Business Context and Reporting Period
Company: Mercury General Corporation (Mercury General)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2007
Business Overview: Mercury General is an insurance holding company primarily engaged in writing private passenger automobile insurance, with significant operations in California (78.3% of direct auto premiums). The Company also writes homeowners, commercial automobile, and other property lines. It operates through 18 subsidiaries, most of which hold an A+ (Superior) or A- (Excellent) rating from A.M. Best.
Key Financial Metrics
| Metric | 2007 | 2006 |
|---|---|---|
| Net Premiums Written | $2,982.0 million | $3,044.8 million |
| Premiums Earned | $2,993.9 million | $2,997.0 million |
| Net Investment Income | $158.9 million | $151.1 million |
| Net Income | $237.8 million | $214.8 million |
| Diluted Earnings Per Share | $4.34 | $3.92 |
| Combined Ratio (GAAP) | 95.4% | 95.0% |
| Loss Ratio (GAAP) | 68.0% | 67.5% |
| Expense Ratio (GAAP) | 27.4% | 27.5% |
| Total Investments (Fair Value) | $3,588.7 million | $3,499.7 million |
| Notes Payable | $138.6 million | $141.6 million |
| Shareholders' Equity | $1,862.0 million | $1,724.1 million |
| Cash Flow from Operations | $216.1 million | $363.2 million |
Material Changes vs. Prior Period
- Premiums: Net premiums written decreased 2.1% and earned premiums decreased 0.1% compared to 2006. The decline was primarily due to a decrease in policies written in non-California operations (specifically New Jersey and Florida) due to competitive market conditions, partially offset by a slight increase in average premium per policy.
- Profitability: Net income increased 10.7% to $237.8 million, driven by higher net investment income and realized gains, despite a slight deterioration in the combined ratio.
- Loss Development: The Company experienced negative loss reserve development of approximately $20 million in 2007. This included $25 million of adverse development in California (driven by bodily injury severity and claim count increases) partially offset by $5 million of positive development in non-California operations (primarily Florida).
- Catastrophes: The Company incurred a pre-tax loss of approximately $23 million due to the October 2007 Southern California fire storms, negatively impacting the loss ratio by 0.8%.
- Investments: Net investment income increased 5.2% to $158.9 million. The after-tax yield on average investments improved to 4.0% from 3.8% in 2006, reflecting a portfolio shift toward tax-exempt securities.
Guidance, Outlook, and Risks
- Market Outlook: Management expects the insurance market to transition from a "soft" to a "hard" market in 2008, with competitors initiating rate increases due to declining profitability in 2007.
- Regulatory Environment:
- California: The California Department of Insurance (DOI) approved a rate filing in January 2008 resulting in a net reduction of approximately 2.5% for the Company's California subsidiaries. The Company is subject to ongoing examinations regarding rating, underwriting, and claims handling practices.
- Florida: New laws effective in 2007 require insurers writing auto policies in Florida to also write homeowners policies. The Company is monitoring potential further enhancements to this law.
- Legal and Tax Contingencies:
- FTB Audit: The California Franchise Tax Board issued proposed assessments totaling approximately $5 million for tax years 2001, 2002, and 2004 regarding state apportionment factors. The Company plans to appeal.
- Class Action: A settlement was approved in December 2007 regarding a class action lawsuit concerning persistency discounts. The Company accrued $5 million related to this settlement.
- Technology: The Company is implementing the "NextGen" computer system and "Internet Business Strategy" (IBS) to replace legacy systems, with full rollout expected by the end of 2008.
- Risks: Key risks include the adequacy of loss reserves, regulatory rate approval delays, catastrophic events (wildfires, earthquakes, hurricanes), and the concentration of revenue in California (78.3% of auto premiums).
Investor Verification Checklist
- Loss Reserve Adequacy: Verify the impact of the $20 million negative loss development, specifically the $25 million adverse development in California bodily injury reserves.
- Regulatory Rate Filings: Monitor the outcome of the California DOI's examination and the impact of the approved 2.5% net rate reduction on future profitability.
- Tax Disputes: Track the status of the $5 million California Franchise Tax Board assessment and the ongoing litigation regarding the 1993-1996 tax assessments.
- Investment Portfolio: Review the exposure to municipal bonds insured by bond insurers (MBIA, FSA, AMBAC, etc.) given the credit market volatility and potential rating downgrades of insurers.
- Broker Concentration: Note that one independent broker accounted for approximately 14% of direct premiums written in 2007.