MERCURY GENERAL CORP annual report, FY2014

Mercury General Corporation — 2014 Form 10-K

Reporting period: Fiscal year ended December 31, 2014. This is an annual filing, not a standalone fourth-quarter report. Mercury primarily writes personal automobile insurance through subsidiaries in 13 states, with California representing 80.9% of 2014 direct premiums written.

Financial performance

Metric	2014	2013	Change / context
Net premiums earned	$2.796 billion	$2.698 billion	Up 3.6%
Total revenues	$3.012 billion	$2.821 billion	Up 6.8%; includes large investment gains
Net income	$177.9 million	$112.1 million	Up 58.7%
Diluted EPS	$3.23	$2.04	Up $1.19
Net cash from operations	$246.5 million	$209.8 million	Up $36.7 million
Combined ratio, GAAP	98.8%	99.6%	Below 100% indicates underwriting profit

Net premiums written rose 4.1% to $2.841 billion, primarily reflecting higher average premiums following California auto and homeowners rate increases.
Net investment income was $125.7 million, versus $124.5 million. Average pre-tax yield declined to 3.9% from 4.1% as lower-yielding investments replaced maturing higher-yielding holdings.
Net realized investment gains were $81.2 million, compared with an $11.4 million loss in 2013. Much of the year-over-year earnings improvement therefore reflected investment valuation and realization results, not solely underwriting.
Reported loss and expense ratios were 71.0% and 27.7%, respectively. The expense ratio included the $27.6 million California regulatory penalty; excluding that charge, management reported a 26.8% expense ratio. Excluding catastrophe losses and prior-year reserve development, the loss ratio was 70.7%, versus 72.0% in 2013.
Fourth-quarter 2014 net premiums earned were $709.4 million; the quarter recorded a $21.0 million net loss, or $0.38 per diluted share, versus $15.4 million net income in fourth-quarter 2013. The 2014 quarterly loss reflected the penalty, falling equity values, and California rainstorm losses.

Balance sheet, debt and liquidity

At year-end, total assets were $4.600 billion, shareholders’ equity was $1.875 billion, and investments at fair value totaled $3.404 billion.
Notes payable increased to $290 million from $190 million. The company had $289.9 million of cash and $372.5 million of short-term investments; management reported $100 million available under its $250 million revolving facility.
Operating cash flow was positive for more than 20 consecutive years, according to management. In 2014, operating cash funded dividends and investments; cash from operations increased partly because of higher premium collections and lower paid losses.
Insurance subsidiaries’ statutory policyholders’ surplus was $1.438 billion, down from $1.529 billion. Net premiums written to statutory surplus was 2.0:1, within the cited 3.0:1 guideline. Each subsidiary exceeded regulatory minimum RBC requirements, although CAIC’s 386% RBC ratio was below a loan-covenant threshold; the company obtained a waiver and contributed $10 million to CAIC.
Shareholder dividends paid were $2.4625 per share in 2014. The board declared a $0.6175 quarterly dividend in February 2015. Subsidiaries could pay approximately $177.5 million in ordinary dividends to the parent in 2015 without extraordinary-dividend approval.

Material changes versus 2013

Underwriting improved: the GAAP combined ratio fell to 98.8% from 99.6%, helped by a lower loss ratio and favorable prior-year reserve development of about $3 million; 2013 had about $3 million of unfavorable development.
Investment gains swung to $81.2 million from a loss of $11.4 million, including gains in fixed maturities but fourth-quarter declines in equity values, particularly energy holdings.
Other operating expenses increased to $249.4 million from $219.5 million, including the regulatory penalty. The 2013 comparison included approximately $10 million of office consolidation and severance costs.
Debt rose by $100 million, primarily from additional unsecured-facility borrowings. The company extended certain facility maturities and increased the unsecured revolver capacity from $200 million to $250 million.
California remained the core market; direct premiums written grew to $2.853 billion from $2.737 billion. California homeowners and commercial auto premiums also increased, while some non-California personal auto rates were reduced.

Outlook, risks and unusual items

No specific earnings or premium-growth guidance is provided. The company described market conditions as mixed and emphasized that results depend on competition, rate approvals, claims trends, and catastrophe experience.
Management said it launched a national advertising campaign in 2015 and expected advertising spending of up to $48 million, compared with $23.1 million in 2014. Further Guidewire system deployments were planned for 2015, including California personal auto claims processing.
The California Insurance Commissioner adopted a proposed decision assessing a $27.6 million civil penalty in the long-running 2004 Notice of Non-Compliance matter. The company accrued the full amount in 2014, disputes the allegations and penalty, and said it intends to defend itself or seek a reasonable settlement. The separate 2010 notice alleges other rating and underwriting noncompliance.
The company identifies reserve adequacy as a major uncertainty. California bodily-injury severity and claim counts may differ from estimates; management cited potential combined unfavorable development of about $54.5 million under specified severity sensitivities for 2012–2014 accident years, and a 2014 claim-count sensitivity range with approximately $16.4 million of unfavorable development at the high end.
Catastrophe losses were approximately $11 million in 2014, versus $17 million in 2013. The company also disclosed maximum potential California Earthquake Authority assessments of approximately $62.5 million based on the latest available information; no assessment was made in 2014. Its catastrophe treaty provides $100 million per occurrence after a $100 million retention, excludes Florida, and was effective through June 30, 2015.
Investment risks include concentration in municipal bonds: 66.6% of total investments at fair value and 86.6% of fixed maturities were tax-exempt municipal securities. A hypothetical 100- or 200-basis-point rate increase was estimated to reduce bond-portfolio fair value by $75.8 million or $151.6 million, respectively.
On January 2, 2015, Mercury acquired California non-standard auto insurer WAIC for $8 million, with $2 million held in escrow, and contributed $15 million of capital after closing. Purchase accounting remained under review.
KPMG gave unqualified opinions on the consolidated financial statements and internal control over financial reporting; management also concluded disclosure controls were effective.

Key facts for investors to verify

Review the status and possible ultimate cost of the $27.6 million California penalty, including the company’s challenge and any resolution of the 2004 and 2010 matters.
Assess whether the improvement in underwriting persists after separating investment gains, the penalty, catastrophe losses, and prior-year reserve development.
Monitor California auto bodily-injury severity, claim-count development, and reserve adequacy, particularly for 2012–2014 accident years.
Check CAIC’s RBC covenant compliance after the waiver and capital contribution, alongside statutory surplus and subsidiary dividend capacity.
Evaluate municipal-bond concentration and interest-rate sensitivity, as well as debt levels and available holding-company liquidity.
Verify WAIC integration, the final acquisition accounting and reserve assessment, and the expected 2015 advertising and technology spending.