MERCURY GENERAL CORP annual report, FY2016

Mercury General Corporation — 2016 Form 10-K

Business and period: Annual report for the year ended December 31, 2016. Mercury General is a property-and-casualty insurer operating in 11 states, principally California. Personal automobile insurance represented 77.3% of direct premiums written; California generated 82.6% of direct premiums written across all lines.

Key financial results

Metric	2016	2015
Net premiums earned	$3.132 billion	$2.958 billion
Total revenues	$3.228 billion	$3.009 billion
Net income	$73.0 million	$74.5 million
Diluted EPS	$1.32	$1.35
Operating cash flow	$287.5 million	$190.2 million
Combined ratio (GAAP)	100.7%	99.2%
Net investment income	$121.9 million	$126.3 million
Net realized investment losses	$34.3 million	$83.8 million

Premium growth reflected rate increases in California private passenger auto and growth in California homeowners and commercial auto policies. The 2016 underwriting result was a $21.2 million loss; a combined ratio above 100% indicates underwriting losses. Net income included an income tax benefit of $2.3 million. Figures are annual unless stated otherwise.

Financial position and liquidity

At year-end, total assets were $4.789 billion, shareholders’ equity $1.752 billion, loss and loss adjustment expense reserves $1.290 billion, and unearned premiums $1.074 billion.
Notes payable rose to $320 million from $290 million. Borrowings bear rates tied to LIBOR; the company reported compliance with loan covenants. A $250 million revolving facility had $70 million of availability.
Cash and short-term investments totaled approximately $596 million. Management said operating cash flow and available liquidity should meet requirements without forced investment sales, while noting future needs could change.
Insurance subsidiaries had $1.442 billion in statutory surplus; each exceeded minimum RBC requirements, with RBC ratios above 375%. Approximately $144 million of ordinary dividends could be paid to the parent in 2017 without extraordinary-dividend approval.
Shareholder dividends paid were $2.4825 per share in 2016. The board declared a $0.6225 quarterly dividend in February 2017.

Material changes and notable items

Prior-year loss reserve development turned sharply adverse: $85.4 million in 2016 versus $12.7 million adverse in 2015 and $3.2 million favorable in 2014. The 2016 deterioration was mainly in California and Florida auto, reflecting higher-than-estimated liability claim severity.
Catastrophe losses were about $27 million in 2016, compared with $19 million in 2015, primarily from severe storms outside California and rainstorms in California.
Investment marks remained a material source of earnings volatility. The company recorded $34.3 million of realized investment losses in 2016, although less than the $83.8 million loss in 2015. Fourth-quarter 2016 net loss was $26.1 million, principally due to declines in fixed-maturity values as interest rates rose.
The company stopped accepting new business in Michigan and Pennsylvania in May 2016 and expected to complete the run-off in 2017. It also restructured non-California claims operations, recording approximately $2 million in employee termination costs.
Direct premiums written increased to $3.172 billion from $3.013 billion. California’s share increased to 82.6% from 81.5%.

Outlook, risks and contingencies

No formal earnings or revenue guidance is provided. Management described the insurance market as hardening, with carriers generally raising rates, but noted results depend on state-level profitability and growth choices. It expected auto repair labor costs to rise faster in 2017 than in 2016; loss frequency increased modestly in 2016.
Key exposures include California concentration, rate-approval delays or restrictions, competition, claim severity and reserve uncertainty, catastrophes, and dependence on independent agents. Management identified 2014–2016 accident years as more likely to develop and noted California auto bodily-injury severity could vary from recorded estimates.
The investment portfolio was heavily concentrated in tax-exempt municipal bonds: 68.8% of total investments at fair value. The company estimated that a 100- or 200-basis-point interest-rate increase would reduce fixed-maturity fair value by $116.4 million or $232.9 million, respectively. Rising rates may also increase interest expense on LIBOR-based debt.
A California DOI penalty of $27.6 million, paid in 2015, was vacated by a trial court in 2016, which ordered a refund plus 7% prejudgment interest. The Commissioner appealed in January 2017. Because of the appeal, the company had not recorded a refund receivable or recognized the vacatur; the separate false-advertising proceeding remained pending.
The company was under California Franchise Tax Board examination for 2003–2013 and reported $13.0 million of unrecognized tax benefits. Management expected no material impact from resolution, but the timing and outcome remained uncertain.
The CEA assessment exposure was estimated at a maximum of $60.2 million based on information available at April 1, 2016; no assessment occurred in 2016. The catastrophe treaty provided specified coverage above a $100 million retention and was effective through June 30, 2017.

Important facts for investors to verify

Whether reserve strengthening continues, particularly for California and Florida auto claims and the more recent accident years.
Whether underwriting margins improve from the 100.7% combined ratio and how approved rate changes compare with actual loss-cost inflation.
The status and accounting treatment of the $27.6 million California penalty refund and related interest following the appeal.
Investment portfolio performance and sensitivity to interest rates, municipal credit conditions, and realized gains or losses.
Parent-company liquidity, subsidiary dividend capacity, debt maturities and variable-rate exposure, and continued dividend coverage.
Progress and costs of the Michigan and Pennsylvania run-off and the company’s efforts to reduce California concentration.