Business context and reporting period
Mercury General Corporation filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2010. The company primarily writes automobile insurance through 13 insurance subsidiaries, with operations concentrated in California. Private passenger auto represented 82.6% of nine-month direct premiums written; California represented 76.8%.
Financial performance and position
Amounts below are in millions of dollars, except per-share data and ratios.
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Total revenue | $766.8 | $861.2 | $2,120.2 | $2,444.2 |
| Net premiums earned | $642.6 | $653.8 | $1,925.9 | $1,979.0 |
| Net investment income | $36.0 | $35.2 | $108.4 | $109.3 |
| Net realized investment gains | $86.4 | $171.4 | $80.8 | $352.5 |
| Net income | $96.8 | $157.7 | $175.8 | $368.8 |
| Diluted earnings per share | $1.77 | $2.85 | $3.21 | $6.70 |
| Combined ratio | 98.0% | 96.4% | 97.8% | 96.5% |
- Net premiums written declined 1.2% in Q3 and 1.7% year to date, which management attributed to fewer policies and slightly lower average premiums amid soft market conditions.
- The nine-month loss ratio was 68.1% versus 67.5%; the expense ratio was 29.7% versus 29.0%. Combined ratios remained below 100%, indicating underwriting profitability, but worsened year over year.
- Operating cash flow was $99.4 million for the nine months, down from $156.5 million. Investing activities used $13.9 million; financing activities used $96.2 million, primarily for $97.0 million of dividends. Cash ended at $174.8 million, down from $185.5 million at year-end 2009.
- At September 30, total investments were $3.223 billion, total assets $4.260 billion, shareholders’ equity $1.851 billion, and notes payable $269.0 million. Cash plus short-term investments totaled approximately $337.0 million.
- Dividends declared were $0.60 per share for Q3 and $1.78 year to date. The fixed maturity portfolio had an AA- weighted-average credit rating and 3.7-year modified duration. Management estimated a 100-basis-point rate increase would reduce bond portfolio fair value by $108.1 million.
Changes versus the prior comparable periods
Net income fell 39% in Q3 and 52% for the nine months. The principal factor was the sharp decline in realized investment gains: down $84.9 million in Q3 and $271.8 million year to date. Nine-month fair-value gains on investments were $76.0 million, compared with $405.6 million in 2009. Premiums and net investment income were also lower year to date, while the combined ratio worsened by 1.3 percentage points. Operating cash flow declined by $57.0 million year to date.
For the first nine months, prior-year reserve development was favorable by approximately $18 million, versus $40 million in 2009. The company attributed 2010 favorable development largely to lower-than-estimated California bodily injury severity and fewer late-reported claims for 2009 accident year losses.
Outlook, commentary, risks and unusual items
- No earnings or revenue guidance is provided. Management cautioned that nine-month results are not necessarily indicative of full-year results.
- Management said it expected operating cash flows and available liquidity to meet requirements without forced investment sales, while noting that changing conditions could require additional funding. A $125 million unsecured senior note matures in August 2011; management said it believed it could obtain sufficient capital for repayment. The company reported compliance with debt covenants.
- Management anticipated a California private-passenger auto rate filing becoming effective December 15, 2010, subject to formal approval. The agreed filing includes rate reductions of 4.96% at Mercury Insurance Company and 4.44% at two other subsidiaries, alongside changes to risk segmentation and discounts.
- California DOI matters remain significant: a 2010 notice alleges 35 instances of noncompliance in rating and underwriting practices and may involve monetary penalties; the company denies the allegations. A separate, older DOI matter also remains unresolved. The filing does not quantify potential exposure.
- The California Franchise Tax Board has proposed significant adjustments for tax years 2001–2005. Management believes the matter will be resolved in the company’s favor, but says an adverse outcome could materially affect results in the period of a ruling. The IRS examination of 2005–2008 was at an early stage with no issues raised to date.
- The company contributed $12.1 million in Q2 2010 to the unsuccessful Proposition 17 campaign; management said the company continued to offer a competitive California product. Q3 other operating expenses also rose, with management citing consulting, advertising and information-technology costs.
- Investment valuation and credit risks include a portfolio heavily weighted toward municipal bonds, exposure to bond insurers with weak ratings, and $51.9 million of Level 3 collateralized debt obligations. Management’s reserve estimates are inherently uncertain; loss reserves were $985.1 million, including approximately $291.5 million of IBNR.
- Other disclosed risks include competition, pricing and loss trends, catastrophe exposure, rate approvals, investment yields and market values, litigation and regulation, tax positions, and information-technology execution. Management reported disclosure controls effective at the reasonable-assurance level and no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether policy counts, pricing and premium trends stabilize, and how the forthcoming California rate changes affect retention, new business and margins.
- Whether favorable reserve development continues and whether ultimate claims costs remain consistent with the company’s estimates.
- The resolution and potential financial consequences of the California DOI notices and the FTB tax examination.
- Investment portfolio credit quality, municipal bond insurer exposure, Level 3 valuations, and sensitivity to interest-rate and equity-market movements.
- Liquidity and refinancing plans for the $125 million senior note due in August 2011, alongside dividend payments and operating cash generation.
- How much reported earnings depend on investment gains: nine-month realized gains were $80.8 million versus $352.5 million in the prior year.