Mercury General Corporation — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Unaudited consolidated results. The company primarily writes personal auto insurance in 13 states, principally California, and also offers homeowners and other property and casualty insurance.
Key financial results
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net premiums earned | $705.2 million | $678.9 million | $2,086.8 million | $2,017.3 million |
| Total revenue | $720.0 million | $728.7 million | $2,290.0 million | $2,111.4 million |
| Net income | $31.3 million | $39.6 million | $198.9 million | $96.8 million |
| Diluted EPS | $0.57 | $0.72 | $3.62 | $1.76 |
| Combined ratio | 96.7% | 99.2% | 96.4% | 98.6% |
- Underwriting and premiums: Net premiums written rose 2.2% in Q3 and 4.0% year to date; earned premiums increased 3.9% and 3.4%, respectively. Management attributed growth mainly to higher average premiums following California rate increases. Combined ratios below 100% indicate underwriting profitability.
- Investment results: Q3 net realized investment losses were $20.1 million, versus $16.2 million in gains a year earlier; the 2014 losses included a $24.0 million decline in equity values, partly offset by fixed-maturity gains. For nine months, realized investment gains were $102.8 million, compared with $7.2 million in losses in 2013; fair-value changes contributed $66.6 million of gains, versus $13.4 million of losses. Nine-month earnings therefore benefited materially from investment gains.
- Cash flow: Operating cash flow was $199.5 million for nine months, up from $169.7 million. Investing activities used $186.8 million, and financing activities provided $0.5 million. Cash at period-end was $279.7 million.
- Balance sheet and liquidity: Total assets were $4.61 billion and shareholders’ equity $1.92 billion at September 30. Cash plus short-term investments totaled approximately $571.0 million. Management cited $50 million available on its $200 million revolving facility and said operating cash flow and investment maturities were expected to support liquidity needs, while noting funding needs could change.
- Debt and capital: Notes payable were $290 million, up from $190 million at year-end, including $150 million drawn on the unsecured revolver. The company reported compliance with loan covenants. Insurance subsidiaries’ combined statutory surplus was $1.5 billion; trailing-year net premiums written to surplus was 1.9:1.
- Dividends: Dividends paid were $0.615 per share in Q3 and $1.845 per share for nine months, compared with $0.6125 and $1.8375, respectively, in 2013.
Material changes and management commentary
- Q3 net income declined despite higher earned premiums and an improved combined ratio, principally reflecting the swing from investment gains to investment losses. Nine-month net income more than doubled, reflecting stronger underwriting results and a large swing to investment gains.
- For nine months, the loss ratio improved to 69.6% from 71.7%; expense ratio was broadly stable at 26.8% versus 26.9%. Favorable prior-accident-year reserve development was approximately $10 million, primarily in California personal auto, partly offset by adverse development in other states. Catastrophe losses were approximately $7 million, mainly East Coast winter freezes, versus $16 million in the prior-year period.
- Net investment income was nearly flat year to date at $93.7 million versus $93.7 million; the reported average annual pretax yield declined to 3.9% from 4.1%, as higher-yielding holdings matured and were replaced at lower yields.
- Management reported 2014 rate changes in 12 states, including California increases implemented in January for preferred auto (6.0%) and homeowners (8.26%), and an October increase for standard auto (6.9%). Some non-California auto rates were decreased.
Outlook, risks, contingencies and unusual items
- The filing provides no specific earnings or revenue guidance. Management cautioned that nine-month results are not necessarily indicative of full-year results.
- Key risks include competitive pricing, uncertainty in loss reserves and claim severity, weather and catastrophe losses, rate-regulatory approvals, investment-market fluctuations, interest rates, credit risk, and legal or regulatory developments.
- Loss and loss-adjustment reserves were $1.063 billion, including approximately $429 million of incurred-but-not-reported reserves. Management considered reserves adequate, but emphasized that estimates are uncertain and ultimate claims may differ.
- The California Department of Insurance’s 2004 and 2010 notices of non-compliance remain unresolved. The company denies the allegations and expects no material financial effect, but notes that potential penalties cannot be assured. The California Franchise Tax Board is examining 2003–2010 returns; proposed assessments for 2003–2006 were affirmed administratively, and the company is considering resolution options. Management does not expect a material impact.
- On October 22, 2014, the company agreed to acquire Workmen’s Auto Insurance Company for $8 million, with closing anticipated in Q1 2015. The acquisition is subsequent to the reporting date.
- The investment portfolio was concentrated in municipal bonds: 66.7% of investments and 86.7% of fixed maturities at fair value. The fixed-maturity portfolio’s weighted-average credit rating was A+, down from AA- at year-end. A hypothetical 100- or 200-basis-point rate increase was estimated to reduce bond fair value by $78.5 million or $157.1 million, respectively.
- A new three-year total-return swap entered in February 2014 had approximately $113 million notional at quarter-end and was secured by about $30 million of U.S. Treasuries. Together with the existing swap, these investment arrangements create exposure to market values, financing costs and collateral requirements.
Most important facts for investors to verify
- Whether the favorable reserve development and improved combined ratio persist, and how subsequent reserve reviews affect the $1.063 billion reserve balance.
- How much reported earnings depend on realized and fair-value investment gains or losses, particularly given Q3 equity-market losses and portfolio exposures.
- The eventual outcomes and potential costs of the California insurance notices and California tax examination.
- Completion, regulatory approval and financial impact of the planned Workmen’s acquisition.
- Liquidity, covenant headroom and refinancing of the $20 million Union Bank loan due January 2015, alongside the company’s higher borrowings.