MCY

Mercury General Corp. 10-Q Summary (Q3 2008)

Business Context and Reporting Period

This filing covers the quarterly period ended September 30, 2008. Mercury General Corporation is a property and casualty insurer headquartered in Los Angeles, California, primarily offering personal automobile insurance. The company operates in California and several other states. The reporting period coincides with significant volatility in global credit and equity markets, which materially impacted the company's investment portfolio valuation.

Key Financial Metrics

Note: Figures in parentheses indicate losses. Data presented in thousands in source; converted to millions for summary.

Material Changes vs. Prior Period

• Investment Losses: The most significant change is the shift from investment gains to massive realized losses. In Q3 2008, the company recorded a net realized investment loss of $277.0 million (vs. $2.0M gain in Q3 2007). For the nine months ended Sept 30, 2008, losses totaled $332.6 million. This was driven by the adoption of SFAS No. 159, which requires fair value changes to be recorded in earnings, combined with market declines due to downgrades of municipal bond insurers and widening credit spreads.
• Underwriting Performance: The combined ratio deteriorated to 102.0% in Q3 2008 from 94.2% in Q3 2007, indicating unprofitable underwriting for the quarter. The loss ratio increased to 73.5% (from 66.5%) due to higher severity in California auto lines, a large commercial property fire loss, and Hurricane Ike impacts. Negative development on prior year reserves was approximately $16 million.
• Premium Volume: Earned premiums decreased 7.0% in Q3 2008 and 5.8% for the nine-month period, reflecting a soft market with lower policy counts and average premiums.
• Tax Benefit: The company recognized a one-time net tax benefit of $17.5 million in Q3 2008 following a favorable court ruling against the California Franchise Tax Board regarding tax years 1993-1996.

Outlook, Risks, and Management Commentary

• Acquisition: On October 10, 2008, the company entered an agreement to acquire Auto Insurance Specialists (AIS) for $120 million, with up to $34.7 million in contingent consideration. Financing is expected via a bank credit facility.
• Market Risks: Management highlights extreme volatility in credit and equity markets. Continued deterioration could lead to additional investment losses. The company notes that funding for future growth may be difficult to obtain given the credit crisis.
• Regulatory Environment: The company faces ongoing examinations by state insurance departments and the California Franchise Tax Board (FTB) for tax years 2001-2004. While management expects to prevail, an unfavorable outcome could materially impact results. New California rating regulations are expected to cause rate reductions for urban drivers and increases for non-urban drivers.
• Reserves: Loss reserves totaled $1,049.2 million, including $328 million in Incurred But Not Reported (IBNR) reserves. The company reported $46 million in adverse development for the nine months ended Sept 30, 2008.

Investor Verification Checklist

• Investment Portfolio Valuation: Verify the extent of exposure to municipal bond insurers (MBIA, FSA, FGIC, AMBAC) and the impact of their downgrades on the $2.6 billion fixed maturity portfolio.
• Underwriting Trends: Monitor the combined ratio and loss severity in California, which accounts for 78% of net written premiums, to assess if the Q3 deterioration is a trend or anomaly.
• Acquisition Financing: Confirm the closing of the $120 million credit facility required for the AIS acquisition amidst tight credit markets.
• Tax Litigation: Track the status of the ongoing FTB examination for tax years 2001-2004, where proposed assessments total approximately $5 million.
• Liquidity Position: Assess the adequacy of the $283.3 million cash and short-term investment balance against potential future loss payments and the need to fund the AIS acquisition.