Business Context and Reporting Period
Company: Mercury General Corporation
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: September 30, 2009
Business Overview: Mercury General is a property and casualty insurer primarily operating in California, with expansion into 12 other states. The company focuses on personal automobile and homeowners insurance, sold largely through independent agents. A significant event during the period was the acquisition of Auto Insurance Specialists (AIS) on January 1, 2009, for $120 million.
Key Financial Metrics
Revenue and Profitability (Nine Months Ended Sept 30, 2009):
- Total Revenues: $2,444,171,000 (vs. $1,916,300,000 in 2008)
- Net Premiums Earned: $1,979,032,000 (vs. $2,128,725,000 in 2008)
- Net Investment Income: $109,334,000 (vs. $116,380,000 in 2008)
- Net Realized Investment Gains: $352,549,000 (vs. Loss of $332,614,000 in 2008)
- Net Income: $368,837,000 (vs. Net Loss of $73,774,000 in 2008)
- Diluted Earnings Per Share: $6.70 (vs. $(1.35) in 2008)
Balance Sheet Highlights (as of Sept 30, 2009):
- Total Assets: $4,273,847,000 (vs. $3,950,195,000 at Dec 31, 2008)
- Total Investments: $3,142,707,000 (Fixed maturities: $2,728,815,000; Equity: $287,720,000)
- Cash and Short-term Investments: $330,366,000 (Cash: $204,194,000; Short-term: $126,172,000)
- Total Liabilities: $2,505,234,000
- Notes Payable: $272,690,000 (Increased from $158,625,000 due to AIS acquisition financing)
- Shareholders' Equity: $1,768,613,000
Cash Flow (Nine Months Ended Sept 30, 2009):
- Operating Cash Flow: $156,460,000 (vs. $72,612,000 in 2008)
- Investing Cash Flow: $(12,612,000) (Net cash used)
- Financing Cash Flow: $24,950,000 (Net cash provided, primarily from a $120M bank loan)
Underwriting Ratios (Nine Months Ended Sept 30, 2009):
- Loss Ratio: 67.5% (vs. 69.7% in 2008)
- Expense Ratio: 29.0% (vs. 28.4% in 2008)
- Combined Ratio: 96.5% (vs. 98.1% in 2008)
Material Changes vs. Prior Period
- Profitability Turnaround: The company reported a net income of $368.8 million for the nine-month period, a stark contrast to the $73.8 million net loss in the same period of 2008. This reversal is primarily driven by a swing in net realized investment gains from a $332.6 million loss in 2008 to a $352.5 million gain in 2009.
- Investment Performance: The significant investment gain is largely attributable to the company's election of the fair value option for its investment portfolio. Market value improvements in fixed maturity and equity securities resulted in $405.6 million in gains due to fair value changes.
- Underwriting Improvement: The combined ratio improved to 96.5%, indicating profitable underwriting. The loss ratio decreased due to positive reserve development of approximately $40 million in 2009, compared to adverse development of $46 million in 2008.
- Premium Volume: Net premiums earned decreased by 7.0% year-over-year, reflecting a decrease in the number of policies written and lower average premiums due to soft market conditions.
- Acquisition Impact: The acquisition of AIS added $9.1 million in revenue and $1.2 million in net income for the nine-month period. It also resulted in $37.6 million of goodwill and $68.5 million of intangible assets.
Guidance, Outlook, Risks, and Unusual Items
Management Commentary and Outlook:
- Cost Reductions: The company implemented cost reduction programs in Q1 2009, including a workforce reduction of approximately 360 employees (7% of the workforce), expected to yield over $20 million in annualized savings.
- Investment Strategy: Management emphasizes maximizing after-tax yields while maintaining a well-diversified, investment-grade portfolio. The portfolio is heavily weighted toward tax-exempt municipal bonds (90% of fixed maturities).
- Contingent Consideration: The AIS acquisition includes a contingent consideration arrangement requiring potential payments of up to $34.7 million based on performance through 2010. Management currently does not expect to pay this amount based on projected performance.
Risks and Contingencies:
- Regulatory Examination: The California Franchise Tax Board is examining tax years 2001-2005 and has proposed significant adjustments. Management believes the outcome will not materially impact financial position but could impact results of operations in the resolution period.
- Legal Proceedings: The company faces various lawsuits incidental to its insurance business, including claims for punitive damages. While an unfavorable ruling could materially impact quarterly results, none are expected to be material to the overall financial position.
- Investment Volatility: Due to the fair value accounting option, earnings are subject to volatility based on capital market fluctuations. The company holds $3.0 million in auction rate securities (Level 3 assets) valued using discounted cash flow models.
- Market Risk: The company is exposed to interest rate risk (modified duration of 5.0 years) and equity price risk. A hypothetical 100 basis point increase in interest rates could decrease the fair value of the bond portfolio by approximately $142.5 million.
Key Facts for Investor Verification
- Fair Value Accounting Impact: Verify the sustainability of earnings given that a significant portion of the $352.5 million investment gain is unrealized and driven by fair value changes rather than cash flow from operations.
- Reserve Development: Confirm the stability of the $40 million positive reserve development reported, as this significantly improved the loss ratio and net income.
- Debt Obligations: Review the terms of the $120 million secured credit facility used for the AIS acquisition, which matures in 2012 and is collateralized by municipal bonds.
- Regulatory Exposure: Monitor the status of the California Franchise Tax Board examination and the potential for fines or penalties related to the Notice of Non-Compliance regarding broker fees.
- Contingent Consideration: Track the performance of the AIS business to determine if the potential $34.7 million contingent payment becomes necessary.