Mercury General Corporation — Q2 2010 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2010; financial statements are unaudited. Mercury primarily writes automobile insurance, with California accounting for 77.0% of first-half direct premiums written.
Financial performance and position
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Net premiums earned | $642.7m | $659.2m | $1,283.3m | $1,325.3m |
| Total revenue | $653.7m | $796.0m | $1,353.5m | $1,582.9m |
| Net income | $17.8m | $114.4m | $79.0m | $211.1m |
| Diluted EPS | $0.32 | $2.07 | $1.44 | $3.83 |
| Combined ratio | 99.0% | 96.1% | 97.7% | 96.5% |
- Net premiums written fell 1.0% in Q2 and 1.9% in the first half, attributed to fewer policies and slightly lower average premiums amid soft market conditions.
- Investment results drove much of the earnings decline: Q2 net realized investment losses were $27.7m versus gains of $99.9m a year earlier; first-half losses were $5.7m versus gains of $181.2m. Q2 fair-value movements included a $44.2m decline in equities, partly offset by a $14.4m increase in fixed maturities.
- First-half underwriting remained profitable, with a combined ratio below 100%, but the ratio worsened year over year. Favorable prior-year reserve development was about $22m, versus $38m in the first half of 2009. Q2 loss and expense ratios were 68.4% and 30.6%, respectively; the expense ratio included a $12.1m Proposition 17 contribution.
- Net investment income was $36.5m in Q2 and $72.4m for six months. The reported before-tax annualized yield was 4.7% for both periods, versus 4.5% and 4.6%, respectively, in 2009.
- First-half operating cash flow was $52.0m, down from $106.4m. Cash was $219.5m at June 30; cash plus short-term investments was $323.2m. Dividends paid were $64.7m.
- At June 30, total assets were $4.18bn, liabilities $2.40bn, and shareholders’ equity $1.79bn. Notes payable totaled $270.0m. The company reported compliance with credit-facility covenants; its $125m senior notes mature in August 2011.
Changes, outlook, and risks
- Year-over-year net income fell sharply, primarily reflecting the swing from substantial investment gains in 2009 to losses in 2010, alongside lower earned premiums and higher operating expenses. Management provided no numerical earnings or premium guidance; it cautioned that first-half results are not necessarily indicative of full-year results.
- Management said operating cash flow and available liquidity were adequate for requirements without forced investment sales, while noting that changing business conditions could require additional funding. Its investment strategy emphasizes after-tax income, safety of principal, and a diversified, investment-grade fixed-income portfolio.
- Market exposures include equity-price, interest-rate, and credit risks. A hypothetical 25% decline in the stock market would reduce common-stock portfolio value by about $81.4m; a 100-basis-point rate increase would reduce bond portfolio value by about $120.5m. These are sensitivities, not forecasts. Municipal bonds made up 91.8% of fixed maturities; insurer downgrades could affect their market values.
- California DOI proceedings are significant: a 2010 notice alleged 35 rating and underwriting compliance violations and could lead to required changes and monetary penalties; the company denied the allegations. A separate, long-running 2004 notice also seeks penalties. The company supported Proposition 17, which failed, and contributed $12.1m in Q2 to the initiative.
- The California Franchise Tax Board has proposed significant adjustments for 2001–2005; management expects a favorable resolution but cannot assure it. An unfavorable ruling could materially affect results in the period of resolution. The IRS examination for 2005–2008 was at an early stage, with no issues raised.
- Management stated that pending litigation or regulatory actions could materially affect quarterly results if decided adversely, though none was expected to be material to financial position. Loss reserves depend on estimates; reported reserves included approximately $299.4m of IBNR.
- The company did not expect to pay contingent consideration of up to $34.7m related to the AIS acquisition, based on projected performance. Disclosure controls were deemed effective, and no material change in internal control was reported.
Investor verification priorities
- Track premium volume, policy counts, average premiums, and combined ratio as soft-market conditions continue.
- Separate underwriting performance from investment fair-value volatility when assessing earnings; review the equity and municipal-bond exposures and insurer credit ratings.
- Monitor reserve development and the adequacy of loss reserves, especially given the estimation uncertainty and reliance on favorable prior-year development.
- Follow outcomes of the California DOI notices and FTB examination, including potential penalties, required business changes, and tax effects.
- Review liquidity and cash generation against dividends, the August 2011 senior-note maturity, and debt covenants.