Mercury General Corporation — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; balance-sheet comparisons are with December 31, 2013. Mercury primarily writes personal automobile insurance through subsidiaries in 13 states, principally California, and also offers homeowners and other insurance lines.
Financial performance
| Metric | Q1 2014 | Q1 2013 / comparison |
|---|---|---|
| Net premiums earned | $683.7 million | $662.6 million; up 3.2% |
| Total revenue | $763.0 million | $740.2 million |
| Net investment income | $30.2 million | $31.2 million |
| Net realized investment gains | $46.7 million | $44.1 million |
| Income before taxes | $102.0 million | $91.0 million |
| Net income | $72.6 million | $66.5 million |
| Diluted earnings per share | $1.32 | $1.21 |
| Operating cash flow | $49.4 million | $58.2 million |
Net premiums written increased 5.0% to $724.7 million. The GAAP loss, expense, and combined ratios were 69.7%, 26.9%, and 96.6%, respectively, versus 70.5%, 27.4%, and 97.9%. A combined ratio below 100% generally indicates underwriting profitability. The 2014 loss ratio included about $4 million of catastrophe losses and $4 million of favorable prior-year reserve development; 2013 included about $1 million of catastrophe losses, $3 million of favorable development, and $6 million of additional loss-adjustment costs. Excluding these items, loss ratios were 69.7% and 69.9%.
Investment gains contributed materially to earnings: fair-value changes generated $45.7 million of the $46.7 million in realized gains. The company reported $0.55 per share of after-tax realized investment gains in Q1 2014. Net investment income and pretax investment yield declined to $30.2 million and 3.9% from $31.2 million and 4.1%, primarily as higher-yielding investments matured and were replaced at lower market yields. The effective tax rate rose to 28.8% from 27.0%.
Financial position, liquidity, and capital
- Total assets were $4.48 billion and shareholders’ equity was $1.86 billion at March 31, 2014.
- Cash was $238.8 million; short-term investments were $303.6 million. Management reported $542.4 million of combined cash and short-term investments and $70 million available on a $200 million revolving credit facility.
- Notes payable increased to $270 million from $190 million, including an additional $80 million borrowed under the unsecured facility. The company reported compliance with all loan covenants.
- Operating cash flow was $49.4 million; dividends paid were $33.8 million. Cash declined $27.7 million during the quarter to $238.8 million.
- Insurance subsidiaries’ statutory surplus was $1.6 billion; the net-premiums-written-to-surplus ratio was 1.8:1, below the cited 3.0:1 industry guideline.
Material changes and management commentary
Premium growth was attributed primarily to higher average premiums per policy following California rate increases effective January 2014: 6.0% for preferred private passenger auto and 8.26% for homeowners. California represented 80.0% of direct premiums written in the quarter. Management attributed the improved expense ratio mainly to the benefit of the 2013 workforce reduction and operational consolidation.
The investment portfolio was $3.32 billion at fair value. Equity securities increased to 11.5% of the portfolio from 8.9% at year-end. The fixed-income portfolio’s estimated weighted-average credit rating decreased to A+ from AA-, primarily after AAA bonds matured and were replaced with lower-rated investment-grade securities. Modified duration, reflecting expected calls, declined to 3.0 years from 3.9 years.
Outlook, risks, contingencies, and unusual items
- The filing provides no specific earnings or premium-growth guidance. Management cautions that interim results are not necessarily indicative of full-year results.
- Key risks include competition and pricing, rate-regulatory approvals, claims severity and loss-reserve estimation, weather and catastrophe losses, investment-market and interest-rate changes, and tax and regulatory matters. Management’s loss-reserve estimate is a significant judgment; reserves were approximately $1.0 billion, including $412.2 million of IBNR at quarter-end.
- Two California Department of Insurance notices of non-compliance, dating from 2004 and 2010, remain unresolved. The company denies the allegations and does not expect the outcomes to materially affect its financial position; the ultimate outcomes and possible penalties are uncertain.
- The company is under California tax examinations for 2003–2010 and is considering options regarding proposed assessments for 2003–2006. Management does not expect resolution to have a material financial impact.
- In February 2014, consolidated subsidiary Fannette Funding LLC entered a three-year total return swap with approximately $38 million notional, paying LIBOR plus 140 basis points and pledging about $30 million of U.S. Treasuries as collateral. A separate existing swap had approximately $159 million notional and $40 million collateral. The filing notes that significant market-value erosion could reduce Fannette’s position; the company may add capital or terminate the swap.
- Management believes current liquidity and operating cash flows are adequate, but notes that future funding needs could require additional financing or asset sales. A 100- or 200-basis-point interest-rate increase was estimated to reduce bond-portfolio fair value by $81.6 million or $163.2 million, respectively.
Important facts for investors to verify
- How much of earnings growth reflects underwriting performance versus realized investment gains and fair-value movements.
- Whether premium-rate increases sustain growth without worsening retention, claims trends, or underwriting profitability.
- Subsequent development of loss reserves, including the favorable prior-year development and catastrophe losses reported this quarter.
- Progress and potential financial consequences of the California regulatory proceedings and tax examinations.
- Investment portfolio credit quality, equity exposure, interest-rate sensitivity, and the risks and collateral terms of the total return swaps.
- Debt levels, revolving-credit availability, covenant compliance, and cash-flow capacity to support dividends and insurance operations.