent events through August 4, 2009, the date the financial statements were issued, and noted no significant matters to be disclosed.

 

20


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

I. 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, natural disasters, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates, 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 ability of the Company to grow and retain business. Additionally, with the adoption of SFAS No. 159, changes in the fair value of the investment portfolio are reflected in the consolidated statements of operations, which may result in volatility of earnings, particularly in times of high volatility in the capital markets.

The Company utilizes standard industry measures to report operating results that may not be presented in accordance with GAAP. Included within Management’s Discussion and Analysis of Financial Condition and Results of Operations is a non-GAAP financial measure, net premiums written, which represents the premiums charged on policies issued during a fiscal period less any reinsurance. The measure is not intended to replace, and should be read in conjunction with, the Company’s GAAP financial results and is reconciled to the most directly comparable GAAP measure, net premiums earned, below in Results of Operations.

B. Operations

The Company generates its revenues through the issuance of insurance policies, primarily covering personal automobiles and dwellings through 13 insurance subsidiaries (“Insurance Companies”). The Company also offers mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. These policies are mostly sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling policies. The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins than many competitors. The Company operates primarily in 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). Direct premiums written during the six-month period ended June 30, 2009 by state and line of business were:

 

     Six Months ended June 30, 2009  
     Private Passenger
Auto
    Commercial
Auto
    Homeowners     Other
Lines
    Total        
     (Amounts in thousands)  

California

   $ 863,279      $ 36,481      $ 101,201      $ 26,549      $ 1,027,510      78.5

Florida

     70,169        7,535        6,986        3,208        87,898      6.7

Texas

     35,977        3,716        791        8,376        48,860      3.7

New Jersey

     40,467        —          —          48        40,515      3.1

Other states

     81,000        3,764        8,171        12,161        105,096      8.0
                                              

Total

   $ 1,090,892      $ 51,496      $ 117,149      $ 50,342      $ 1,309,879      100
                                              
     83.3     3.9     9.0     3.8     100  

The Company also generates income from its investment portfolio. Approximately $74.1 million in pre-tax investment income was generated during the six-month period ended June 30, 2009 on average investments of approximately $3.2 billion, at cost, for the six-month period ended June 30, 2009, compared to $78.3 million pre-tax investment income during the corresponding period in 2008 on average investments of approximately $3.5 billion, at cost, for the six-month period ended June 30, 2008. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.

The Company’s operating results have allowed it to consistently generate positive cash flow from operations, which was approximately $106.4 million and $12.9 million for the six-month periods ended June 30, 2009 and 2008, respectively. Cash flow from operations has historically been used to pay shareholder dividends and to help support growth.

 

21


II. Results of Operations

Three Months Ended June 30, 2009 compared to Three Months Ended June 30, 2008

A. Revenue

Net premiums earned and net premiums written for the three-month period ended June 30, 2009 decreased approximately 7.3% and 6.8%, respectively, from the corresponding period in 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.

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 income 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 Company net premiums written to net premiums earned:

 

     Three Months Ended June 30,
     2009    2008
     (in thousands)

Net premiums written

   $ 637,405    $ 684,177

Decrease in net unearned premiums

     21,806      27,027
             

Net premiums earned

   $ 659,211    $ 711,204
             

B. Profitability

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

 

    Three Months ended June 30,  
    2009     2008  

Loss ratio

  67.6   68.8

Expense ratio

  28.5   28.2
           

Combined ratio

  96.1   97.0
           

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio was affected by positive development of approximately $31 million and adverse development of approximately $9 million on prior periods’ loss reserves for the three-month periods ended June 30, 2009 and 2008, respectively. Excluding the effect of prior accident years’ loss development, the loss ratio was 72.3% and 67.6% for the three-month periods ended June 30, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years’ loss development is primarily due to increased loss severity and lower average premiums earned per policy, partially offset by lower loss frequency.

The expense ratio is determined by matching expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The expense ratio slightly increased primarily due to the impact of the amortization of AIS deferred commissions, which is described below.

The combined ratio of losses and expenses 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. The Company’s underwriting performance contributed approximately $26 million of income (approximately $5 million of loss when excluding prior accident periods reserve development) and approximately $21 million of income (approximately $30 million of income when excluding prior accident periods reserve development) to the Company’s results of operations before income tax expense for the three-month periods ended June 30, 2009 and 2008, respectively.

Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. As AIS is now a wholly-owned subsidiary, commissions paid are no longer deferrable. During the three-month period ended June 30, 2009, the amortization of deferred commissions offset by deferrable direct sales cost impacted the statement of operations by $3 million. The Company expects no material impact after June 30, 2009.

 

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C. Investments

The following table summarizes the investment results of the Company:

 

     Three Months ended June 30,  
     2009     2008  
     (Amounts in thousands)  

Average invested assets at cost (1)

   $ 3,195,308      $ 3,455,387   

Net investment income:

    

Before income taxes

   $ 36,212      $ 38,995   

After income taxes

   $ 32,557      $ 34,441   

Average annual yield on investments:

    

Before income taxes

     4.5     4.5

After income taxes

     4.1     4.0

Net realized investment gains

   $ 99,862      $ 36,496   
 
  (1) Fixed maturities at amortized cost, and equities and short-term investments at cost.

Included in net income are net realized investment gains of $99.9 million for the three-month period ended June 30, 2009 compared with net realized investment gains of $36.5 million for the three-month period ended June 30, 2008. Net realized investment gains include gains of $123.6 million for the three-month period ended June 30, 2009 due to changes in the fair value of total investments measured at fair value pursuant to SFAS No. 159 compared with $22.6 million for the three-month period ended June 30, 2008. The gains during the three-month period ended June 30, 2009 arise from the market value improvements on the Company’s fixed maturity and equity securities. During the three-month period ended June 30, 2009, the Company recorded approximately $46.4 million and $77.2 million in gains due to changes in the fair value of its fixed maturity portfolio and equity portfolio, respectively. The primary cause of the significant gains in fair value of equity securities was the overall improvement in the equity markets, which saw a growth of approximately 15.2% in the S&P 500 Index during the three-month period ended June 30, 2009.

The income tax expenses for the three-month periods ended June 30, 2009 and 2008 were $46.5 million and $25.5 million, respectively. The increase resulted primarily from changes in the fair value of the investment portfolio.

Six Months Ended June 30, 2009 compared to Six Months Ended June 30, 2008

A. Revenue

Net premiums earned and net premiums written in the six-month period ended June 30, 2009 decreased approximately 7.5% and 7.4%, respectively, from the corresponding period in 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.

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 income 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 Company net premiums written to net premiums earned:

 

     Six Months Ended June 30,
     2009    2008
     (in thousands)

Net premiums written

   $ 1,308,297    $ 1,413,443

Decrease in net unearned premiums

     16,977      18,677
             

Net premiums earned

   $ 1,325,274    $ 1,432,120
             

 

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B. Profitability

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

 

     Six Months ended June 30,  
             2009                     2008          

Loss ratio

   67.2   67.9

Expense ratio

   29.3   28.3
            

Combined ratio

   96.5   96.2
            

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio was affected by positive development of approximately $38 million and adverse development of approximately $17 million on prior periods’ loss reserves for the six-month periods ended June 30, 2009 and 2008, respectively. Excluding the effect of prior accident years’ loss development, the loss ratio was 70.0% and 66.8% for the six-month periods ended June 30, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years’ loss development is primarily due to increased loss severity and lower average premiums earned per policy, partially offset by lower loss frequency.

The expense ratio is determined by matching expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The expense ratio increased primarily due to an accrual for a reduction in workforce during the three-month period ended March 31, 2009 and the impact of the amortization of AIS deferred commissions, both of which are described below.

The combined ratio of losses and expenses 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. The Company’s underwriting performance contributed approximately $47 million of income (approximately $9 million of income when excluding prior accident periods reserve development) and approximately $54 million of income (approximately $71 million of income when excluding prior accident periods reserve development) to the Company’s results of operations before income tax expense for the six-month periods ended June 30, 2009 and 2008, respectively.

To improve profitability, during the three-month period ended March 31, 2009, the Company implemented several cost reduction programs, including a salary freeze, a suspension of the employee 401(k) matching program, and a workforce reduction of approximately 360 employees (7% of workforce) primarily located in California. As a result of the workforce reduction, an $8 million expense was recorded ($5 million to losses and loss adjustment expenses, $3 million to other operating expenses) during the three-month period ended March 31, 2009. The annualized cost savings from these cost reduction programs are expected to be over $20 million, which began to be realized in the three-month period ended June 30, 2009.

Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. As AIS is now a wholly-owned subsidiary, commissions paid are no longer deferrable. During the six-month period ended June 30, 2009, the amortization of deferred commissions offset by deferrable direct sales cost impacted the statement of operations by $15 million. The Company expects no material impact after June 30, 2009.

C. Investments

The following table summarizes the investment results of the Company:

 

     Six Months ended June 30,  
     2009     2008  
     (Amounts in thousands)  

Average invested assets at cost (1)

   $ 3,229,138      $ 3,480,177   

Net investment income:

    

Before income taxes

   $ 74,126      $ 78,294   

After income taxes

   $ 65,970      $ 68,805   

Average annual yield on investments:

    

Before income taxes

     4.6     4.5

After income taxes

     4.1     4.0

Net realized investment gains (losses)

   $ 181,176      $ (55,641
 
  (1) Fixed maturities at amortized cost, and equities and short-term investments at cost.

 

24


Included in net income are net realized investment gains of $181.2 million for the six-month period ended June 30, 2009 compared with net realized investment losses of $55.6 million for the six-month period ended June 30, 2008. Net realized investment gains include gains of $214.4 million for the six-month period ended June 30, 2009 due to changes in the fair value of total investments measured at fair value pursuant to SFAS No. 159 compared with losses of $70.7 million for the six-month period ended June 30, 2008. The gains during the six-month period ended June 30, 2009 arise from the market value improvements on the Company’s fixed maturity and equity securities. During the six-month period ended June 30, 2009, the Company recorded approximately $147.4 million and $66.9 million in gains due to changes in the fair value of its fixed maturity portfolio and equity portfolio, respectively. The primary cause of the significant gains in the Company’s equity portfolio was due to the large allocation to energy related stocks. Energy related stocks experienced a significant growth in value more than that of the overall stock market, which saw a slight growth of approximately 1.8% in the S&P 500 Index.

The income tax expenses for the six-month periods ended June 30, 2009 and 2008 were $89.9 million and $10.4 million, respectively. The increase resulted primarily from changes in the fair value of the investment portfolio.

III. Liquidity and Capital Resources

A. Cash Flows

The principal sources of funds for the Insurance Companies are premiums, sales and maturities of invested assets and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments.

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 $289.3 million at June 30, 2009, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

Net cash provided from operating activities in the six-month period ended June 30, 2009 was $106.4 million, an increase of $93.4 million over the corresponding period in 2008. This increase was primarily due to additional operating cash flows from AIS and a decrease in losses and loss adjustment expenses paid during the six-month period ended June 30, 2009 compared with the corresponding period in 2008. The Company has utilized the cash provided from operating activities primarily for the development of information technology such as the NextGen and Mercury First computer systems and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $235.0 million, were primarily reinvested by the Company in high grade fixed maturity securities.

The following table shows the estimated fair value of fixed maturity securities at June 30, 2009 by contractual maturity in the next five years:

 

     Fixed maturities
     (Amounts in thousands)

Due in one year or less

   $ 24,177

Due after one year through two years

     22,692

Due after two years through three years

     31,258

Due after three years through four years

     86,783

Due after four years through five years

     139,509
      
   $ 304,419
      

Effective January 1, 2009, the Company acquired AIS for $120 million. The acquisition was financed by a $120 million credit facility that is secured by municipal bonds held as collateral. The credit facility calls for the collateral requirement to be greater than the loan amount. The collateral requirement is calculated as the fair market value of the municipal bonds held as collateral multiplied by the advance rates, which vary based on the credit quality and duration of the assets held and range between 75% and 100% of the fair value of each bond. The loan matures on January 1, 2012 with interest payable at a floating rate of LIBOR rate plus 125 basis points. In addition, the Company may be required to pay up to $34.7 million over the next two years as additional consideration for the AIS acquisition. The Company plans to fund that portion of the purchase price, if necessary, from cash on hand and cash flow from operations. On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on the loan for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is not designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change.

 

25


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 believes that this strategy maintains the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a recognized market risk and asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.

The following table sets forth the composition of the total investment portfolio of the Company at June 30, 2009 and December 31, 2008:

 

     June 30, 2009    December 31, 2008
     Cost (1)    Fair Value    Cost (1)    Fair Value
     (Amounts in thousands)

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 9,922    $ 10,099    $ 9,633    $ 9,898

States, municipalities and political subdivisions

     2,409,548      2,346,427      2,370,879      2,187,668

Mortgage-backed securities

     162,166      148,167      216,483      202,326

Corporate securities

     93,251      86,281      77,097      65,727

Redeemable preferred stock

     49,288      33,838      54,379      16,054
                           
     2,724,175      2,624,812      2,728,471      2,481,673
                           

Equity securities:

           

Common stock:

           

Public utilities

     30,223      35,726      32,293      39,148

Banks, trusts and insurance companies

     19,316      13,291      20,451      11,328

Industrial and other

     277,747      197,922      330,030      186,294

Non-redeemable preferred stock

     20,999      11,874      20,999      10,621
                           
     348,285      258,813      403,773      247,391
                           

Short-term investments

     94,574      94,557      208,278      204,756
                           

Total investments

   $ 3,167,034    $ 2,978,182      3,340,522      2,933,820
                           
 
  (1) Fixed maturities at amortized cost, and equities and short-term investments at cost.

At June 30, 2009, approximately 78.6% of the Company’s total investment portfolio at fair value and 89.1% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Shorter duration redeemable preferred stocks and collateralized mortgage obligations together represented 6.1% of the Company’s total investment portfolio at fair value. Equity holdings consist of perpetual preferred stocks and dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. At June 30, 2009, short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any material direct equity investment in subprime lenders.

During the six-month period ended June 30, 2009, the Company recognized approximately $181.2 million in net realized investment gains, which include approximately $148.2 million and $26.6 million related to fixed maturity securities and equity securities, respectively. Included in the gains were $147.4 million and $66.9 million in gains due to changes in the fair value of the Company’s fixed maturity portfolio and equity security portfolio, respectively, measured at fair value pursuant to SFAS No. 159. Partially offsetting the gain due to changes in the fair value of the Company’s equity security portfolio was approximately $40.6 million in loss from the sale of equity securities.

 

26


Fixed maturity securities

Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy resulted in a portfolio with a moderate duration. The nominal average maturity of the overall bond portfolio, including short-term investments, was 12.9 years at June 30, 2009, which reflects a portfolio 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, including short-term investments, was approximately 8.8 years, 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 6.1 years at June 30, 2009, including collateralized mortgage obligations with modified durations of approximately 1.6 years and short-term investments that carry no duration. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in interest rates; modified duration is considered a better indicator of price volatility than simple maturity alone.

Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-. To calculate the weighted-average credit quality ratings as disclosed throughout this Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At June 30, 2009, bond holdings rated below investment grade and non rated bonds totaled $107.3 million and $39.7 million, respectively, at fair value, and represented approximately 4.1% and 1.5%, respectively, of total fixed maturity securities. At December 31, 2008, bond holdings of lower than investment grade and non rated bonds totaled $55.4 million and $49.5 million, respectively, and represented approximately 2.2% and 2.0%, respectively, of total fixed maturity securities.

The following table presents the credit quality rating of the Company’s fixed maturity portfolio by types of security at June 30, 2009 at fair value. 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 six-month period ended June 30, 2009, with 72.0% of fixed maturity securities at fair value experiencing no change in their overall rating. Approximately 26.0% experienced downgrades during the period, offset by approximately 2.0% in credit upgrades. The majority of the downgrades were due to continued downgrading of the monoline insurance carried on much of the municipal holdings. The majority of the downgrades was slight and still within the investment grade portfolio and only approximately $14.7 million at fair value was downgraded to below investment grade during the quarter, allowing the Company to maintain a high overall credit rating on its fixed maturity securities.

 

27


     June 30, 2009        
     AAA     AA     A     BBB     Non Rated/Other     Total  
     (Amounts in thousands)        

U.S. government bonds and agencies:

            

Treasuries

   $ 6,826      $ —        $ —        $ —        $ —        $ 6,826   

Government agency

     3,273        —          —          —          —          3,273   
                                                

Total

     10,099        —          —          —          —          10,099   
                                                
     100.0             100.0

Municipal securities:

            

Insured (1)

     2,220        541,213        652,359        98,643        27,485        1,321,920   

Uninsured

     291,199        326,431        196,599        154,516        55,762        1,024,507   
                                                

Total

     293,419        867,644        848,958        253,159        83,247        2,346,427   
                                                
     12.5     37.0     36.2     10.8     3.5     100.0

Mortgage-backed securities:

            

Agencies

     113,843        —          —          —          —          113,843   

Non-agencies:

            

Prime

     10,495        714        611        3,055        4,326        19,201   

Alt-A

     2,998        5,834        1,545        2,293        2,453        15,123   
                                                

Total

     127,336        6,548        2,156        5,348        6,779        148,167   
                                                
     85.9     4.4     1.5     3.6     4.6     100.0

Corporate securities:

            

Financial

     4,401        11,022        16,720        11,902        12,176        56,221   

Energy

     —          —          —          5,660        8,874        14,534   

Communications

     —          —          —          6,268        —          6,268   

Utilities

     —          —          —          3,490        2,089        5,579   

Basic materials

     —          —          —          3,624        —          3,624   

Consumer - cyclical

     —          —          —          —          55        55   
                                                

Total

     4,401        11,022        16,720        30,944        23,194        86,281   
                                                
     5.1     12.7     19.4     35.9     26.9     100.0

Redeemable preferred stock:

            

Corporate - Hybrid (CDO)

     —          —          —          —          33,394        33,394   

Redeemable preferred stock

     —          —          —          —          444        444   
                                                

Total

     —          —          —          —          33,838        33,838   
                                                
             100.0     100.0

Total

   $ 435,255      $ 885,214      $ 867,834      $ 289,451      $ 147,058      $ 2,624,812   
                                                
     16.6     33.7     33.1     11.0     5.6     100.0

 

(1) Insured municipal bonds based on underlying ratings: AAA: $11,111, AA: $368,288, A: $650,861, BBB: $104,136, Non rated/Other: $187,524

 

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1. Municipal securities

The Company had approximately $2.3 billion at fair value ($2.4 billion at amortized cost) in municipal bonds at June 30, 2009, with an unrealized loss of $63.1 million which represents 63.5% of the unrealized losses in the entire fixed maturity portfolio. Approximately half of the municipal bond positions are insured by bond insurers. For insured municipal bonds that have underlying ratings, the weighted-average rating was AA- at June 30, 2009.

The following table shows the Company’s insured municipal bond portfolio by bond insurer at June 30, 2009 and at December 31, 2008.

 

     June 30, 2009    December 31, 2008

Municipal bond insurer

   Rating (1)    Fair value    Rating (1)    Fair value
     (Amounts in thousands)

MBIA

   BBB    $ 677,963    BBB    $ 606,301

AMBAC (2)

   BB      215,380    BBB      193,701

FSA

   AA      213,062    AA      205,249

ASSURED GTY

   AA      40,927    AA      16,664

XLCA

   CC      40,621    CCC      38,393

CIFG

   CCC      16,441    B      16,278

ACA

   NR      14,365    NR      13,899

RADIAN

   BB      14,265    BBB      15,155

FGIC

   NR      5,098    CCC      9,048

Other

   N/A      83,798    N/A      81,283
                   
      $ 1,321,920       $ 1,195,971
                   
 
  (1) Management’s estimate of average of ratings issued by Standard & Poor’s, Moody’s and Fitch.

 

  (2) Downgraded to CC subsequent to June 30, 2009.

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, avoiding 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.

At June 30, 2009, municipal securities included auction rate securities. The Company owned $2.9 million and $3.0 million at fair value of auction rate securities at June 30, 2009 and December 31, 2008, respectively. Auction rate securities were valued based on a discounted cash flow model with certain inputs that were not observable in the market, to which SFAS No. 157 refers as Level 3 inputs.

2. Mortgage-backed securities

The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for approximately $15.1 million and $16.3 million ($19.7 million and $20.0 million amortized cost) of Alt-A mortgages at June 30, 2009 and December 31, 2008, 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 June 30, 2009, the Company had no holdings in commercial mortgage-backed securities.

The weighted-average rating of the Company’s Alt-A mortgages is A and the weighted-average rating of the entire mortgage backed securities portfolio is AA+.

3. Corporate securities

Included in the fixed maturity securities are $86.3 million of fixed rated corporate securities which have a duration of 4.8 years and a weighted-average rating of BBB+.

 

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4. Redeemable preferred stock

Included in fixed maturities securities are redeemable preferred stocks, which represent approximately 1% of the total investment portfolio at June 30, 2009, and had a weighted-average rating of less than investment grade.

Equity securities

Equity holdings consist of non-redeemable preferred stocks and common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. The net gain due to changes in fair value of the Company’s equity portfolio during the six-month period ended June 30, 2009 was $66.9 million. The primary cause of the significant gains in the Company’s equity portfolio was due to the large allocation to energy related stocks. During the six-month period ended June 30, 2009, energy related stocks experienced a significant growth in value more than that of the overall stock market, which saw a slight growth of approximately 1.8% in the S&P 500 Index.

The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At June 30, 2009, 8.7% of the total investment portfolio at fair value was held in equity securities, compared to 8.4% at December 31, 2008.

Short-term investments

At June 30, 2009, short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities redeemable on a daily or weekly basis.

C. 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 $1.4 billion at June 30, 2009, and net premiums written for the twelve months ended on that date of $2.6 billion, the ratio of premium writings to surplus was 1.9 to 1.

IV. Regulatory and Litigation Matters

The Department of Insurance (“DOI”) in each state in which the Company operates conducts periodic financial and market conduct examinations of the Company’s insurance subsidiaries domiciled within the respective state. The following table provides a summary of current financial and market conduct examinations:

 

  State  

  

Exam Type

  

Period Under Review

  

Status

CA    Rating & Underwriting    2004 to 2007    Field work has been completed. Awaiting final report.
NJ    Market Conduct    Sept 2007 to Aug 2008    Field work has been completed. Awaiting final report.
OK    Financial    2005 to 2007    Report was issued in May 2009
FL    Market Conduct    Sept 2005 to Dec 2006    Report was issued in June 2009
TX    Financial    2005 to 2008    Data submitted and field work is pending.

No material findings have been noted in the examinations above.

In March 2006, the California DOI issued an Amended Notice of Non-Compliance (“NNC”) to the NNC originally issued in February 2004 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. Through this action, 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 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 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. A hearing before the administrative law judge has been set to start on September 14, 2009.

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will

 

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rule against the Company is probable. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may, but is not likely to, have a material impact on the Company’s quarterly results of operations; however, it is not expected to be material to the Company’s financial position. For a further discussion of the Company’s pending material regulatory matters and litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

V. Critical Accounting Policies and Estimates

A. Reserves

The preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves as required by SFAS No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”), and SFAS No. 5, “Accounting for Contingencies” (“SFAS No. 5”). 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 all 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 can 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 independent actuarial consultants 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 actuarial consultants for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss development, average severity and claim count development methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves and industry claims data 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 one 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 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 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 paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company primarily uses this method for loss adjustment expenses because specific case reserves are generally not established for loss adjustment expenses.

In states with little operating history where there are insufficient claims data to prepare a reserve analysis relying solely on Company historical data, the Company generally projects ultimate losses using industry average loss data or expected loss ratios. As the Company develops an operating history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development methods. The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous similar catastrophes.

At June 30, 2009, the Company recorded its point estimate of approximately $1,070.0 million in losses and loss adjustment expenses liability which includes approximately $373.6 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 which occurred on or prior to June 30, 2009 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 provision.

 

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The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires reduction for previously reported accident years, positive 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, negative development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For the six-month period ended June 30, 2009, the Company reported positive development of approximately $38 million on the 2008 and prior accident years’ loss and loss adjustment expense reserves which at December 31, 2008 totaled approximately $1.1 billion. The positive loss development was almost entirely from the California operations and resulted primarily from decreases in the personal automobile loss severity estimates for the 2008 and 2007 accident years and fewer late reported claims than originally anticipated for the 2008 accident year.

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, 2008.

B. Premiums

The Company complies with SFAS No. 60 in recognizing revenue on insurance policies written. The Company’s insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums, net of investment income. To the extent that any of the Company’s lines of business become substantially unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business.

C. Investments

Beginning January 1, 2008, all of the Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required by SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), as amended, and SFAS No. 159. Prior to January 1, 2008, the Company’s fixed maturity and equity investment portfolios were classified either as “available for sale” or “trading” and carried at fair value under SFAS No. 115, as amended. The Company adopted SFAS No. 157 and SFAS No. 159 as of January 1, 2008. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges or trading markets, and were valued at the last transaction price on the balance sheet date. Changes in fair value of the investments are reflected in net realized investment gains or losses in the consolidated statements of operations as required under SFAS No. 115, as amended, and SFAS No. 159.

D. Fair Value of Financial Instruments

Certain financial assets and financial liabilities are recorded at fair value. 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. The fair values of the Company’s financial instruments are generally based on, or derived from, executable bid prices. In the case of financial instruments transacted on recognized exchanges, the observable prices represent quotations for completed transactions from the exchange on which the financial instrument is principally traded.

The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipalities, certain corporate and other debt securities, corporate equity securities, and exchange traded funds. Over 99% of the fair value of the financial instruments held at June 30, 2009 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 in a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.

Certain financial instruments that the Company holds or may acquire may lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced 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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E. Income Taxes

At June 30, 2009, the Company’s deferred income taxes were in a net asset position primarily as a result of the fair value declines in the investment portfolio in recent months, which resulted from extreme volatility in the capital markets and a widening of credit spreads beyond historic norms. 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 is based on estimates of anticipated capital gains, available capital gains realized in prior years that could be utilized through carryback, and tax-planning strategies available to generate future taxable capital gains, all 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 significant portion of the unrealized loss positions at year-end, are not due to default risk. Thus, the principal amounts are believed to be 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 has prior years’ realized capital gains available to offset realized capital losses, via the filing of carryback refund claims. The Company also has 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 properties of its appreciated real estate holdings. Finally, the Company has an established history of generating capital gain premiums earned through its common stock call option program. Based on the continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and the Company’s favorable track record in generating net capital gains from this program in both upward and downward markets, management believes it will be able to generate sufficient amounts of option premium capital gains (more than sufficient to offset any losses on the underlying stocks employed in the program) on a consistent, long term basis.

The Company has the capability to implement these 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 will enable management to use its discretion 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 full benefits of its deferred tax assets. Thus, as a result of the Company’s strategies and an improvement in the fair values of our investments, a $2.2 million valuation allowance recognized at March 31, 2009 was reversed at June 30, 2009. 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.

F. Goodwill

Goodwill represents the excess of amounts paid for acquiring businesses over the fair value of the net assets acquired. The Company annually evaluates goodwill for impairment using widely accepted valuation techniques to estimate the fair value of its reporting units. The Company also reviews its goodwill for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill may exceed its implied fair value.

G. Contingent Liabilities

The Company has known, and may have unknown, potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the notes to the consolidated financial statements if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the ultimate outcome of contingent liabilities, an unfavorable result may have a material impact on the Company’s quarterly results of operations; however, it is not expected to be material to the Company’s financial position.

VI. Forward-Looking Statements

Certain statements in this report on Form 10-Q that are not historical facts constitute “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 Form 10-Q and from those that may be expressed or implied by the forward-looking statements.

 

33


Factors that could cause or contribute to such differences include, among others: the competition currently existing in the automobile insurance markets in states where the Company does business; the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates; the accuracy and adequacy of the Company’s pricing methodologies; a successful integration of the operations of AIS and the achievement of the synergies and revenue growth from the acquisition of AIS; 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 or regulations, tax position challenges by the California Franchise Tax Board, and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the timing of premium rate changes for the Company’s private passenger automobile policies; the performance of and general market risk associated with the Company’s investment portfolio, including the impact of current economic conditions on the Company’s market and investment portfolio; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; court decisions and 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; acts of war and terrorist activities; 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 Form 10-Q or, in the case of any document the Company incorporates by reference, the date of that document. Investors also should 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, 2008 and in Item 1A. Risk Factors in Part II - Other Information of this Quarterly Report on Form 10-Q.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company is subject to various market risk exposures. 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 credit worthiness 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 subsidiary. Executive oversight of investment activities is conducted primarily through the Company’s investment committee. The investment committee focuses on strategies to enhance 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.

Credit risk

Credit risk is risk due to uncertainty in a counterparty’s ability to meet its obligations. Credit risk is managed by maintaining a weighted-average fixed maturities portfolio credit quality rating of AA-. 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 89.4% of its fixed maturity portfolio at June 30, 2009 at fair value, are broadly diversified geographically and of those approximately 99.7% are in the tax-exempt sector. The largest holdings are in populous states such as Texas (16.3%) and California (12.1%); however, such holdings are further diversified primarily between cities, counties, schools, public works, hospitals and state general obligations. In California, the Company owns approximately $7.6 million at fair value of general obligations of the state at June 30, 2009. Credit risk is addressed

 

34


by limiting exposure to any particular issuer to ensure diversification. Taxable fixed maturity securities represent 10.9% of the Company’s fixed maturity portfolio. Approximately 43.5% of the Company’s taxable fixed maturity securities were comprised of U.S. government bonds and agencies, which were rated AAA at June 30, 2009. Approximately 18.6% of the Company’s taxable fixed maturity securities 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 its ability to recover its investment on an individual issue basis.

Credit ratings for the Company’s fixed maturity portfolio were stable during the six-month period ended June 30, 2009, with 72.0% of the fixed maturity portfolio at fair value experiencing no change in their overall rating. Approximately 26.0% experienced downgrades during the period, offset by approximately 2.0% in credit upgrades. The majority of the downgrades were due to continued downgrading of the monoline insurance carried on much of the municipal holdings. The majority of the downgrades was slight and still within the investment grade portfolio and only approximately $14.7 million at fair value was downgraded to below investment grade during the quarter, allowing the Company to maintain a high overall credit rating on its fixed maturity securities.

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 June 30, 2009, the Company’s primary objective for common equity investments is current income. The fair value of the equity investment consists of $246.9 million in common stocks and $11.9 million in non-redeemable preferred stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market. The current market expectation is cautiously optimistic following government programs designed to sustain the economy. The Company has also allocated more to the energy sector relative to the S&P 500 Index to hedge against potential inflationary pressures on the equity markets possible in a sudden economic recovery.

The common equity portfolio represents approximately 8.3% 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 weighted-average Beta for the Company’s common stock holdings was 1.15 at June 30, 2009. Based on a hypothetical 25% or 50% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by approximately $71.0 million or $142.0 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 88.1% 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 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 increase in municipal bond credit spreads in 2008 caused overall interest rates to increase, which resulted in the increase in the duration of the Company’s portfolio. Consequently, the modified duration of the bond portfolio, including short-term investments, is 6.1 years at June 30, 2009. Given a hypothetical parallel increase of 100 basis or 200 basis points in interest rates, the fair value of the bond portfolio at June 30, 2009 would decrease by approximately $160.4 million or $320.8 million, respectively.

Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on its $125 million fixed 7.25% rate senior notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes.

 

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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 the Company’s 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 report. 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.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations; however, none is expected to be material to the Company’s financial position. For a detailed description of the pending material lawsuits, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

 

Item 1A. Risk Factors

The Company’s business, operations, and financial position are subject to various risks. These risks are described elsewhere in this report 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, 2008. The risk factors identified in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008 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. Submission of Matters to a Vote of Security Holders

The Company held its Annual Meeting of Shareholders on May 13, 2009. The matters voted upon at the meeting included the election of all nine directors. The votes cast with respect to this matter were as follows:

Election of Directors:

 

Nominee

   Number of
Shares Voted
For
   Number of
Shares
Withheld

Nathan Bessin

   40,227,756    2,916,884

Bruce A. Bunner

   42,201,328    943,312

Michael D. Curtius

   42,202,553    942,087

Richard E. Grayson

   42,074,469    1,070,171

George Joseph

   42,256,963    887,677

Martha E. Marcon

   41,946,331    1,198,309

Donald. P. Newell

   41,946,309    1,198,331

Donald R. Spuehler

   41,957,933    1,186,706

Gabriel Tirador

   42,209,069    935,571

 

Item 5. Other Information

None

 

Item 6. Exhibits

 

10.34    Credit Agreement, dated as of January 2, 2009, among Mercury Casualty Company, Mercury General Corporation, Bank of America, N.A., and the lenders party thereto
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.

 

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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: August 4, 2009     By:    /s/    Gabriel Tirador
      Gabriel Tirador
      President and Chief Executive Officer
Date: August 4, 2009     By:   /s/    Theodore Stalick
      Theodore Stalick
      Vice President and Chief Financial Officer

 

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