SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal Year Ended December 31, 2002

Commission File No. 0-3681

 

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

 

California

    

95-221-1612

(State or other jurisdiction

    

(I.R.S. Employer

of incorporation or organization)

    

Identification No.)

4484 Wilshire Boulevard, Los Angeles, California

    

90010

(Address of principal executive offices)

    

(Zip Code)

 

Registrant’s telephone number, including area code: (323) 937-1060

 

Securities registered pursuant to Section 12(b) of the Act

 

Title of Class


 

Name of Exchange on Which Registered


Common Stock

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act

 

NONE

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   x      No   ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes   x      No   ¨

 

The aggregate market value of the Registrant’s voting stock held by non-affiliates of the Registrant at June 28, 2002, was approximately $1,236,439,302 (based upon the closing sales price on the New York Stock Exchange for such date, as reported by the Wall Street Journal).

 

At February 14, 2003, the Registrant had issued and outstanding an aggregate of 54,388,148 shares of its Common Stock.

 

Documents Incorporated by Reference

 

Portions of the definitive proxy statement for the Annual Meeting of Shareholders of Registrant to be held on May 14, 2003 are incorporated herein by reference into Part III hereof.

 



 

Item 1.    Business

 

General

 

Mercury General Corporation (“Mercury General”) and its subsidiaries (collectively, the “Company”) are engaged primarily in writing all risk classifications of automobile insurance in a number of states, principally California. During 2002, private passenger automobile insurance and commercial automobile insurance accounted for 88.5% and 3.7%, respectively, of the Company’s total gross premiums written. The percentage of gross automobile insurance premiums written during 2002 by state was 86.0% in California, 6.2% in Florida, 4.3% in Texas, 1.2% in Oklahoma, 0.9% in Illinois, 0.9% in Georgia and 0.5% in all other states. The Company also writes homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance and commercial property insurance. The non-automobile lines of insurance accounted for 7.8% of gross written premiums in 2002, of which approximately 15.1% was in commercial lines.

 

The Company offers automobile policyholders the following types of coverage: bodily injury liability, underinsured and uninsured motorist, personal injury protection, property damage liability, comprehensive, collision and other hazards. The Company’s published maximum limits of liability for bodily injury are $250,000 per person, $500,000 per accident and, for property damage, $250,000 per accident. Subject to special underwriting approval, the combined policy limits may be as high as $1,000,000 for vehicles written under the Company’s commercial automobile plan. However, under the majority of the Company’s automobile policies, the limits of liability are equal to or less than $100,000 per person, $300,000 per accident and $50,000 for property damage.

 

In 2002, all of the Company’s subsidiaries actively writing insurance, except American Mercury Insurance Company (“AMI”) and American Mercury Lloyds Insurance Company (“AML”), maintained their rating of A+ (Superior) by A.M. Best & Co. (“A.M. Best”). This is the second highest of the fifteen rating categories in the A.M. Best rating system, which range from A++ (Superior) to F (In Liquidation). AMI and AML, which accounted for approximately 5% of the Company’s 2002 net written premiums, maintained their A.M. Best rating of A- (Excellent).

 

The principal executive offices of Mercury General are located in Los Angeles, California. The home office of its California insurance subsidiaries and the Company’s computer and operations center is located in Brea, California. The Company maintains branch offices in a number of locations in California as well as branch offices in Richmond, Virginia, Latham, New York, Vernon Hills, Illinois, Atlanta, Georgia, Clearwater, Florida, Oklahoma City, Oklahoma, and Austin, Dallas, Fort Worth, Houston and San Antonio, Texas. The Company has approximately 3,300 employees.

 

Website Access to Information

 

The internet address for the Company’s website is www.mercuryinsurance.com. The Company makes available on its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to such reports (the “SEC Reports”) filed or furnished to the SEC pursuant to Federal securities laws as soon as reasonably practicable after each SEC Report is filed with, or furnished to the SEC. In addition, copies of the SEC Reports are available, without charge, upon written or faxed request to the Company’s Chief Financial Officer, Mercury General Corporation, 4484 Wilshire Boulevard, Los Angeles, California 90010 (fax: (323) 857-4923).

 

Organization

 

Mercury General, an insurance holding company, is the parent of Mercury Casualty Company (“Mercury Casualty or MCC”), a California automobile insurer founded in 1961 by George Joseph, Mercury General’s Chief Executive Officer. In addition to MCC, Mercury General has seven direct and six indirect subsidiaries. The Company also manages and controls a Texas county mutual insurer through a management agreement. The Company’s insurance operations in California are conducted through three California insurance company subsidiaries, Mercury Casualty, Mercury Insurance Company (“Mercury Insurance or MIC”), and California Automobile Insurance

 

2


Company (“Cal Auto”). The Company formed two subsidiaries, Mercury Insurance Company of Georgia (“MICGA”) and Mercury Insurance Company of Illinois (“MICIL”) in 1989 to write automobile insurance and added Mercury Indemnity Company of Georgia (“MIDGA”) and Mercury Indemnity Company of Illinois (“MIDIL”) in 1992 to write preferred risk automobile insurance in those two states. In December 1996, the Company acquired American Mercury Insurance Company (formerly, American Fidelity Insurance Company) and American Fidelity Insurance Management Company, Inc. (“AFIMC”), a Texas corporation which serves as the attorney-in-fact for American Mercury Lloyds Insurance Company (formerly, American Fidelity Lloyds Insurance Company), a Texas insurer.

 

In December 1999, the Company acquired control of Concord Insurance Services, Inc. (“Concord”), a Texas insurance agency headquartered in Houston, Texas. In September 2000, the Company acquired the authority and right to manage and control Elm County Mutual Insurance Company (“Elm”), a mutual insurance company organized under Chapter 17 of the Texas Insurance Code. The acquisition was made through the purchase of a management agreement from Employers Reinsurance Corporation. Effective January 2, 2001, Elm County Mutual Insurance Company’s name was changed to Mercury County Mutual Insurance Company (“MCM”). MCM’s results of operations are included in the consolidated results of the Company effective September 30, 2000. In December 2001, the Company received authority to write automobile insurance in the state of Florida through two newly established companies, Mercury Insurance Company of Florida (“MICFL”) and Mercury Indemnity Company of Florida (“MIDFL”). In January 2002, MICFL commenced writing new business as well as renewing business that was previously written through MCC in Florida.

 

Prior to January 1, 2001, Mercury General furnished management services to its California, Georgia, Illinois and Oklahoma subsidiaries. Since January 1, 2001, these management services have been provided by Mercury Insurance Services, LLC (“MISLLC”), a subsidiary of Mercury Casualty. Mercury General, its subsidiaries and AML and MCM, are referred to collectively as the “Company” unless the context indicates otherwise. Mercury General Corporation individually is referred to as “Mercury General.” All of the subsidiaries as a group, including AML and MCM, but excluding AFIMC, MISLLC and Concord, are referred to as the “Insurance Companies.” The term “California Companies” refers to Mercury Casualty, Mercury Insurance and California Automobile Insurance Company.

 

Underwriting

 

The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Insurance Commissioners of the applicable states. Automobile insurance rates on voluntary business in California are subject to prior approval by the California Department of Insurance (“DOI”). The Company uses its own extensive data base to establish rates and classifications. The California DOI has in effect rating factor regulations that influence the weight the Company ascribes to various classifications of data.

 

At December 31, 2002, “good drivers” (as defined by the California Insurance Code) accounted for approximately 76% of all voluntary private passenger automobile policies in force in California, while the higher risk categories accounted for approximately 24%. The private passenger automobile renewal rate in California (the rate of acceptance of offers to renew) averages approximately 96%. The Company also offers homeowners insurance to California residents.

 

The Company also offers a monthly pay policy through Cal Auto targeted at higher risk (“non-standard”) drivers. This voluntary business accounts for approximately 9% of the total voluntary private passenger automobile policies in force in California.

 

The Company’s Oklahoma and Texas private passenger automobile business in force, underwritten through AMI, is primarily standard and preferred risks. AMI offers a non-standard policy in Texas and Oklahoma and homeowners insurance to Oklahoma residents. The non- standard policies in force represent approximately 29% of the total policies in force written by AMI and is less than 1% of the Company’s total policies in force at December 31, 2002 and was not material.

 

3


 

The Company also offers non-standard private passenger automobile coverage in Texas through Concord. Non-standard policies in force, written through Concord, were not a significant portion of the Company’s total policies in force at December 31, 2002.

 

The Company’s Florida private passenger automobile business in force, underwritten by MICFL in 2002, consists of standard, non-standard and preferred risks and accounts for approximately 5% of the Company’s total policies in force at December 31, 2002. The Company also offers homeowners insurance to Florida residents. The amount of Florida homeowners policies in force at December 31, 2002 was not material.

 

The Company’s Illinois, Georgia, Virginia and New York private passenger automobile business in force is primarily standard and preferred risks and represents less than 3% of the Company’s total policies in force at December 31, 2002. The Company also offers homeowners insurance to Illinois and Georgia residents.

 

Production and Servicing of Business

 

The Company sells its policies through more than 2,700 independent agents and brokers, of which approximately 1,000 are located in California, approximately 800 are located in Florida and approximately 400 represent AMI in Oklahoma and Texas. The remainder are located in Georgia, Illinois, New York and Virginia. Over half of the agents and brokers in California have represented the Company for more than ten years. The agents and brokers, most of whom also represent one or more competing insurance companies, are independent contractors selected and appointed by the Company.

 

Other than one broker that produced approximately 16%, 17% and 18% during 2002, 2001, and 2000, respectively, of the Company’s total direct premiums written, no agent or broker accounted for more than 2% of direct premiums written.

 

The Company believes that it compensates its agents’ and brokers’ above the industry average. During 2002, total commissions and bonuses incurred were 16.4% of net premiums written.

 

The Company, in an effort to assist its agents and brokers, released a new software design, “Quicksilver,” which streamlines the quoting and new business application process. Quicksilver is internet based, increases accessibility to its agents and brokers and reduces the support required by the Company’s previous system. Quicksilver contains intuitive underwriting features providing faster and more accurate price quotes, and a simple design which enables users with little or no experience to utilize this application immediately.

 

The Company’s advertising budget is allocated amongst television, newspaper and direct mailing media to provide the best coverage available within defined media markets. While the majority of these advertising costs are borne by the Company, a portion of these costs are reimbursed by the Company’s agents and brokers based upon the number of account leads generated by the advertising. The Company believes that its advertising program is important to create brand awareness and to remain competitive in the current insurance climate and intends to maintain the current level of advertising in 2003 (See Competitive Conditions).

 

Claims

 

Claims operations are conducted by the Company. The claims staff administers all claims and directs all legal and adjustment aspects of the claims process. The Company adjusts most claims without the assistance of outside adjusters.

 

Loss and Loss Adjustment Expense Reserves

 

The Company maintains reserves for the payment of losses and loss adjustment expenses for both reported and unreported claims. Loss reserves are estimated based upon a case-by-case evaluation of the type of claim

 

4


involved and the expected development of such claim. The amount of loss reserves and loss adjustment expense reserves for unreported claims are determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

 

The ultimate liability may be greater or less than stated loss reserves. Reserves are closely monitored and are analyzed quarterly by the Company’s actuarial consultants using current information on reported claims and a variety of statistical techniques. The Company does not discount to a present value that portion of its loss reserves expected to be paid in future periods. The Tax Reform Act of 1986 does, however, require the Company to discount loss reserves for Federal income tax purposes.

 

The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expenses, net of reinsurance deductions, as shown on the Company’s consolidated financial statements for the periods indicated:

 

    

Year ended December 31,


    

2002


  

2001


  

2000


    

(Amounts in thousands)

Net reserves for losses and loss adjustment expenses, beginning of year

  

$

516,592

  

$

463,803

  

$

418,800

Incurred losses and loss adjustment expenses:

                    

Provision for insured events of the current year

  

 

1,242,060

  

 

993,510

  

 

878,144

Increase in provision for insured events of prior years

  

 

26,183

  

 

16,929

  

 

23,637

    

  

  

Total incurred losses and loss adjustment expenses

  

 

1,268,243

  

 

1,010,439

  

 

901,781

    

  

  

Payments:

                    

Losses and loss adjustment expenses attributable to insured events of the current year

  

 

759,165

  

 

636,007

  

 

562,163

Losses and loss adjustment expenses attributable to insured events of prior years

  

 

360,781

  

 

321,643

  

 

294,615

    

  

  

Total payments

  

 

1,119,946

  

 

957,650

  

 

856,778

    

  

  

Net reserves for losses and loss adjustment expenses at the end of the period

  

 

664,889

  

 

516,592

  

 

463,803

Reinsurance recoverable

  

 

14,382

  

 

18,334

  

 

28,417

    

  

  

Gross liability at end of year

  

$

679,271

  

$

534,926

  

$

492,220

    

  

  

 

The increase in the provision for insured events of prior years in 2002, 2001 and 2000 largely relates to an increase in the ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs.

 

The difference between the reserves reported in the Company’s consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and those reported in the statements filed with the DOI in accordance with statutory accounting principles (“SAP”) is shown in the following table:

 

    

December 31,


    

2002


  

2001


  

2000


    

(Amounts in thousands)

Reserves reported on a SAP basis

  

$

664,889

  

$

516,592

  

$

463,803

Reinsurance recoverable

  

 

14,382

  

 

18,334

  

 

28,417

    

  

  

Reserves reported on a GAAP basis

  

$

679,271

  

$

534,926

  

$

492,220

    

  

  

 

5


 

Under SAP, reserves are stated net of reinsurance recoverable in contrast to GAAP where reserves are stated gross of reinsurance recoverable.

 

The following table represents the development of loss reserves for the period 1992 through 2002. The top line of the table shows the reserves at the balance sheet date, net of reinsurance recoverable for each of the indicated years. This represents the estimated amount of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including an estimate for losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the cumulative amounts paid as of successive years with respect to that reserve liability. The middle portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The bottom line shows the redundancy (deficiency) that exists when the original reserve estimates are greater (less) than the re-estimated reserves at December 31, 2002.

 

In evaluating the information in the table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.

 

    

As of December 31,


    

1992


  

1993


  

1994


    

1995


    

1996


    

1997


  

1998


    

1999


    

2000


    

2001


    

2002


    

(Amounts in thousands)

Net reserves for losses and loss adjustment expenses

  

$

239,203

  

$

214,525

  

$

223,392

 

  

$

250,990

 

  

$

311,754

 

  

$

386,270

  

$

385,816

 

  

$

418,800

 

  

$

463,803

 

  

$

516,592

 

  

$

664,889

Paid (cumulative) as of:

                                                                                          

One year later

  

 

135,188

  

 

143,272

  

 

145,664

 

  

 

167,226

 

  

 

206,390

 

  

 

247,310

  

 

263,805

 

  

 

294,615

 

  

 

321,643

 

  

 

360,781

 

      

Two years later

  

 

184,119

  

 

187,641

  

 

198,967

 

  

 

225,158

 

  

 

291,552

 

  

 

338,016

  

 

366,908

 

  

 

403,378

 

  

 

431,498

 

               

Three years later

  

 

197,371

  

 

204,606

  

 

214,403

 

  

 

248,894

 

  

 

316,505

 

  

 

369,173

  

 

395,574

 

  

 

429,787

 

                        

Four years later

  

 

201,365

  

 

207,704

  

 

219,596

 

  

 

253,708

 

  

 

324,337

 

  

 

379,233

  

 

402,000

 

                                 

Five years later

  

 

202,383

  

 

209,930

  

 

220,852

 

  

 

255,688

 

  

 

329,109

 

  

 

381,696

                                          

Six years later

  

 

203,578

  

 

210,281

  

 

221,771

 

  

 

257,041

 

  

 

329,825

 

                                                 

Seven years later

  

 

203,461

  

 

210,767

  

 

222,912

 

  

 

256,654

 

                                                          

Eight years later

  

 

203,657

  

 

211,655

  

 

222,492

 

                                                                   

Nine years later

  

 

203,673

  

 

211,212

                                                                            

Ten years later

  

 

203,544

                                                                                   

Net reserves re-estimated as of:

                                                                                          

One year later

  

 

204,479

  

 

204,451

  

 

216,684

 

  

 

247,122

 

  

 

324,572

 

  

 

376,861

  

 

393,603

 

  

 

442,437

 

  

 

480,732

 

  

 

542,775

 

      

Two years later

  

 

204,999

  

 

207,089

  

 

222,861

 

  

 

254,920

 

  

 

329,210

 

  

 

378,057

  

 

407,047

 

  

 

449,094

 

  

 

481,196

 

               

Three years later

  

 

203,452

  

 

210,838

  

 

221,744

 

  

 

257,958

 

  

 

327,749

 

  

 

383,588

  

 

410,754

 

  

 

446,242

 

                        

Four years later

  

 

204,603

  

 

210,890

  

 

222,957

 

  

 

257,196

 

  

 

329,339

 

  

 

386,522

  

 

409,744

 

                                 

Five years later

  

 

203,705

  

 

211,192

  

 

221,947

 

  

 

256,395

 

  

 

332,570

 

  

 

385,770

                                          

Six years later

  

 

204,161

  

 

210,739

  

 

221,942

 

  

 

257,692

 

  

 

332,939

 

                                                 

Seven years later

  

 

203,775

  

 

210,719

  

 

223,215

 

  

 

258,743

 

                                                          

Eight years later

  

 

203,928

  

 

211,845

  

 

224,276

 

                                                                   

Nine years later

  

 

203,853

  

 

212,902

                                                                            

Ten years later

  

 

203,729

                                                                                   

Net cumulative redundancy (deficiency)

  

 

35,474

  

 

1,623

  

 

(884

)

  

 

(7,753

)

  

 

(21,185

)

  

 

500

  

 

(23,928

)

  

 

(27,442

)

  

 

(17,393

)

  

 

(26,183

)

      

 

6


 

   

As of December 31,


 
   

1993


   

1994


   

1995


   

1996


   

1997


   

1998


   

1999


   

2000


   

2001


   

2002


 
   

(Amounts in thousands)

       

Gross liability—end of year

 

215,301

 

 

227,499

 

 

253,546

 

 

336,685

 

 

409,061

 

 

405,976

 

 

434,843

 

 

492,220

 

 

534,926

 

 

679,271

 

Reinsurance recoverable

 

(776

)

 

(4,107

)

 

(2,556

)

 

(24,931

)

 

(22,791

)

 

(20,160

)

 

(16,043

)

 

(28,417

)

 

(18,334

)

 

(14,382

)

   

 

 

 

 

 

 

 

 

 

Net liability—end of year

 

214,525

 

 

223,392

 

 

250,990

 

 

311,754

 

 

386,270

 

 

385,816

 

 

418,800

 

 

463,803

 

 

516,592

 

 

664,889

 

   

 

 

 

 

 

 

 

 

 

Gross re-estimated liability—latest

 

220,154

 

 

237,152

 

 

268,412

 

 

360,557

 

 

410,755

 

 

431,458

 

 

463,527

 

 

510,276

 

 

560,834

 

     

Re-estimated recoverable—latest

 

(7,252

)

 

(12,876

)

 

(9,669

)

 

(27,618

)

 

(24,985

)

 

(21,714

)

 

(17,285

)

 

(29,080

)

 

(18,059

)

     
   

 

 

 

 

 

 

 

 

     

Net re-estimated liability—latest

 

212,902

 

 

224,276

 

 

258,743

 

 

332,939

 

 

385,770

 

 

409,744

 

 

446,242

 

 

481,196

 

 

542,775

 

     
   

 

 

 

 

 

 

 

 

     

Gross cumulative redundancy (deficiency)

 

(4,853

)

 

(9,653

)

 

(14,866

)

 

(23,872

)

 

(1,694

)

 

(25,482

)

 

(28,684

)

 

(18,056

)

 

(25,908

)

     
   

 

 

 

 

 

 

 

 

     

 

For calendar years 1998 through 2002, the Company’s previously estimated loss reserves produced a deficiency which was reflected in the following years incurred losses. The Company attributes a large portion of the deficiency to an increase in the ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs.

 

Throughout the 1990’s average bodily injury costs decreased until 1998 when they began to rise. Since individual losses for this coverage tend to develop slower than for the collision or physical damage line, it is difficult for the actuaries to identify such a change in trend until well after the year has closed. Furthermore, once the Company knows it is in an inflationary trend, it is difficult to determine the magnitude of the inflation due to the slower developing nature of the bodily injury claims.

 

During 2002, the Company increased the bodily injury severity inflation rate that it recorded for the 2001 and 2002 accident years from approximately 4% to approximately 8% on its California automobile lines which contributed significantly to the Company’s total adverse development on 2001 and prior accident years. Management will continue to monitor inflation trends closely, but believes the 8% inflation rate recorded to be reasonable and its best estimate based on the information currently available. Future information will become available which could change Management’s assumptions.

 

For calendar year 1997, the Company’s previously estimated loss reserves produced a minor redundancy. The Company attributes the favorable loss development primarily to the effect of Proposition 213, a California initiative passed in November 1996 that prevents uninsured motorists, drunk drivers and fleeing felons from collecting awards for “pain and suffering” (See Regulations—California Financial Responsibility Law). This law produced an overall reduction in bodily injury loss severity for calendar year 1997. In addition, a law, effective January 1, 1997 requiring proof of insurance before registration of a motor vehicle resulted in a much smaller pool of uninsured motorists, thereby decreasing the frequency of uninsured motorists claims (See Regulations—California Financial Responsibility Law).

 

For calendar years 1995 and 1996, the Company’s previously estimated loss reserves produced deficiencies. These deficiencies relate to increases in the Company’s ultimate estimates for loss adjustment expenses, which are based principally on the Company’s actual experience. The adverse development on such reserves reflects the increases in the legal expenses of defending the Company’s insureds arising from the Company’s policy of aggressively defending, including litigating, exaggerated bodily injury claims arising from minimal impact automobile accidents.

 

For calendar year 1994, the Company’s previously estimated loss reserve produced a small deficiency indicating that the Company was reasonably accurate in establishing the initial reserve for that year.

 

For calendar years 1992 and 1993, the Company’s previously estimated loss reserves produced redundancies. The Company attributes this favorable loss development to several factors. First, the Company had completed its

 

7


development of a full complement of claims personnel early in this period. Second, during 1988, the California Supreme Court reversed what was known as the “ Royal Globe ” doctrine, which, since 1978, had permitted third party plaintiffs to sue insurers for alleged “bad faith” in resolving claims, even when the plaintiff had voluntarily agreed to a settlement. This doctrine had placed undue pressures on claims representatives to settle legitimate disputes at unfairly high settlement amounts. After the reversal of Royal Globe , the Company believes that it has been able to achieve fairer settlements, because both parties are in a more equal bargaining position. See Regulations—Third Party “Bad Faith” Legislation. Third, during the years 1988 through 1990, the volume of business written in the Assigned Risk Program expanded substantially as rates were suppressed at grossly inadequate levels. Following the California Insurance Commissioner’s approval of an 85% temporary rate increase in September 1990, the volume of assigned risk business had declined by nearly 80%. Many of the claims associated with the high volume of assigned risk business in the 1988-1990 period were later found to be fraudulent or grossly exaggerated and were settled in subsequent periods for substantially less than had been initially reserved.

 

Operating Ratios

 

Loss and Expense Ratios

 

Loss and underwriting expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. Losses and loss adjustment expenses, on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses on a statutory basis are stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratios are less than 100%. The Company’s loss ratio, expense ratio and combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in the following table. The Company’s ratios include lines of insurance other than private passenger automobile. Since these other lines represent only a small percentage of premiums written, the Company believes its ratios can be compared to the industry ratios included in the table.

 

    

Year ended December 31,


 
    

2002


      

2001


    

2000


    

1999


    

1998


 

Loss Ratio

  

72.8

%

    

73.2

%

  

72.2

%

  

66.5

%

  

61.1

%

Expense Ratio

  

25.6

 

    

26.0

 

  

26.4

 

  

26.5

 

  

26.3

 

    

    

  

  

  

Combined Ratio

  

98.4

%

    

99.2

%

  

98.6

%

  

93.0

%

  

87.4

%

    

    

  

  

  

Industry combined ratio (all writers)(1)

  

103.0

%(2)

    

107.5

%

  

108.1

%

  

102.6

%

  

100.1

%

Industry combined ratio (excluding direct writers)(1)

  

(N.A.

)

    

105.8

%

  

108.6

%

  

102.3

%

  

99.1

%


(1)   Source: A.M. Best, Aggregates & Averages (1999 through 2002), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends).
(2)   Source: A.M. Best, “Best’s Review, January 2003,” “Review Preview.”
(N.A.)  Not   available.

 

Under GAAP, the loss ratio is computed in the same manner as under statutory accounting, but the expense ratio is determined by matching underwriting expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The following table sets forth the Company’s loss ratio, expense ratio and combined ratio determined in accordance with GAAP for the last five years.

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


    

1999


    

1998


 

Loss Ratio

  

72.8

%

  

73.2

%

  

72.2

%

  

66.5

%

  

61.1

%

Expense Ratio

  

26.0

 

  

26.4

 

  

26.3

 

  

26.8

 

  

26.6

 

    

  

  

  

  

Combined Ratio

  

98.8

%

  

99.6

%

  

98.5

%

  

93.3

%

  

87.7

%

    

  

  

  

  

 

8


 

Premiums to Surplus Ratio

 

The following table shows, for the periods indicated, the Insurance Companies’ statutory ratios of net premiums written to policyholders’ surplus. While there is no statutory requirement applicable to the Company which establishes a permissible net premium writings to surplus ratio, widely recognized guidelines established by the National Association of Insurance Commissioners (“NAIC”) indicate that this ratio should be no greater than 3 to 1.

 

    

Year ended December 31,


    

2002


  

2001


  

2000


  

1999


  

1998


    

(Amounts in thousands, except ratios)

Net premiums written

  

$

1,865,046

  

$

1,442,886

  

$

1,272,447

  

$

1,206,171

  

$

1,144,051

Policyholders’ surplus

  

$

1,014,935

  

$

1,045,104

  

$

954,753

  

$

853,794

  

$

767,223

Ratio

  

 

1.8 to 1

  

 

1.4 to 1

  

 

1.3 to 1

  

 

1.4 to 1

  

 

1.5 to 1

 

Risk Based Capital

 

In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which established recommended minimum capital requirements for casualty companies. The formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. Based on the formula adopted by the NAIC, the Company has calculated the Risk-Based Capital Requirements of each of the Insurance Companies as of December 31, 2002. Each of the companies exceeded the highest level of minimum required capital.

 

Statutory Accounting Principles

 

The Company’s results are reported in accordance with GAAP, which differ from amounts reported in accordance with SAP as prescribed by insurance regulatory authorities. Specifically, under GAAP:

 

    Policy acquisition costs such as commissions, premium taxes and other variable costs incurred in connection with writing new and renewal business are capitalized and amortized on a pro rata basis over the period in which the related premiums are earned, rather than expensed as incurred, as required by SAP.

 

    Certain assets are included in the consolidated balance sheets, whereas, under SAP, such assets are designated as “nonadmitted assets,” and charged directly against statutory surplus. These assets consist primarily of premium receivables that are outstanding over 90 days, federal deferred tax assets in excess of statutory limitations, furniture, equipment, leasehold improvements and prepaid expenses.

 

    Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, respectively, as required by SAP.

 

    Fixed maturities securities, which are classified as available-for-sale, are reported at current market values, rather than at amortized cost, or the lower of amortized cost or market, depending on the specific type of security, as required by SAP.

 

    Equity securities are reported at quoted market values which may differ from the NAIC market values as required by SAP.

 

    Costs for application computer software developed or obtained for internal use are capitalized and amortized over their useful life, rather then expensed as incurred, as required by SAP.

 

9


 

    The differing treatment of income and expense items results in a corresponding difference in federal income tax expense. Changes in deferred income taxes are reflected as an item of income tax benefit or expense, rather than recorded directly to surplus as regards policyholders, as required by SAP. Admittance testing may result in a charge to unassigned surplus for non-admitted portions of deferred tax assets. Under GAAP reporting, a valuation allowance may be recorded against the deferred tax asset and reflected as an expense.

 

Investments and Investment Results

 

The investments of the Company are directed by the Company’s Chief Investment Officer under the supervision of the Company’s Board of Directors. The Company follows an investment policy which is regularly reviewed and revised. The Company’s policy emphasizes investment grade, fixed income securities and maximization of after-tax yields and places certain restrictions to limit portfolio concentrations and market exposure. The Company does not invest with a view to achieving realized gains. However, sales of securities are undertaken, with resulting gains or losses, in order to enhance after-tax yield and keep the portfolio in line with current market conditions. Tax considerations are important in portfolio management, and have been made more so since 1986 when the alternative minimum tax (“AMT”) was imposed on casualty companies. Changes in loss experience, growth rates and profitability produce significant changes in the Company’s exposure to AMT liability, requiring appropriate shifts in the investment asset mix between taxable bonds, tax-exempt bonds and equities in order to maximize after-tax yield.

 

The following table sets forth the composition of the investment portfolio of the Company at the dates indicated:

 

    

December 31,


    

2002


  

2001


  

2000


    

Amortized Market

  

Amortized Market

  

Amortized Market

    

Cost


  

Value


  

Cost


  

Value


  

Cost


  

Value


    

(Amounts in thousands)

Taxable bonds

  

$

198,994

  

$

185,643

  

$

283,991

  

$

271,925

  

$

151,281

  

$

152,704

Tax-exempt state and municipal bonds

  

 

1,352,616

  

 

1,433,242

  

 

1,260,485

  

 

1,298,637

  

 

1,292,711

  

 

1,336,555

Sinking fund preferred stocks

  

 

14,150

  

 

13,986

  

 

15,704

  

 

15,871

  

 

19,905

  

 

20,215

    

  

  

  

  

  

Total fixed maturity investments

  

 

1,565,760

  

 

1,632,871

  

 

1,560,180

  

 

1,586,433

  

 

1,463,897

  

 

1,509,474

Equity investments incl. perpetual preferred stocks

  

 

233,297

  

 

230,981

  

 

277,925

  

 

277,787

  

 

250,593

  

 

252,510

Short-term cash investments

  

 

286,806

  

 

286,806

  

 

71,951

  

 

71,951

  

 

32,977

  

 

32,977

    

  

  

  

  

  

Total investments

  

$

2,085,863

  

$

2,150,658

  

$

1,910,056

  

$

1,936,171

  

$

1,747,467

  

$

1,794,961

    

  

  

  

  

  

 

The Company continually evaluates the recoverability of its investment holdings. When a decline in value of fixed maturities or equity securities is considered other than temporary, the Company writes the security down to fair value by recognizing a loss in the Consolidated Statement of Income. The Company recognized losses of $71.7 million of investment write-downs considered to be other than temporarily impaired during 2002. Declines in value considered to be temporary, are charged as unrealized losses to shareholders’ equity as accumulated other comprehensive income. At December 31, 2002, the Company had a net unrealized gain on all investments of $64.8 million before income taxes which is comprised of unrealized gains of $102.9 million offset by unrealized losses of $38.1 million. Of these unrealized losses, approximately $27 million relate to fixed maturities which are current on their debt servicing obligations. The remaining unrealized losses of approximately $11.1 million relate to equity securities for which approximately 64% of the unrealized losses represent securities with unrealized losses of less than 10% of their amortized costs. The Company has concluded that the gross unrealized losses of

 

10


$38.1 million at December 31, 2002 were temporary in nature. However, facts and circumstances may change which could result in a decline in market value considered to be other than temporary.

 

At year-end, approximately 67% of the Company’s total investment portfolio, at market values, and 88% of its total fixed maturity investments, at market values, were invested in medium to long term, investment grade tax-exempt revenue and municipal bonds. Shorter duration sinking fund preferred stocks and collateralized mortgage obligations represented approximately 4% of the Company’s total investment portfolio, at market values, and 5.2% of its total fixed maturity investments, at market value, at December 31, 2002. The average Standard & Poor’s rating of the Company’s bond holdings was AA at December 31, 2002.

 

The nominal average maturity of the overall bond portfolio which includes collateralized mortgage obligations and short term cash investments was 12.0 years at December 31, 2002 which reflects a heavier portfolio mix in medium to long term, investment grade tax-exempt revenue and municipal bonds. The call-adjusted average maturity of the overall bond portfolio was shorter, approximately 5.7 years, because holdings are heavily weighted with high coupon issues which are expected to be called prior to maturity. The modified duration of the overall bond portfolio reflecting anticipated early calls was 4.4 years at December 31, 2002 and includes collateralized mortgage obligations with modified durations of approximately 1.1 years and short term cash investments that carry no duration. The modified duration on the bond portfolio excluding the collateralized mortgage obligations and the short term cash investments was 5.2 years. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a much better indicator of price volatility than simple maturity alone. The longer the duration, the greater the price volatility in relation to changes in interest rates. Holdings of lower than investment grade bonds constitute approximately 1.9% of total assets.

 

Equity holdings consist primarily of perpetual preferred stocks and dividend bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. At year end, short term cash investments consisted of highly rated short duration securities redeemable on a daily or weekly basis. This component of the portfolio was increased by management when longer term investment opportunities were considered unattractive as a result of the current interest rate environment.

 

The following table summarizes the investment results of the Company for the five years ended December 31, 2002:

 

    

Year ended December 31,


 
    

2002(1)


      

2001(1)


      

2000(1)


      

1999


      

1998


 
    

(Amounts in thousands)

 

Averaged invested assets (includes short-term cash

investments(2))

  

$

2,035,279

 

    

$

1,828,455

 

    

$

1,710,176

 

    

$

1,595,466

 

    

$

1,473,843

 

Net investment income:

                                                    

Before income taxes

  

 

113,083

 

    

 

114,511

 

    

 

106,466

 

    

 

99,374

 

    

 

96,169

 

After income taxes

  

 

99,071

 

    

 

98,909

 

    

 

95,154

 

    

 

89,598

 

    

 

87,199

 

Average annual yield on investments:

                                                    

Before income taxes

  

 

5.6

%

    

 

6.3

%

    

 

6.2

%

    

 

6.2

%

    

 

6.5

%

After income taxes

  

 

4.9

%

    

 

5.4

%

    

 

5.6

%

    

 

5.6

%

    

 

5.9

%

Net realized investment gains (losses) after income taxes

  

 

(45,768

)(3)

    

 

4,233

 

    

 

2,564

 

    

 

(7,754

)

    

 

(2,552

)

Net increase (decrease) in unrealized gains/losses on all investments after income

taxes

  

$

25,165

 

    

$

(13,896

)

    

$

70,342

 

    

$

(90,667

)

    

$

5,065

 


(1)   Includes MCM for the last three months of 2000 and the full year in 2001 and 2002.

 

11


(2)   Fixed maturities and equities at cost.
(3)   Includes $46.6 million of investment write-downs, net of tax benefit that the Company considered to be other than temporary.

 

Competitive Conditions

 

The property and casualty insurance industry is highly competitive. The insurance industry consists of a large number of companies, many of which operate in more than one state, offering automobile, homeowners and commercial property insurance, as well as insurance coverage in other lines. Many of the Company’s competitors have larger volumes of business and greater financial resources than the Company. Based on the most recent regularly published statistical compilations, the Company in 2001 was the sixth largest writer of private passenger automobile insurance in California. All of the Company’s competitors having greater shares of the California market sell insurance either directly and/or through exclusive agents, rather than through independent agents.

 

The property and casualty insurance industry is highly cyclical, characterized by periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. In the Company’s view, the overall profitability of the California marketplace during the 1996 through 1998 time period created a favorable environment for automobile insurance writers. Many major automobile insurers attempted to capitalize on the favorable climate by increasing their marketing efforts and reducing rates in attempts to capture more business. These industry wide rate reductions and increased severity trends on bodily injury, collision and physical damage coverages contributed to the deterioration of industry loss ratios in the years 1999 through 2002 (See Operating Ratios—Loss and Expense Ratios).

 

Most competitors have filed for and implemented rate increases. Consequently, the industry has now entered a period of rising premium rates and reduced underwriting capacity (See Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations—Overview). The Company implemented rate increases in 2002, and plans to make additional filings for rate increases in California as well as other states. Despite the increases, the Company believes that its rates will remain competitive in the marketplace.

 

Price and reputation for service are the principal means by which the Company competes with other automobile insurers. The Company believes that it has a good reputation for service, and it has, historically, been among the lowest-priced insurers doing business in California according to surveys conducted by the California DOI. In addition to good service and competitive pricing, for those insurers dealing through independent agents or brokers, as the Company does, the marketing efforts of agents and brokers is also a means of competition.

 

All rates charged by private passenger automobile insurers are subject to the prior approval of the California DOI. (See Regulation—Automobile Insurance Rating Factor Regulations).

 

The Company encounters similar competition in each state and each line of business in which it operates outside California.

 

Reinsurance

 

The Company maintains property reinsurance under a treaty with Swiss Re, which is rated A++ by A.M. Best, effective January 1, 1999. Prior to October 1, 2002, the treaty provided $750,000 coverage in excess of $250,000 for each risk subject to a maximum of $2,250,000 for any one occurrence. A second layer of coverage provides an additional $1,000,000 in excess of the first $1,000,000 per risk. Effective March 1, 2002, a third layer of coverage provides an additional $3,000,000 in excess of the first $2,000,000 for coverage which exceeds $2,000,000 in insured value. On October 1, 2002, the first layer of the treaty was amended from $750,000 in excess of $250,000 to $500,000 in excess of $500,000.

 

12


 

The Company has in place a treaty reinsurance agreement with Swiss Re, where risks written under personal umbrella policies are ceded to Swiss Re on a 100% quota share basis. The treaty provides $4 million coverage in excess of $1 million for each risk.

 

The Company does not maintain catastrophe reinsurance for property and automobile physical damage business because the Company believes it has adequate capitalization to absorb catastrophe losses in these lines. The Company periodically reviews its requirements for catastrophic reinsurance particularly in areas that are prone to catastrophes such as Florida and California. For California, the Company has reduced its catastrophe exposure from earthquakes due to the placement of earthquake risks, written in conjunction with California homeowners policies, with the California Earthquake Authority. (See Regulation—California Earthquake Authority). Although the Company’s catastrophe exposure to earthquakes has been reduced, the Company continues to have catastrophe exposure for fire following an earthquake.

 

The Employer’s Reinsurance Corporation (“ERC”) reinsured AMI through working layer treaties for property and casualty losses in excess of $200,000. For the years 1990 through 1996 the mechanical breakdown line of business was reinsured with Constitution Reinsurance Corporation through a quota-share treaty covering 50% to 85% of the business written depending on the year the policy was incepted. For policies effective on or after January 1, 1997, AMI is retaining the full exposure. AMI has other reinsurance treaties and facultative arrangements in place for various smaller lines of business.

 

All new business written by MCM is ceded to either MCC or AMI. MCM continues to maintain reinsurance treaties with several different reinsurers covering policies prior to January 1, 2001. The Company also holds a formal guarantee from ERC which reimburses MCM if any of the reinsurers fail to satisfy their obligations under their respective reinsurance agreements.

 

If the reinsurers were unable to perform their obligations under the reinsurance treaty, the Company would be required, as primary insurer, to discharge all obligations to its insureds in their entirety.

 

Regulation

 

The Company’s business in California is subject to regulation and supervision by the California DOI, which has broad regulatory, supervisory and administrative powers.

 

The powers of the California DOI primarily include the prior approval of insurance rates and rating factors and the establishment of standards of capital and surplus requirements and solvency which must be met and maintained, restrictions on dividend payments and transactions with affiliates. The regulation and supervision by the California DOI are designed principally for the benefit of policyholders and not for insurance company shareholders.

 

The California DOI’s Market Conduct Division is responsible for conducting periodic examinations of companies to ensure compliance with California Insurance Code and California Code of Regulations with respect to rating, underwriting and claims handling practices. The most recent examination covered the underwriting and rating practices applied to its homeowners multiple peril, personal automobile, commercial multiple peril and commercial automobile insurance of the California Companies and AMI during the period January 1, 1999 through December 31, 2001. The report on the examination is pending finalization by the California DOI. The California DOI also conducts periodic financial examinations of the Company’s California domiciled insurance subsidiaries. The last examination was as of December 31, 2000. The reports on the results of those examinations were issued in June 2002. There were no recommended adjustments to the statutory financial statements as filed by the California domiciled insurance subsidiaries.

 

The insurance subsidiaries outside California are subject to the regulatory powers of the insurance departments of those states. Those powers are similar to the regulatory powers in California enumerated above.

 

13


Generally, the regulations relate primarily to standards of solvency and are designed for the benefit of policyholders and not of insurance company shareholders.

 

In California and Georgia, insurance rates require prior approval from the State DOI, while Illinois and Texas only require that rates be filed with the DOI. Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be “excessive, inadequate or unfairly discriminatory.”

 

The California DOI has required all insurers offering persistency discounts to make class plan filings by January 15, 2003, removing the portability of these discounts. Persistency discounts represent discounts on policy rates extended to consumers based upon the number of consecutive years that the consumers carried insurance coverage. The Company made its filing and is currently awaiting DOI approval. The changes made in the Company’s plan are revenue neutral for the Company’s existing business. The removal of persistency discounts could have an impact on the Company’s price competitiveness in attracting new business. However, this impact, if any, is undeterminable.

 

The Georgia DOI conducted an examination of MICGA and MIDGA as of December 31, 2000. The reports on the results of that examination are not yet available. The Illinois DOI conducted an examination of MICIL and MIDIL as of December 31, 2000. The reports on that examination are not yet available. The Oklahoma DOI conducted an examination of AMI as of December 31, 1998. The exam resulted in no material findings or recommendations. The State of Texas commenced an examination of MCM in the fall of 2002. The State of Florida notified the Company of its intent to conduct examinations of MICFL and MIDFL.

 

The operations of the Company are dependent on the laws of the state in which it does business and changes in those laws can materially affect the revenue and expenses of the Company. The Company retains its own legislative advocates in California. The Company also makes financial contributions to officeholders and candidates. In 2002 and 2001, those contributions amounted to $726,950 and $490,815, respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines to be appropriate.

 

Insurance Guarantee Association

 

The California Insurance Guarantee Association (the “Association”) was created to provide for payment of claims for which insolvent insurers of most casualty lines are liable but which cannot be paid out of such insurers’ assets. The Company is subject to assessment by the Association for its pro-rata share of such claims based on premiums written in the particular line in the year preceding the assessment by insurers writing that line of insurance in California. Insurance subsidiaries in the other states are also subject to the provisions of similar insurance guaranty associations. Such assessments are based upon estimates of losses to be incurred in liquidating an insolvent insurer. In a particular year, the Company cannot be assessed an amount greater than 2% of its premiums written in the preceding year. Assessments are recouped through a mandated surcharge to policyholders the year after the assessment. The Company accounts for assessments in accordance with AICPA Statement of Position 97-3 (“SOP 97-3”), which requires the recognition of a liability when an assessment is levied or information is available indicating that an assessment is probable. In addition, SOP 97-3 prohibits the recognition of an asset for recoveries related to new business or renewal of short duration policies. Although the Company intends to recover assessments through policy surcharges, no such assets have been recorded at December 31, 2002.

 

During 2002, the Company paid approximately $293,000 to the California Insurance Guarantee Association for an assessment relating to its commercial property business. In December 2002, the Florida Insurance Guaranty Association levied an assessment of approximately $536,000 to the Company relating primarily to the insolvency of the Aries Insurance Company. The Company expects to recover these assessments in 2003. No other assessments were imposed against the Company in the last five years.

 

14


 

Holding Company Act

 

The California Companies are subject to regulation by the California DOI pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the “Holding Company Act”). The California DOI may examine the affairs of each of the California companies at any time. The Holding Company Act requires disclosure of any material transactions among the companies. Certain transactions and dividends defined to be of an “extraordinary” type may not be effected if the California DOI disapproves the transaction within 30 days after notice. Such transactions include, but are not limited to, certain reinsurance transactions and sales, purchases, exchanges, loans and extensions of credit, and investments, in the net aggregate, involving more than the lesser of 3% of the respective California companies admitted assets or 25% of surplus as to policyholders, as of the preceding December 31. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the preceding 12 months, exceeds the greater of 10% of the insurance company’s statutory policyholders’ surplus as of the preceding December 31 or the insurance company’s statutory net income for the preceding calendar year. An insurance company is also required to notify the California DOI of any dividend after declaration, but prior to payment.

 

The Holding Company Act also provides that the acquisition or change of “control” of a California domiciled insurance company or of any person who controls such an insurance company cannot be consummated without the prior approval of the Insurance Commissioner. In general, a presumption of “control” arises from the ownership of voting securities and securities that are convertible into voting securities, which in the aggregate constitute 10% or more of the voting securities of a California insurance company or of a person that controls a California insurance company, such as Mercury General. A person seeking to acquire “control,” directly or indirectly, of the Company must generally file with the Insurance Commissioner an application for change of control containing certain information required by statute and published regulations and provide a copy of the application to the Company. The Holding Company Act also effectively restricts the Company from consummating certain reorganizations or mergers without prior regulatory approval.

 

The insurance subsidiaries in Florida, Georgia, Illinois, Oklahoma and Texas are subject to holding company acts in those states, the provisions of which are substantially similar to those of the Holding Company Act. Regulatory approval was obtained from California, Oklahoma and Texas before the acquisition of AMI was completed. Approval was granted by Texas for the transaction in which the Company acquired control of MCM.

 

Assigned Risks

 

Automobile liability insurers in California are required to sell bodily injury liability, property damage liability, medical expense and uninsured motorist coverage to a proportionate number (based on the insurer’s share of the California automobile casualty insurance market) of those drivers applying for placement as “assigned risks.” Drivers seek placement as assigned risks because their driving records or other relevant characteristics, as defined by Proposition 103, make them difficult to insure in the voluntary market. During the last five years, approximately 0.3% of the direct automobile insurance premium written by the Company was for assigned risk business. In 2002, assigned risks represented 0.2% of total automobile direct premiums written and 0.2% of total automobile direct premium earned. Premium rates for assigned risk business are set by the California DOI. In October 1990, more stringent rules for gaining entry into the Assigned Risk Program were approved, resulting in a substantial reduction in the number of assigned risks insured by the Company since 1991. Since January 1, 1994, the California Insurance Code has required that rates established for this program be adequate to support this program’s losses and expenses. The last rate increase approved by the Commissioner approximated 4.8% and became effective June 1, 1995. The Commissioner approved a rate decrease of 28.3% effective February 1, 1999. The number of assignments decreased in 2000 and increased in 2001 and 2002. The Company attributes the low level of assignments to the competitive voluntary market.

 

15


 

Automobile Insurance Rating Factor Regulations

 

Since 1989, California Proposition 103 has required that property and casualty insurance rates be approved by the Insurance Commissioner prior to their use, and that no rate be approved which is excessive, inadequate, unfairly discriminatory or otherwise in violation of the provisions of the initiative. The proposition specified four statutory factors required to be applied in “decreasing order of importance” in determining rates for private passenger automobile insurance: (1) the insured’s driving safety record, (2) the number of miles the insured drives annually, (3) the number of years of driving experience of the insured and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to risk of loss and adopted by regulation. The statute further provided that insurers are required to give at least a 20% discount to “good drivers,” as defined, from rates that would otherwise be charged to such drivers and that no insurer may refuse to insure a “good driver.”

 

The Company, and most other insurers, historically charged different rates for residents of different geographical areas within California. The rates for urban areas, particularly in Los Angeles, have been generally substantially higher than for suburban and rural areas. The Company’s geographical rate differentials have been derived by actuarial analysis of the claims costs in a given area.

 

In September 1996, the California Insurance Commissioner issued permanent rating factor regulations which were designed to implement the Proposition 103 guidelines and replaced emergency regulations which had been in use since 1989. They required all automobile insurers in California to submit new rating plans complying with the regulations in early 1997. The Company submitted its new proposed rating plan on March 11, 1997.

 

The Company’s plan, and the plans of most other California automobile insurers, were approved by the DOI in October 1997. The Company’s plan became effective October 1, 1997. The rate changes resulting from implementation of that plan have not materially affected the Company’s competitive position or its profitability.

 

California Financial Responsibility Law

 

Effective January 1, 1997, California enacted a new law which requires proof of insurance for the registration (new or renewal) of a motor vehicle. It also provides for substantial penalties for failure to supply proof of insurance if a driver is stopped for a traffic violation. Media attention to the new law resulted in a surge of new business applications during the first half of 1997. The renewal experience of this new business has been similar to that of the Company’s existing business.

 

In November 1996, an initiative sponsored by the California Insurance Commissioner was overwhelmingly approved by the California voters. This initiative provides that uninsured drivers who are injured in an automobile accident are able to recover only actual, out-of-pocket medical expenses and lost wages and are not entitled to receive awards for general damages, i.e., “pain and suffering.” This restriction also applies to drunk drivers and fleeing felons. The law has helped in controlling loss costs.

 

Third Party “Bad Faith” Legislation

 

Recent initiatives to reinstate third party “bad faith” lawsuits have been unsuccessful. If such legislation is enacted, it could have a significant detrimental effect on the Company’s operating results. This would particularly be the case if the Company had difficulty in implementing rate increases to compensate for increased loss costs.

 

California Earthquake Authority

 

The California Earthquake Authority (“CEA”) is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. Since 1998, the Company places all new and renewal earthquake coverage offered with its homeowners policy through the California Earthquake Authority. The Company receives a small fee for placing business with the CEA.

 

16


 

Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 18, 2002, is approximately $28.7 million.

 

Terrorism Risk Insurance Act of 2002

 

On November 26, 2002, the federal government enacted the Terrorism Risk Insurance Act of 2002 (the “Act”), which established a temporary Federal program that provides for a system of shared public and private compensation for insured commercial property and casualty losses resulting from acts of terrorism, as defined within the Act. The Terrorism Insurance Program (the “Program”) requires all commercial property and casualty insurers licensed in the United States to participate. The Program provides that in the event of a terrorist attack, as defined, resulting in insurance industry losses exceeding $5 million, the U.S. government will provide funding to the insurance industry on an annual aggregate basis of 90% of covered losses up to $100 billion. Each insurance company is subject to a deductible based upon a percentage of the previous year’s direct earned premium; with the percentage increasing each year. The Program requires that insurers notify in-force commercial policyholders by February 24, 2003 that coverage for terrorism acts is provided and the cost for this coverage. The Company is required to offer this coverage at each subsequent renewal even if the policyholder elected to exclude this coverage in the previous policy period. The Program became effective upon enactment and runs through December 31, 2005.

 

The Company writes a limited amount of commercial property policies and does not write policies on properties considered to be a target of terrorist activities such as airports, hotels, large office structures, amusement parks, landmark defined structures or other public facilities. In addition, there is not a high concentration of policies in any one area where increased exposure to terrorist threats exist. Consequently, the Company believes its exposure relating to acts of terrorism is low and consequently, few policyholders will buy this coverage.

 

Item 2.    Properties

 

The home office of the California Companies and the Company’s computer facilities are located in Brea, California in 238,000 square feet of office space owned by the Company.

 

The Company’s executive offices are located in a 36,000 square foot office building in Los Angeles, California, owned by Mercury Casualty. The Company occupies approximately 95% of the building and leases the remaining office space to others.

 

In November 2001, the Company purchased twelve acres of land in Rancho Cucamonga, California. Construction of a 100,000 square foot office building commenced in 2002 with completion anticipated in 2003. In 2002, the Company purchased an additional six and one half acres of land adjacent to the twelve acres of land. This space will be used to support the Company’s recent growth and future expansion. Any space in the building that is not occupied by the Company may be leased to outside parties.

 

The Company leases all of its other office space. Office location is not material to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.

 

17


 

Item 3.    Legal Proceedings

 

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company has established reserves for lawsuits which the Company is able to estimate its potential exposure. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. The Company believes that adverse results, if any, in the actions currently pending should not have a material effect on the Company’s operations or financial position.

 

In Robert Krumme, On Behalf Of The General Public vs. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company (Superior Court for the City and County of San Francisco), initially filed June 30,2000, the plaintiff is asserting unfair trade practices claim under Section 17200 of the California Business and Professions Code. Specifically, the case involves a dispute over the legality of broker fees (generally less than $100 per policy) charged by independent brokers who sell the Company’s products to consumers that purchase insurance policies written by the California Companies. The plaintiff asserts that the brokers who sell the Company’s products should not charge broker fees and that the Company benefits from these fees and should be liable for them. The plaintiff is seeking an elimination of the broker fees and restitution of previously paid broker fees. Following a four-day trial, in December 2002, proposed findings of fact and conclusions of law in favor of the plaintiff were issued stating that the Company’s brokers are indistinguishable from agents and should not charge broker fees, and that the broker fees are attributable to the Company, suggesting the Company could be held responsible for restitution. The Company filed objections to the proposed findings of fact and conclusions of law and requested a hearing. A hearing on the Company’s objections was granted and is scheduled for March 18, 2003. The Company intends to continue to vigorously defend this case.

 

In Sheila Leivas, Individually And On Behalf Of All Others Similarly Situated vs. Mercury Insurance Company (Orange County Superior Court), filed July 12, 2002, the Company is defending a suit involving a dispute over premium retained by the Company during a time when the plaintiff was not covered following a voluntary cancellation of the policy and prior to reinstatement of the policy. The plaintiff is seeking to have the case certified as a class action. The plaintiff is seeking actual and punitive damages, and injunctive relief. The Company was successful on its demurrer to the plaintiff’s original complaint. The plaintiff has filed an amended complaint and the Company intends to file a demurrer to the amended complaint. The Company intends to continue to vigorously defend this case.

 

In Dan O’Dell, individually and On behalf of others similarly situated v. Mercury Insurance Company, Mercury General Corporation (Los Angeles Superior Court), filed July 12,2002, the plaintiffs are challenging the Company’s use of certain automated database vendors to assist in valuing total loss claims. The plaintiff is seeking to have the case certified as a class action. The plaintiffs allege that these automated databases systematically undervalue total loss claims to the detriment of insureds. The plaintiffs are seeking actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with four other similar cases, and also with three other cases relating to medical payment claims (discussed below). The Company intends to vigorously defend this lawsuit jointly with other defendants in the coordinated proceedings.

 

In Marissa Goodman, on her own behalf and on behalf of all others similarly situated v. Mercury Insurance Company (Los Angeles Supreme Court), filed June 16, 2002, the plaintiff is challenging the Company’s use of certain automated database vendors to assist in valuing claims for medical payments. Plaintiff is seeking to have the case certified as a class action. As with the O’Dell case above, and the other cases in the coordinated proceedings, plaintiff alleges that these automated databases systematically undervalue medical payment claims to the detriment of insureds. Plaintiffs are seeking actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. As discussed above, the case has been coordinated with three other similar cases, and also with four other cases relating to total loss claims. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.

 

18


 

A stay of all actions is currently in place in the coordinated proceedings in which O’Dell and Goodman case are included. Hearings on the demurrers and other preliminary motions of the defendants are expected to take place sometime in the summer of 2003.

 

The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. (See Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Overview, and Note 6 of Notes to Consolidated Financial Statements.)

 

Item 4.    Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of security holders by the Company during the fourth quarter of the fiscal year covered by this report.

 

EXECUTIVE OFFICERS OF THE COMPANY

 

The following table sets forth certain information concerning the executive officers of the Company as of February 14, 2003:

 

Name


  

Age


  

Position


George Joseph

  

81

  

Chairman of the Board and Chief Executive Officer

Gabriel Tirador

  

38

  

President and Chief Operating Officer

Cooper Blanton, Jr.

  

76

  

Executive Vice President

Bruce E. Norman

  

54

  

Senior Vice President—Marketing

Joanna Y. Moore

  

47

  

Vice President and Chief Claims Officer

Kenneth G. Kitzmiller

  

56

  

Vice President—Underwriting

Theodore R. Stalick

  

39

  

Vice President and Chief Financial Officer

Judy A. Walters

  

56

  

Vice President—Corporate Affairs and Secretary

Greg Schueman

  

34

  

Vice President and Chief Technology Officer

Christopher Graves

  

37

  

Vice President and Chief Investment Officer

Charles Toney

  

41

  

Vice President—Chief Actuary

 

19


 

Mr. Joseph, Chief Executive Officer of the Company and Chairman of its Board of Directors, has served in those capacities since 1961. Mr. Joseph has more than 45 years experience in the property and casualty insurance business.

 

Mr. Tirador, President and Chief Operating Officer, served as the Company’s assistant controller from March 1994 to December 1996. During January 1997 to February 1998 he served as the Vice President and Controller of the Automobile Club of Southern California. He rejoined the Company in February 1998 as Vice President and Chief Financial Officer. He was appointed President and Chief Operating Officer in October 2001. Mr. Tirador has over fifteen years experience in the property and casualty insurance industry and is a Certified Public Accountant.

 

Mr. Blanton, Executive Vice President, joined the Company in 1966 and supervised its underwriting activities from 1967 until September 1995. He was appointed Executive Vice President of Mercury Casualty and Mercury Insurance in 1983 and was named Executive Vice President of Mercury General in 1985. In May 1995, he was named President of the Georgia and Illinois insurance company subsidiaries and in February 1996 he was elected to the Board of Directors of those companies. In January 1999, he was named Chairman of the Board of AMIC and President in April 2000. Mr. Blanton has over 40 years of experience in underwriting and other aspects of the property and casualty insurance business.

 

Mr. Norman, Senior Vice President in charge of Marketing, has been employed by the Company since 1971. Mr. Norman was named to his current position in February 1999, and has been a Vice President since October 1985 and a Vice President of Mercury Casualty since 1983. Mr. Norman has supervised the selection and training of agents and managed relations between agents and the Company since 1977. In February 1996, he was elected to the Board of Directors of each of the California Companies.

 

Ms. Moore, Vice President and Chief Claims Officer, joined the Company in the claims department in March 1981. She was named Vice President of Claims of Mercury General in August 1991 and has held her present position since July 1995.

 

Mr. Kitzmiller, Vice President in charge of Underwriting, has been employed by the Company in the underwriting department since 1972. In August 1991, he was appointed Vice President of Underwriting of Mercury General and has supervised the underwriting activities of the Company since early 1996.

 

Mr. Stalick, Vice President and Chief Financial Officer, joined the Company as Corporate Controller in June 1997. In October 2000, he was named Chief Accounting Officer, a role he held until appointed to his current position in October 2001. Mr. Stalick is a Certified Public Accountant.

 

Ms. Walters has been employed by the Company since 1967, and has served as its Secretary since 1982. Ms. Walters was named Vice President—Corporate Affairs in June 1998.

 

Mr. Schueman, Vice President and Chief Technology Officer, joined the company in April 2002, and is responsible for all information technology functions. He previously worked as a director in information technology at Farmers Insurance from 2000 to 2002 and at Pinkerton from 1997 to 1999. He was responsible for strategic planning, in addition to other IT responsibilities. Mr. Schueman began his career at Price Waterhouse in Management Consulting.

 

Mr. Graves, Vice President and Chief Investment Officer, has been employed by the Company in the investment department since 1986. Mr. Graves was appointed Chief Investment Officer in June 1998, and named Vice President in April 2001.

 

Mr. Toney, Vice President and Chief Actuary, joined the Company in May 1984 as a programmer/analyst. In 1994 he earned his Fellowship in the Casualty Actuarial Society and was appointed to his current position.

 

20


PART II

 

Item 5.    Market for the Registrant’s Common Equity and Related Security Holder Matters

 

Price Range of Common Stock

 

The common stock is traded on the New York Stock Exchange (symbol: MCY). The following table shows the high and low sales prices per share in each quarter during the past two years as reported in the consolidated transaction reporting system.

 

    

High


  

Low


2001

             

1st Quarter

  

$

43.813

  

$

32.210

2nd Quarter

  

$

36.950

  

$

32.000

3rd Quarter

  

$

41.200

  

$

33.180

4th Quarter

  

$

44.500

  

$

38.810

    

High


  

Low


2002

             

1st Quarter

  

$

46.85

  

$

39.21

2nd Quarter

  

$

51.15

  

$

45.01

3rd Quarter

  

$

48.55

  

$

39.25

4th Quarter

  

$

46.10

  

$

37.25

 

The closing price of the Company’s common stock on February 14, 2003 was $35.54.

 

Dividends

 

Following the public offering of its common stock in November 1985, the Company has paid regular quarterly dividends on its common stock. During 2002 and 2001, the Company paid dividends on its common stock of $1.20 per share and $1.06 per share, respectively. On January 31, 2003, the Board of Directors declared a $0.33 quarterly dividend payable on March 27, 2003 to stockholders of record on March 17, 2003.

 

The common stock dividend rate has been increased nineteen times since dividends were initiated in January, 1986, at an annual rate of $0.05, adjusted for the two-for-one stock splits in September 1992 and September 1997. For financial statement purposes, the Company records dividends on the declaration date. The Company expects to continue the payment of quarterly dividends, however, the continued payment and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions.

 

As a holding company, Mercury General is largely dependent upon dividends from its subsidiaries to pay dividends to its shareholders. These subsidiaries are subject to state laws that restrict their ability to distribute dividends. The state laws permit a casualty insurance company to pay dividends and advances within any 12-month period, without any prior regulatory approval, in an amount up to the greater of 10% of statutory earned surplus at the preceding December 31, or statutory net income for the calendar year preceding the date the dividend is paid. Under this test, the direct insurance subsidiaries of the Company are entitled to pay dividends to Mercury General during 2003 of up to approximately $98 million. (See Item 1. Business—Regulation—Holding Company Act, and Note 9 of Notes to Consolidated Financial Statements). Mercury General is contesting a recent FTB ruling which disallows the dividend-received deductions from all insurance holding companies, regardless of domicile. The ultimate outcome of this matter could affect future dividend policy (See Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Overview, and Note 6 of Notes to Consolidated Financial Statements).

 

21


 

Shareholders of Record

 

The approximate number of holders of record of the Company’s common stock as of February 14, 2003 was 235. The approximate number of beneficial holders as of February 14, 2003 was 7,700.

 

Item 6.    Selected Consolidated Financial Data

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


  

1999


    

1998


 
    

(Amounts in thousands, except per share data)

 

Income Data:

                                          

Earned Premiums

  

$

1,741,527

 

  

$

1,380,561

 

  

$

1,249,259

  

$

1,188,307

 

  

$

1,121,584

 

Net investment income

  

 

113,083

 

  

 

114,511

 

  

 

106,466

  

 

99,374

 

  

 

96,169

 

Net realized investment gains (losses)

  

 

(70,412

)

  

 

6,512

 

  

 

3,944

  

 

(11,929

)

  

 

(3,926

)

Realized gain from sale of subsidiary

  

 

—  

 

  

 

—  

 

  

 

—  

  

 

—  

 

  

 

2,586

 

Other

  

 

2,073

 

  

 

5,396

 

  

 

6,349

  

 

4,924

 

  

 

5,710

 

    


  


  

  


  


Total Revenues

  

 

1,786,271

 

  

 

1,506,980

 

  

 

1,366,018

  

 

1,280,676

 

  

 

1,222,123

 

    


  


  

  


  


Losses and loss adjustment expenses

  

 

1,268,243

 

  

 

1,010,439

 

  

 

901,781

  

 

789,103

 

  

 

684,468

 

Policy acquisition costs

  

 

378,385

 

  

 

301,670

 

  

 

268,657

  

 

267,399

 

  

 

252,592

 

Other operating expenses

  

 

74,875

 

  

 

62,335

 

  

 

59,733

  

 

50,675

 

  

 

44,941

 

Interest

  

 

4,100

 

  

 

7,727

 

  

 

7,292

  

 

4,960

 

  

 

4,842

 

    


  


  

  


  


Total Expenses

  

 

1,725,603

 

  

 

1,382,171

 

  

 

1,237,463

  

 

1,112,137

 

  

 

986,843

 

    


  


  

  


  


Income before income taxes

  

 

60,668

 

  

 

124,809

 

  

 

128,555

  

 

168,539

 

  

 

235,280

 

Income taxes

  

 

(5,437

)

  

 

19,470

 

  

 

19,189

  

 

34,830

 

  

 

57,754

 

    


  


  

  


  


Net Income

  

$

66,105

 

  

$

105,339

 

  

$

109,366

  

$

133,709

 

  

$

177,526

 

    


  


  

  


  


Per Share Data:

                                          

Basic earnings per share

  

$

1.22

 

  

$

1.94

 

  

$

2.02

  

$

2.45

 

  

$

3.23

 

    


  


  

  


  


Diluted earnings per share

  

$

1.21

 

  

$

1.94

 

  

$

2.02

  

$

2.44

 

  

$

3.21

 

    


  


  

  


  


Dividends paid

  

$

1.20

 

  

$

1.06

 

  

$

.96

  

$

.84

 

  

$

.70

 

    


  


  

  


  


    

December 31,


 
    

2002


    

2001


    

2000


  

1999


    

1998


 
    

(Amounts in thousands, except per share data)

 

Balance Sheet Data:

                                          

Total investments

  

$

2,150,658

 

  

$

1,936,171

 

  

$

1,794,961

  

$

1,575,465

 

  

$

1,590,645

 

Premiums receivable

  

 

186,446

 

  

 

143,612

 

  

 

123,070

  

 

115,654

 

  

 

107,950

 

Total assets

  

 

2,645,296

 

  

 

2,316,540

 

  

 

2,142,263

  

 

1,906,367

 

  

 

1,877,025

 

Unpaid losses and loss adjustment
expenses

  

 

679,271

 

  

 

534,926

 

  

 

492,220

  

 

434,843

 

  

 

405,976

 

Unearned premiums

  

 

545,485

 

  

 

421,342

 

  

 

365,579

  

 

340,846

 

  

 

327,129

 

Notes payable

  

 

128,859

 

  

 

129,513

 

  

 

107,889

  

 

92,000

 

  

 

78,000

 

Deferred income tax liability (asset)

  

 

(17,004

)

  

 

(1,252

)

  

 

8,336

  

 

(28,541

)

  

 

22,639

 

Shareholders’ equity

  

 

1,098,786

 

  

 

1,069,711

 

  

 

1,032,905

  

 

909,591

 

  

 

917,375

 

Book value per share

  

 

20.21

 

  

 

19.72

 

  

 

19.08

  

 

16.73

 

  

 

16.80

 

 

22


Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

The operating results of property and casualty insurance companies are subject to significant fluctuations from quarter-to-quarter and from year-to-year due to the effect of competition on pricing, the frequency and severity of losses, including the effect of natural disasters on losses, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates and other factors such as changes in tax laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the ability of the Company to grow and retain business.

 

The Company operates primarily in the state of California, which was the only state it produced business in prior to 1990. The Company expanded its operations into Georgia and Illinois in 1990. With the acquisition of American Fidelity Insurance Group (“AFI”) in December 1996, now AMI, the Company expanded into the states of Oklahoma and Texas. The Company expanded its operations into the state of Florida during 1998 and further expansion into Texas occurred with the Concord Insurance Services, Inc. transaction in December 1999 and the Mercury County Mutual Insurance Company (“MCM”) transaction in September 2000. In 2001, the Company expanded into Virginia and New York.

 

During 2002, approximately 85.1% of the Company’s net premiums written were derived from California.

 

Implementing rate changes varies by state with California and Georgia requiring prior approval from the DOI before a rate can be implemented. Illinois and Texas only require that rates be filed with the DOI, while Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be “excessive, inadequate or unfairly discriminatory.”

 

Effective March 1, 2002, the Company implemented a 4.1% rate increase for new and renewal California private passenger automobile insurance written by MIC, which represents approximately 50% of company-wide premiums written, and a 6.9% combined rate increase for new and renewal California private passenger automobile insurance written by MCC and Cal Auto, which represent approximately 26% of company-wide premiums written. The Company also implemented an additional 3.2% rate increase for California private passenger automobile insurance written by MIC, and an additional 6.9% rate increase in California private passenger automobile insurance written by MCC and Cal Auto effective November 1, 2002.

 

Effective July 15, 2002, the Company implemented a 10.1% rate increase in Florida private passenger automobile insurance and has also taken rate increases in other states where business is written. The Company received approval for an approximate 7.1% rate increase for Florida private passenger automobile insurance, effective February 1, 2003 for new business and March 10, 2003 for renewal business.

 

A 6.9% rate increase on the California’s homeowner’s line of business was approved and became effective on May 15, 2002. The Company also received approval for an additional 6.9% California homeowner’s rate increase that was implemented December 15, 2002.

 

The Company has pending rate increases on its California private passenger automobile insurance of 4.6% on MIC and 6.9% on MCC and Cal Auto. The Company will continue to seek additional rate increases in California as well as other states at a rate that keeps pace with or exceeds loss cost inflation.

 

Despite the increases, the Company believes that its rates will remain competitive in the marketplace. During 2002, the Company continued its marketing efforts for name recognition and lead generation. The Company believes that its marketing effort combined with price and reputation makes the Company very competitive in California.

 

23


 

Since March 31, 1994, Private Passenger Automobile policies in force in California have increased from approximately 300,000 to 950,000 at December 31, 2002, an annual rate of increase of approximately 14%. Policy count growth for the year 2002 was at a 15% rate, an improvement over 2001 when the rate was at 7%. Management believes the increase is due in large part to favorable competitive rates, a good reputation and a highly visible and targeted advertising strategy.

 

In September 1996, the California Insurance Commissioner issued permanent rating factor regulations requiring automobile insurance rates to be determined by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The regulations further require that each of the four factors be applied in decreasing order of importance.

 

The Company submitted a proposed rating plan in response to these regulations in March 1997. The Company’s plan was approved by the California DOI and became effective October 1, 1997. Although the rate changes produced some minor dislocations, implementation of the plan has not materially changed the Company’s overall competitive position or its profitability.

 

The California DOI has required all insurers offering persistency discounts to make class plan filings by January 15, 2003, removing the portability of these discounts. Persistency discounts represent discounts on policy rates extended to consumers based upon the number of consecutive years that the consumers carried insurance coverage. The Company made it’s filing and is currently awaiting DOI approval. The changes made in the Company’s plan are revenue neutral for the Company’s existing business. The removal of persistency discounts could have an impact on the Company’s price competitiveness in attracting new business. However, this impact, if any, is undeterminable.

 

The State of California has completed income tax audits on Mercury General’s California tax returns for the tax years ended December 31, 1993 through 2000. As part of these audits, the California Franchise Tax Board (“FTB”) is challenging Mercury General’s ability to deduct a portion of its management and interest expenses. Upon completion of these audits, the FTB proposed assessments of approximately $7.6 million, plus interest, for tax years 1993 through 1996. The Company has formally appealed the proposed assessments and expects a hearing before the California State Board of Equalization (“SBE”) will take place in March 2003.

 

Management strongly disagrees with the positions taken by the FTB and believes that the issues will ultimately be resolved in favor of the Company. Accordingly, no provision for additional state income tax liabilities for the tax years 1993 through 1996 has been made in the consolidated financial statements.

 

In a recent court ruling that affects the tax years 1997 through 2000, a statute that allowed Mercury General a tax deduction for the dividends received from its wholly-owned insurance subsidiaries was held unconstitutional on the grounds that it discriminated against out-of-state insurance holding companies. Based on the court ruling, the FTB is taking the position that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB is disallowing dividend-received deductions for all insurance holding companies, regardless of domicile, for tax years ending on or after December 1, 1997 (See Note 6 “Income Taxes” to the Consolidated Financial Statements). The Company has been assessed $17.3 million plus interest for the 1997 through 2000 tax years. The Company intends to protest the proposed assessments. The FTB has recently begun an audit of the 2001 tax year.

 

This ruling by the court has confused certain long standing aspects of the California tax law and has already resulted in legislative proposals for relief which, if approved, would reduce or eliminate the amount of the FTB’s proposed assessment against the Company. In addition, without such legislation, years of future litigation may be required to determine the ultimate outcome. Consequently, the ultimate amount that the Company may be required to pay is impossible to predict at the present time and the Company has not recorded a provision for additional state income tax liabilities related to this matter.

 

24


 

Management has taken actions to minimize any potential tax liabilities on 2001 and future inter-company dividends. However, if management’s actions are ineffective or the issue is not resolved favorably with the State of California, additional state taxes of approximately 9% (6% after the federal tax benefit of deducting state taxes) could be owed on dividends Mercury General receives from its insurance subsidiaries. While the Company intends to continue paying dividends to its shareholders, an unsatisfactory conclusion to the inter-company dividend issue could affect future dividend policy.

 

The Company is also involved in proceedings incidental to its insurance business (See Item 3. Legal Proceedings, and Note 11 of Notes to Consolidated Financial Statements).

 

Critical Accounting Policies

 

The preparation of the Company’s financial statements requires judgment and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”) and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision.

 

The Company complies with the SFAS No. 60 definition of how insurance enterprises should recognize revenue on insurance policies written. The Company’s insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums. To the extent that any of the Company’s lines of business become substantially unprofitable, then a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business.

 

The Company carries its fixed maturity and equity investments at market value as required for securities classified as “Available for Sale” by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). In most cases, market valuations were drawn from trade data sources. In no case were any valuations made by the Company’s management. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date. The Company constantly evaluates its investments for other than temporary declines and writes them off as realized losses through the Statement of Income, as required by SFAS No. 115 when recovery of the net book value appears doubtful. Temporary unrealized investment gains and losses are credited or charged directly to shareholders’ equity as accumulated other comprehensive income, net of applicable taxes. It is possible that future information will become available about the Company’s current investments that would require accounting for them as realized losses due to other than temporary declines in value. The financial statement effect would be to move the unrealized loss from accumulated other comprehensive income on the Balance Sheet to realized investment losses on the Statements of Income.

 

The Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits incidental to our business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the financial statement footnotes if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the

 

25


ultimate outcome of contingent liabilities, management does not expect them to have a material effect on the consolidated operations or financial position.

 

Statement of Financial Accounting Standards SFAS No. 141, “Business Combinations” (“SFAS No. 141”) and Statement of Financial Accounting Standards SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”) became effective January 1, 2002. SFAS No. 141 requires companies to apply the purchase method of accounting for all business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interest method. SFAS No. 142 changes the method by which companies may recognize intangible assets in purchase business combinations and generally requires identifiable intangible assets to be recognized separately from goodwill. In addition, it eliminates the amortization of all existing and newly acquired goodwill on a prospective basis and requires companies to assess goodwill for impairment, at least annually, based on the fair value of the reporting unit.

 

At December 31, 2002, the Company had on its books approximately $7.3 million in Goodwill related to the 1999 acquisition of Concord and approximately $9.3 million of intangible assets with indefinite useful lives related to the MCM acquisition.

 

As required by SFAS No. 142, the Company has assessed these assets and determined that they are not impaired. Furthermore, as required by SFAS No. 142, the Company did not amortize these assets after 2001. Total amortization expense in 2001 related to these assets was $1.9 million.

 

Results of Operations

 

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

 

Premiums earned in 2002 of $1,741.5 million increased 26.1% and net premiums written in 2002 of $1,865.0 million increased 29.3% over amounts recorded in 2001. These premium increases were principally attributable to increased policy sales and rate increases in the California automobile insurance lines, California homeowners insurance, Florida automobile insurance and Texas automobile insurance.

 

The California private passenger automobile insurance marketplace is experiencing rising premium rates. The Company and virtually all of its competitors have filed and implemented rate increases, which helped spur the Company’s premium growth during 2002 (See Overview).

 

The GAAP loss ratio in 2002 (loss and loss adjustment expenses related to premiums earned) was 72.8% compared with 73.2% in 2001. The lower loss ratio was primarily driven by rate increases which were partially offset by rising loss severity trends and adverse loss development from prior periods.

 

The GAAP expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 26.0% in 2002 and 26.4% in 2001. While expenses generally increased in 2002, the increase was at a slightly lower rate than the increase in premium volume. The majority of expenses vary directly with premiums.

 

Total losses and expenses in 2002, excluding interest expense of $4.1 million, were $1,721.5 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $20.0 million, compared with an underwriting gain of $6.1 million in 2001.

 

Investment income in 2002 was $113.1 million, compared with $114.5 million in 2001. The after-tax yield on average investments of $2,035.3 million (cost basis) was 4.87%, compared with 5.41% on average investments of $1,828.5 million (cost basis) in 2001. The effective tax rate on investment income was 12.4% in 2002, compared to 13.6% in 2001. The lower tax rate in 2002 reflects a shift in the mix of the Company’s portfolio from taxable to non-taxable issues. Bonds matured and called in 2002 totaled $120.5 million, compared to $67.6 million in 2001. Assuming market interest rates remain the same, the Company expects approximately $300 million of bonds to

 

26


mature or be called in 2003. The proceeds will be reinvested into securities meeting the Company’s investment profile and will earn lower yields than previously generated.

 

Net realized investment losses in 2002 were $70.4 million, compared with net realized gains of $6.5 million in 2001. Included in the net realized investment losses for 2002 are $71.7 million of investment write-downs that the Company considered to be other-than-temporarily impaired. The investment write-downs were on investments primarily in the telecommunications and energy sectors.

 

The income tax benefit of $5.4 million in 2002 is primarily due to realized losses recognized on securities deemed to be other than temporarily impaired. Excluding the effect of net realized gains (losses) from both 2002 and 2001 results in an effective tax rate of 14.7% in 2002 compared with an effective tax rate of 14.5% in 2001.

 

Net income in 2002 was $66.1 million or $1.21 per share (diluted), compared with $105.3 million or $1.94 per share (diluted), in 2001. Diluted per share results are based on 54.5 million average shares in 2002 and 54.4 million shares in 2001. Basic per share results were $1.22 in 2002 and $1.94 in 2001.

 

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

 

Premiums earned in 2001 of $1,380.6 million increased 10.5% and net premiums written in 2001 of $1,442.9 million increased 13.4% over amounts recorded in 2000. Contributing to the overall premium written growth were increased policy sales in the California automobile insurance lines as well as increased production in California homeowners insurance, Florida automobile insurance and Texas automobile insurance.

 

The GAAP loss ratio (loss and loss adjustment expenses related to premiums earned) was 73.2% in 2001 and 72.2% in 2000. The less favorable loss ratio is primarily driven by higher loss ratios in the California automobile and homeowners lines of business which are primarily offset by lower loss ratios in Florida, Georgia and Illinois automobile lines of business.

 

The GAAP expense ratio in 2001 (policy acquisition costs and other operating expenses related to premiums earned) was 26.4% compared with 26.3% in 2000. The expense ratio was relatively unchanged as total expenses increased at essentially the same rate as premium volume. The majority of expenses vary directly with premiums.

 

Total losses and expenses in 2001, excluding interest expense of $7.7 million, were $1,374.4 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $6.1 million compared with an underwriting gain of $19.1 million in 2000.

 

Investment income in 2001 was $114.5 million compared with $106.5 million in 2000. The after-tax yield on average investments of $1,828.5 million (cost basis) was 5.41%, compared with 5.56% on average investments of $1,710.2 million (cost basis) in 2000. The effective tax rate on investment income in 2001 was 13.6%, compared with 10.6% in 2000. The higher tax rate and decrease in investment yields in 2001 reflect a shift in the Company’s portfolio mix from non-taxable to taxable issues. Bonds matured and called in 2001 totaled $67.6 million compared with $45.6 million in 2000.

 

Realized investment gains in 2001 were $6.5 million compared with realized losses of $3.9 million in 2000.

 

The income tax provision of $19.5 million in 2001 represented an effective rate of 15.6%, compared with an effective rate of 14.9% in 2000. The higher rate in 2001 reflects a shift in a portion of the Company’s investments from tax-exempt issues to taxable issues.

 

Net income in 2001 was $105.3 million or $1.94 per share (diluted), compared with $109.4 million or $2.02 per share (diluted), in 2000. Diluted per share results are based on 54.4 million average shares in 2001 and 54.3 million shares in 2000. Basic per share results were $1.94 in 2001 and $2.02 in 2000.

 

27


 

Liquidity and Capital Resources

 

Mercury General is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, Mercury General’s insurance subsidiaries are entitled to pay, without extraordinary approval, dividends of approximately $98 million in 2003, less dividends paid during the preceding twelve month period. The actual amount of dividends paid from insurance subsidiaries to Mercury General during 2002 was $75 million. As of December 31, 2002, Mercury General also had approximately $36 million in fixed maturity securities, equity securities and cash that can be utilized to satisfy its direct holding company obligations.

 

The principal sources of funds for Mercury General’s insurance subsidiaries are premiums, sales and maturity of invested assets and dividend and interest income from invested assets. The principal uses of funds for Mercury General’s insurance subsidiaries are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments. Mercury General’s insurance subsidiaries generate substantial positive cash flows, particularly when the Company experiences growth, from operations as premiums are typically received in advance of the time when claim payments are required. The Company expects cash flow from operations along with its cash and short-term cash investment portfolio of $300 million to continue to satisfy the Company’s liquidity requirements. Management increased cash and short term cash investments by nearly $225 million when other longer term investment opportunities were considered unattractive as a result of the current interest rate environment.

 

Net cash provided from operating activities in 2002 was $342.6 million, an increase of $143.1 million over 2001. This increase was primarily due to the growth in premiums collected of $338.7 million over 2001; reflecting increases in both policy sales and rates partially offset by an increase in losses paid in 2002. The Company has reinvested a portion of cash provided by operating activities in the construction of additional office space and the purchase and development of information technology. Excess cash not used in investing and financing activities was invested in short term cash investments. Funds derived from the sale, redemption or maturity of investments of $663.5 million, were reinvested by the Company generally in higher rated fixed maturity and equity securities.

 

The market value of all investments held at market as “Available for Sale” exceeded the amortized cost of $2,085.9 million at December 31, 2002 by $64.8 million. That unrealized gain, reflected in shareholders’ equity, as Accumulated Other Comprehensive Income, net of applicable tax effects, was $42.1 million at December 31, 2002 compared with a gain of $17.0 million at December 31, 2001. The increase in unrealized gains at December 31, 2002 is due mainly to the write-down of investments that the Company considered to be other than temporarily impaired.

 

As of December 31, 2002, the average Standard & Poor’s rating of the $1,551.6 million bond portfolio (at amortized cost) was AA, while the average effective maturity, giving effect to anticipated early call provisions, approximates 5.7 years. The modified duration of the bond portfolio at year-end was 4.4 years which includes collateralized mortgage obligations and short term cash investments. Modified duration measures the length of time it takes, on average, to receive the present value of all cash flows produced by a bond, including reinvestment of interest income. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a much better indicator of price volatility than simple maturity alone. Municipal bond holdings are broadly diversified geographically and by obligor. Traditionally, it has been the Company’s policy not to invest in high yield or “junk” bonds. At December 31, 2002, bond holdings rated below investment grade totaled $50.1 million at market (cost $68.8 million), or less than 2% of total assets. An increase in the portfolio’s average rating from A at December 31, 2001 to AA at December 31, 2002 reflects a larger percentage of the portfolio invested in higher rated municipal bonds and collateralized mortgage obligations while divesting lower rated corporate bonds.

 

Fixed maturity investments of $1,565.8 million (amortized cost), include $14.2 million (amortized cost) of sinking fund preferred stocks, principally utility issues. The market value of all fixed maturities exceeded cost by $67.1 million at December 31, 2002.

 

28


 

The Company has recently commenced writing covered call options through listed exchanges and over the counter with the intent of generating additional income or return on capital. The Company as the writer of an option bears the market risk of an unfavorable change in the price of the security underlying the written option. The options written thus far have been covered call options on equity securities that it already owns as mandated by statutory regulation. The financial impact of these transactions was not significant in 2002. The board of directors has authorized investments in underlying securities for this program not to exceed $20 million.

 

Equity holdings of $231.0 million at market (cost $233.3 million), including perpetual preferred issues, are largely confined to the public utility and finance sectors and represent about 21% of total shareholders’ equity.

 

The Company continually evaluates the recoverability of its investment holdings. When a decline in value of fixed maturities or equity securities is considered other than temporary, the Company writes the security down to fair value by recognizing a loss in the Consolidated Statement of Income. The Company recognized losses of $71.7 million of investment write-downs considered to be other than temporarily impaired during 2002. Declines in value considered to be temporary, are charged as unrealized losses, net of taxes to shareholders’ equity as accumulated other comprehensive income. At December 31, 2002, the Company had a net unrealized gain on all investments of $64.8 million before income taxes which is comprised of unrealized gains of $102.9 million offset by unrealized losses of $38.1 million. Of these unrealized losses, approximately $27 million relate to fixed maturities which are current on their debt servicing obligations. The remaining unrealized losses of approximately $11.1 million relate to equity securities for which approximately 64% of the unrealized losses represent securities with unrealized losses of less than 10% of their amortized costs. The Company has concluded that the gross unrealized losses of $38.1 million at December 31, 2002 were temporary in nature. However, facts and circumstances may change which could result in a decline in market value considered to be other than temporary.

 

On August 7, 2001, the Company completed a public debt offering issuing $125 million of senior notes payable under a $300 million shelf registration filed with the SEC in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year commencing February 15, 2002. These notes mature on August 15, 2011. The Company used the proceeds from the senior notes to retire amounts payable under existing revolving credit facilities, which were terminated. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate of LIBOR plus 107 basis points. The swap significantly reduced interest expense in 2002, but does expose the Company to higher interest expense in future periods, should LIBOR rates increase. The effective annualized interest rate in 2002 was 2.9%. The swap is accounted for as a fair value hedge under SFAS No. 133 (See Item 7A. Quantitative and Qualitative Disclosures About Market Risk).

 

As part of the Elm County Mutual transaction the Company agreed to make annual $1 million payments to Employers Reinsurance Corporation over 7 years beginning September 30, 2001. At December 31, 2002, the Company is carrying a note payable for $4.2 million, which represents the discounted value of the five remaining payments using a 7% rate.

 

Under the Company’s stock repurchase program, the Company may purchase over a one-year period up to $200 million of Mercury General’s common stock. The purchases may be made from time to time in the open market at the discretion of management. The program will be funded by dividends received from the Company’s insurance subsidiaries who generate cash flow through the sale of lower yielding tax-exempt bonds, the proceeds of the senior note issuance and internal cash generation. Since the inception of the program in 1998, the Company has purchased 1,266,100 shares of common stock at an average price of $31.36. The shares purchased were retired. No stock was purchased in 2002 or 2001.

 

In August 1998, the Company’s Employee Stock Ownership Plan (the “Plan”) purchased 115,000 shares of Mercury General’s common stock in the open market at a price of $43.05 per share. The purchases were funded by a five year term bank loan of $5 million to the Plan which is guaranteed by the Company. At December 31, 2002,

 

29


the loan balance was $1 million and was recorded in the balance sheet as other liabilities. As of December 31, 2002, all shares have been allocated or committed to be released to the employees. The net effective rate of interest on the loan in 2002 was 2.3%.

 

The NAIC utilizes a risk-based capital formula for casualty insurance companies which establishes a hypothetical minimum capital level that is compared to the Company’s actual capital level. The formula has been designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. The Company has calculated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 2002. Each of the Insurance Companies’ policyholders’ surplus exceeded the highest level of minimum required capital.

 

Except for Company-occupied buildings and land to be utilized for Company office space, the Company has no direct investments in real estate and no holdings of mortgages secured by commercial real estate. As of December 31, 2002, the Company has invested approximately $11.1 million for the purchase of 18.5 acres of land and the construction of a new 100,000 square foot office building in Rancho Cucamonga, California. The Company estimates that it will spend an additional $15 million of internally generated funds to complete the construction during 2003. This space will be used to support the Company’s recent growth and future expansion. Any space in the building that is not occupied by the Company may be leased to outside parties.

 

During 2002, the Company was notified that the Hewlett Packard 3000 (“HP 3000”) mainframe system which the Company utilizes for its core insurance applications will no longer be supported by Hewlett Packard after December 2006. Although mainframe system support will be available through other information technology service providers, the Company has recently formed a team of experienced information technology employees to design and develop the Company’s legacy replacement strategy. The project is in the early stages and the Company has not yet determined the cost to replace the HP 3000 system.

 

The Company has certain obligations to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2002, certain long-term aggregate contractual obligations and credit-related commitments are summarized as follows:

 

    

Payments Due by Period


Contractual Obligations


  

Total


  

Within 1 year


  

1-3 years


  

4-5 years


  

After 5 years


    

(Amounts in thousands)

Debt (including interest)

  

$

207,577

  

$

10,066

  

$

27,188

  

$

18,135

  

$

152,188

Capital Lease Obligations

  

 

2,480

  

 

1,156

  

 

1,324

  

 

—  

  

 

—  

Operating Leases

  

 

24,612

  

 

5,130

  

 

13,861

  

 

5,418

  

 

203

Office Building Development

  

 

11,000

  

 

11,000

  

 

—  

  

 

—  

  

 

—  

    

  

  

  

  

Total Contractual Obligations

  

$

245,669

  

$

27,352

  

$

42,373

  

$

23,553

  

$

152,391

    

  

  

  

  

 

Interest on the debt was calculated using the fixed rate of 7.25% on the Senior Note Payable.

 

The Company places all new and renewal earthquake coverage offered with its homeowners policy through the California Earthquake Authority. The Company receives a small fee for placing business with the CEA.

 

Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most current information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 18, 2002, is approximately $28.7 million.

 

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Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to statutory policyholders’ surplus should not exceed 3.0 to 1. Based on the combined surplus of all of the Insurance Companies of $1,014.9 million at December 31, 2002, and net written premiums for the twelve months ended on that date of $1,865.0 million, the ratio of writings to surplus was approximately 1.8 to 1.

 

Item 7A.    Quantitative and Qualitative Disclosures about Market Risks

 

The Company is subject to various market risk exposures including interest rate risk and equity price risk. The following disclosure reflects estimates of future performance and economic conditions. Actual results may differ.

 

The Company invests its assets primarily in fixed maturity investments, which at December 31, 2002 comprised 76% of total investments at market value. Tax-exempt bonds represent 88% of the fixed maturity investments with the remaining amount consisting of sinking fund preferred stocks and taxable bonds. Equity securities, consisting primarily of preferred stocks, account for 11% of total investments at market. The remaining 13% of the investment portfolio consists of highly liquid short-term investments which are primarily short-term money market funds.

 

The value of the fixed maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio goes up with the opposite holding true in rising interest rate environments. A common measure of the interest sensitivity of fixed maturity assets is modified duration, a calculation that takes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate fluctuations.

 

The Company has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company’s investment philosophy has resulted in a portfolio with a moderate duration.

 

Due to the current interest rate environment, management believes it prudent to reduce the duration of the Company’s bond portfolio. Bond investments made by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. Consequently, the modified duration of the bond portfolio excluding collateralized obligations and short term cash investments, declined from 6.5 years at December 31, 2001 to 5.2 years at December 31, 2002. Given a hypothetical parallel increase of 100 basis points in interest rates, the fair value of the bond portfolio would decrease by approximately $84 million.

 

At December 31, 2002, the Company’s strategy for common equity investments was a buy and hold strategy which focuses primarily on current income with a secondary focus on capital appreciation. The value of the common equity investments consists of $107.0 million in common stocks and $124.0 million in non-sinking fund preferred stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market. The non-sinking fund preferred stocks are typically valued using credit spreads to U. S. Treasury benchmarks. This causes them to be comparable to fixed income securities in terms of interest rate risk.

 

During most of the year 2002, non-sinking fund preferred stocks were not actively traded by the market, though lower interest rates intrinsically benefit their market values. At December 31, 2002, the duration on the Company’s non-sinking fund preferred stock portfolio was 8.2 years. This implies that an upward parallel shift in the yield curve by 100 basis points would reduce the asset value at December 31, 2002 by approximately $12 million, everything else remaining the same.

 

The remainder of the equity portfolio, representing 5% of total investments at market value, consists primarily of public utility common stocks. These assets are theoretically defensive in nature and therefore have low volatility to changes in market price as measured by their Beta. However, the Company did not experience low volatility in 2002. Beta is a measure of a security’s systematic (non-diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in the return of the market. The average Beta for the Company’s

 

31


common stock holdings was 0.66. Based on a hypothetical 20% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by approximately $14 million.

 

Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on its $125 million fixed rate senior notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes.

 

New Accounting Standards

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs and it applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. Under SFAS No. 143, a company is required to 1) record an existing legal obligation associated with the retirement of a tangible long-lived asset as a liability when incurred and the amount of the liability be initially measured at fair value, 2) recognize subsequent changes in the liability that result from (a) the passage of time and (b) revisions in either the timing or amount of estimated cash flows and 3) upon initially recognizing a liability for an asset retirement obligation, an entity shall capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, with earlier application encouraged. The adoption of SFAS No. 143 will not have a material impact on the financial statements.

 

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). The objectives of SFAS No. 144 are to address significant issues relating to the implementation of SFAS Statement No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS No. 121”) and to develop a single accounting model based on the framework established in SFAS No. 121 for long-lived assets to be disposed of by sale whether previously held and used or newly acquired. Even though SFAS No. 144 supersedes SFAS No. 121, it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 supersedes the accounting and reporting provisions of Accounting Principles Board Opinion No. 30 “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” (“APB No. 30”) for segments of a business to be disposed of. However, SFAS No. 144 retains the requirement of APB No. 30 that entities report discontinued operations separately from continuing operations and extends that reporting requirement to “a component of an entity” that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as “held for sale”. SFAS No. 144 also amends the guidance of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to eliminate the exception to consolidation for a temporarily controlled subsidiary. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The adoption of SFAS No. 144 did not have a material effect on the Company’s earnings or financial position.

 

In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No. 145”). The objectives of SFAS No. 145 are to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS No. 145 related to the rescission of Statement 4 are applicable to fiscal years beginning after May 15, 2002. The provisions related to Statement 13 are applicable to transactions occurring after May 15, 2002. All other provisions of SFAS No. 145 are applicable to financial statements issued on or after

 

32


May 15, 2002. Management of the Company anticipates that the adoption of SFAS No. 145 will not have a material effect on the Company’s earnings or financial position.

 

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Terminations Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred as opposed to the date of an entity’s commitment to an exit plan as required under EITF 94-3. SFAS No. 146 also requires that measurement of the liability associated with exit or disposal activities be at fair value. SFAS No. 146 is effective for the Company for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the Company’s financial statements.

 

In October 2002, the FASB issued SFAS No. 147, “Acquisition of Certain Financial Institutions” (“SFAS No. 147”), which addresses the financial accounting and reporting for the acquisition of all or a part of a financial institution, except for transactions between two or more mutual enterprises. Under SFAS No. 147, the acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, Business Combinations. SFAS No. 147 also provides guidance on accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises. SFAS No. 147 is effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions related to accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises are effective October 1, 2002. Management of the Company anticipates that the adoption of SFAS No. 147 is not expected to have a material impact on the Company’s financial statements.

 

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This Interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. Management of the Company anticipates that the adoption of this Interpretation is not expected to have a material impact on the Company’s financial statements.

 

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS No. 148”) which amends SFAS Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148 (See Note 13 in Notes to Consolidated Financial Statements).

 

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51” (“FIN No. 46”). FIN No. 46 requires existing unconsolidated

 

33


variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. FIN No. 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The implementation of FIN No. 46 is not expected to have a material impact on the Company’s financial statements.

 

Forward-looking statements

 

Certain statements in this report on Form 10-K that are not historical fact constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, our strategy for growth, business development, regulatory approvals, market position, expenditures, financial results and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause our actual business, prospects and results of operations to differ materially from the historical information contained in this Form 10-K and from those that may be expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California automobile insurance markets, our success in expanding our business in states outside of California, the impact of potential third party “bad-faith” legislation, changes in laws or regulations, the outcome of tax position challenges by the California FTB, third party relations and approvals, and decisions of courts, regulators and governmental bodies, particularly in California, our ability to obtain and the timing of the approval of the California Insurance Commissioner for premium rate changes for private passenger automobile policies issued in California and similar rate approvals in other states where we do business, our success in integrating and profitably operating the businesses we have acquired, the level of investment yields we are able to obtain with our investments in comparison to recent yields and the market risk associated with out investment portfolio, the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies, uncertainties related to assumptions and projections generally, inflation and changes in economic conditions, changes in driving patterns and loss trends, acts of war and terrorist activities, court decisions and trends in litigation and health care and auto repair costs, and other uncertainties, all of which are difficult to predict and many of which are beyond our control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Form 10-K or, in the case of any document we incorporate by reference, the date of that document. Investors also should understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements.

 

34


 

Quarterly Data

 

Summarized quarterly financial data for 2002 and 2001 is as follows (in thousands except per share data):

 

    

Quarter Ended


    

March 31


  

June 30


    

Sept. 30


  

Dec. 31


2002

                             

Earned premiums

  

$

386,637

  

$

418,146

 

  

$

455,467

  

$

481,277

Income (loss) before income taxes

  

$

34,838

  

$

(7,563

)

  

$

16,677

  

$

16,716

Net income

  

$

28,954

  

$

1,301

 

  

$

18,520

  

$

17,330

Basic earnings per share

  

$

.53

  

$

.02

 

  

$

.34

  

$

.33

Diluted earnings per share

  

$

.53

  

$

.02

 

  

$

.34

  

$

.32

Dividends declared per share

  

$

.30

  

$

.30

 

  

$

.30

  

$

.30

2001

                             

Earned premiums

  

$

323,772

  

$

338,171

 

  

$

351,896

  

$

366,722

Income before income taxes

  

$

28,597

  

$

31,798

 

  

$

39,967

  

$

24,447

Net income

  

$

24.708

  

$

26,465

 

  

$

32,055

  

$

22,111

Basic earnings per share

  

$

.46

  

$

.49

 

  

$

.59

  

$

.41

Diluted earnings per share

  

$

.45

  

$

.49

 

  

$

.59

  

$

.41

Dividends declared per share

  

$

.265

  

$

.265

 

  

$

.265

  

$

.265

 

35


 

Item 8.    Financial Statements

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

    

Page


Independent Auditors’ Report

  

37

Consolidated Financial Statements:

    

Consolidated Balance Sheets as of December 31, 2002 and 2001

  

38

Consolidated Statements of Income for Each of the Years in the Three-Year Period Ended December 31, 2002

  

39

Consolidated Statements of Comprehensive Income for Each of the Years in the Three-Year Period Ended December 31, 2002

  

40

Consolidated Statements of Shareholders’ Equity for Each of the Years in the Three-Year Period Ended December 31, 2002

  

41

Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2002

  

42

Notes to Consolidated Financial Statements

  

43

 

36


INDEPENDENT AUDITORS’ REPORT

 

The Board of Directors

Mercury General Corporation:

 

We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

 

KPMG LLP

 

Los Angeles, California

January 31, 2003

 

37


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

DECEMBER 31, 2002 AND 2001

Amounts expressed in thousands, except share amounts

 

ASSETS


          
    

2002


 

2001


 

Investments:

              

Fixed maturities available for sale (amortized cost $1,565,760 in 2002 and $1,560,180 in 2001)

  

$

1,632,871

 

$

1,586,433

 

Equity securities available for sale (cost $233,297 in 2002 and $277,925 in 2001)

  

 

230,981

 

 

277,787

 

Short-term cash investments, at cost, which approximates market

  

 

286,806

 

 

71,951

 

    

 


Total investments

  

 

2,150,658

 

 

1,936,171

 

Cash

  

 

13,191

 

 

3,851

 

Receivables:

              

Premiums receivable

  

 

186,446

 

 

143,612

 

Premium notes

  

 

21,761

 

 

17,256

 

Accrued investment income

  

 

26,203

 

 

27,979

 

Other

  

 

25,035

 

 

29,529

 

    

 


    

 

259,445

 

 

218,376

 

Deferred policy acquisition costs

  

 

107,485

 

 

83,440

 

Fixed assets, net

  

 

61,619

 

 

44,448

 

Deferred income taxes

  

 

17,004

 

 

1,252

 

Other assets

  

 

35,894

 

 

29,002

 

    

 


Total assets

  

$

2,645,296

 

$

2,316,540

 

    

 


LIABILITIES AND SHAREHOLDERS’ EQUITY


          

Losses and loss adjustment expenses

  

$

679,271

 

$

534,926

 

Unearned premiums

  

 

545,485

 

 

421,342

 

Notes payable

  

 

128,859

 

 

129,513

 

Loss drafts payable

  

 

64,346

 

 

53,629

 

Accounts payable and accrued expenses

  

 

61,270

 

 

46,638

 

Current income tax

  

 

6,654

 

 

4,367

 

Other liabilities

  

 

60,625

 

 

56,414

 

    

 


Total liabilities

  

 

1,546,510

 

 

1,246,829

 

    

 


Commitments and contingencies

              

Shareholders’ equity:

              

Common stock without par value or stated value:

              

Authorized 70,000,000 shares; issued and outstanding 54,361,698 shares in 2002 and 54,276,798 in 2001

  

 

55,933

 

 

53,955

 

Accumulated other comprehensive income

  

 

42,140

 

 

16,975

 

Unearned ESOP compensation

  

 

—  

 

 

(1,000

)

Retained earnings

  

 

1,000,713

 

 

999,781

 

    

 


Total shareholders’ equity

  

 

1,098,786

 

 

1,069,711

 

    

 


Total liabilities and shareholders’ equity

  

$

2,645,296

 

$

2,316,540

 

    

 


 

See accompanying notes to consolidated financial statements.

 

 

38


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

Three years ended December 31, 2002

Amounts expressed in thousands, except per share data

 

    

2002


    

2001


  

2000


Revenues:

                      

Earned premiums

  

$

1,741,527

 

  

$

1,380,561

  

$

1,249,259

Net investment income

  

 

113,083

 

  

 

114,511

  

 

106,466

Net realized investment gains (losses)

  

 

(70,412

)

  

 

6,512

  

 

3,944

Other

  

 

2,073

 

  

 

5,396

  

 

6,349

    


  

  

Total revenues

  

 

1,786,271

 

  

 

1,506,980

  

 

1,366,018

    


  

  

Expenses:

                      

Losses and loss adjustment expenses

  

 

1,268,243

 

  

 

1,010,439

  

 

901,781

Policy acquisition costs

  

 

378,385

 

  

 

301,670

  

 

268,657

Other operating expenses

  

 

74,875

 

  

 

62,335

  

 

59,733

Interest

  

 

4,100

 

  

 

7,727

  

 

7,292

    


  

  

Total expenses

  

 

1,725,603

 

  

 

1,382,171

  

 

1,237,463

    


  

  

Income before income taxes

  

 

60,668

 

  

 

124,809

  

 

128,555

Income tax (benefit) expense

  

 

(5,437

)

  

 

19,470

  

 

19,189

    


  

  

Net income

  

$

66,105

 

  

$

105,339

  

$

109,366

    


  

  

Basic earnings per share

  

$

1.22

 

  

$

1.94

  

$

2.02

    


  

  

Diluted earnings per share

  

$

1.21

 

  

$

1.94

  

$

2.02

    


  

  

 

 

 

See accompanying notes to consolidated financial statements.

 

39


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

Three Years ended December 31, 2002

Amounts expressed in thousands

 

    

2002


    

2001


    

2000


 

Net income

  

$

66,105

 

  

$

105,339

 

  

$

109,366

 

Other comprehensive income (loss), before tax:

                          

Unrealized gains (losses) on securities:

                          

Unrealized holding gains (losses) arising during period

  

 

(30,623

)

  

 

(16,854

)

  

 

109,432

 

Less: reclassification adjustment for net losses (gains) included in net income

  

 

69,303

 

  

 

(4,524

)

  

 

(1,214

)

    


  


  


Other comprehensive income (loss), before tax

  

 

38,680

 

  

 

(21,378

)

  

 

108,218

 

Income tax (benefit) expense related to unrealized holding gains (losses) arising during period

  

 

(10,741

)

  

 

(5,899

)

  

 

38,301

 

Income tax expense (benefit) related to reclassification adjustment for (gains) losses included in net income

  

 

24,256

 

  

 

(1,583

)

  

 

(425

)

    


  


  


Comprehensive income, net of tax

  

$

91,270

 

  

$

91,443

 

  

$

179,708

 

    


  


  


 

 

 

 

See accompanying notes to consolidated financial statements.

 

40


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

Three years ended December 31, 2002

Amounts expressed in thousands

 

    

2002


    

2001


    

2000


 

Common stock, beginning of year

  

$

53,955

 

  

$

52,162

 

  

$

50,963

 

Proceeds of stock options exercised

  

 

1,581

 

  

 

1,344

 

  

 

1,304

 

Tax benefit on sales of incentive stock options

  

 

389

 

  

 

587

 

  

 

549

 

Release of common stock by the ESOP

  

 

8

 

  

 

(138

)

  

 

(358

)

Purchase and retirement of common stock

  

 

—  

 

  

 

—  

 

  

 

(296

)

    


  


  


Common stock, end of year

  

 

55,933

 

  

 

53,955

 

  

 

52,162

 

    


  


  


Accumulated other comprehensive income (loss), beginning of year

  

 

16,975

 

  

 

30,871

 

  

 

(39,471

)

Net increase (decrease) in other comprehensive income, net of tax

  

 

25,165

 

  

 

(13,896

)

  

 

70,342

 

    


  


  


Accumulated other comprehensive income, end of year

  

 

42,140

 

  

 

16,975

 

  

 

30,871

 

    


  


  


Unearned ESOP compensation, beginning of year

  

 

(1,000

)

  

 

(2,000

)

  

 

(3,000

)

Amortization of unearned ESOP compensation

  

 

1,000

 

  

 

1,000

 

  

 

1,000

 

    


  


  


Unearned ESOP compensation, end of year

  

 

—  

 

  

 

(1,000

)

  

 

(2,000

)

    


  


  


Retained earnings, beginning of year

  

 

999,781

 

  

 

951,872

 

  

 

901,099

 

Purchase and retirement of common stock

  

 

—  

 

  

 

—  

 

  

 

(6,683

)

Net income

  

 

66,105

 

  

 

105,339

 

  

 

109,366

 

Dividends paid to shareholders

  

 

(65,173

)

  

 

(57,430

)

  

 

(51,910

)

    


  


  


Retained earnings, end of year

  

 

1,000,713

 

  

 

999,781

 

  

 

951,872

 

    


  


  


Total shareholders’ equity

  

$

1,098,786

 

  

$

1,069,711

 

  

$

1,032,905

 

    


  


  


 

 

 

See accompanying notes to consolidated financial statements.

 

41


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Three Years Ended December 31, 2002

Amounts expressed in thousands

 

    

2002


    

2001


    

2000


 

Cash flows from operating activities:

                          

Net income

  

$

66,105

 

  

$

105,339

 

  

$

109,366

 

Adjustments to reconcile net income to net cash provided from operating activities:

                          

Increase in unpaid losses and loss adjustment expenses

  

 

144,345

 

  

 

42,706

 

  

 

41,719

 

Increase in unearned premiums

  

 

124,143

 

  

 

55,763

 

  

 

15,389

 

Increase in premium notes receivable

  

 

(4,505

)

  

 

(3,051

)

  

 

(831

)

Increase in premiums receivable

  

 

(42,834

)

  

 

(20,542

)

  

 

(7,417

)

(Decrease) increase in reinsurance recoveries

  

 

(955

)

  

 

19,335

 

  

 

(1,509

)

Increase in deferred policy acquisition costs

  

 

(24,045

)

  

 

(12,314

)

  

 

(7,151

)

Increase in premiums collected in advance

  

 

7,558

 

  

 

6,922

 

  

 

2,284

 

Increase in loss drafts payable

  

 

10,717

 

  

 

3,675

 

  

 

9,891

 

(Increase) decrease in accrued income taxes, excluding deferred tax on change in unrealized gain

  

 

(27,003

)

  

 

(1,209

)

  

 

2,153

 

Increase (decrease) in accounts payable and accrued expenses

  

 

14,632

 

  

 

6,923

 

  

 

(13,407

)

Depreciation

  

 

10,233

 

  

 

8,477

 

  

 

6,926

 

Net realized investment (gains) losses

  

 

70,412

 

  

 

(6,512

)

  

 

(3,944

)

Bond accretion, net

  

 

(6,982

)

  

 

(9,229

)

  

 

(7,337

)

Other, net

  

 

741

 

  

 

3,169

 

  

 

6,938

 

    


  


  


Net cash provided from operating activities

  

 

342,562

 

  

 

199,452

 

  

 

153,070

 

Cash flows from investing activities:

                          

Fixed maturities available for sale:

                          

Purchases

  

 

(480,335

)

  

 

(341,471

)

  

 

(294,827

)

Sales

  

 

327,464

 

  

 

186,949

 

  

 

137,448

 

Calls or maturities

  

 

119,460

 

  

 

71,758

 

  

 

54,914

 

Equity securities available for sale:

                          

Purchases

  

 

(207,535

)

  

 

(90,067

)

  

 

(83,372

)

Sales

  

 

216,565

 

  

 

64,450

 

  

 

81,294

 

Mercury County Mutual Insurance Company (ELM) transaction less cash acquired (See Note 8)

  

 

—  

 

  

 

—  

 

  

 

(5,138

)

(Decrease) increase in receivable from securities

  

 

(1,246

)

  

 

167

 

  

 

(200

)

Increase in short-term cash investments

  

 

(214,855

)

  

 

(38,974

)

  

 

10,591

 

Purchase of fixed assets

  

 

(29,389

)

  

 

(18,095

)

  

 

(8,342

)

Sale of fixed assets

  

 

2,241

 

  

 

563

 

  

 

1,031

 

    


  


  


Net cash used in investing activities

  

 

(267,630

)

  

 

(164,720

)

  

 

(106,601

)

Cash flows from financing activities:

                          

Net proceeds from issuance of senior notes

  

 

—  

 

  

 

123,309

 

  

 

—  

 

Increase in notes payable

  

 

—  

 

  

 

—  

 

  

 

37,000

 

Net payments under credit arrangements

  

 

(1,000

)

  

 

(103,039

)

  

 

(27,000

)

Dividends paid to shareholders

  

 

(65,173

)

  

 

(57,430

)

  

 

(51,910

)

Proceeds from stock options exercised

  

 

1,581

 

  

 

1,344

 

  

 

1,303

 

Purchase and retirement of common stock

  

 

—  

 

  

 

—  

 

  

 

(6,979

)

Payments on ESOP loan

  

 

(1,000

)

  

 

(1,000

)

  

 

(1,000

)

    


  


  


Net cash used in financing activities

  

 

(65,592

)

  

 

(36,816

)

  

 

(48,586

)

    


  


  


Net increase (decrease) in cash

  

 

9,340

 

  

 

(2,084

)

  

 

(2,117

)

Cash:

                          

Beginning of the year

  

 

3,851

 

  

 

5,935

 

  

 

8,052

 

    


  


  


End of the year

  

$

13,191

 

  

$

3,851

 

  

$

5,935

 

    


  


  


 

See accompanying notes to consolidated financial statements.

 

42


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2002 and 2001

 

(1)    Significant Accounting Policies

 

Principles of Consolidation and Presentation

 

The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. In 2002, 2001 and 2000, over 85% of the net written premiums were from California.

 

The consolidated financial statements include the accounts of Mercury General Corporation (the “Company”) and its wholly-owned subsidiaries, Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Inc., Mercury Insurance Company of Georgia, Mercury Insurance Company of Illinois, Mercury Insurance Company of Florida, Mercury Indemnity Company of Georgia, Mercury Indemnity Company of Illinois, Mercury Indemnity Company of Florida, Mercury Insurance Services, LLC (MISLLC), American Mercury Insurance Company (AMIC), AFI Management Company, Inc. (AFIMC), American Mercury Lloyds Insurance Company (AML) and Mercury County Mutual Insurance Company (MCM). American Mercury MGA, Inc. (AMMGA), is a wholly owned subsidiary of AMIC. AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact, AFIMC. MCM is not owned by the Company but is controlled through a management contract. The results of MCM are included in the financial statements effective September 30, 2000. MCM is discussed further in Note 8 of the Notes to Consolidated Financial Statements. The financial statements also include Concord Insurance Services, Inc., (Concord) a Texas insurance agency owned by the Company. All of the subsidiaries as a group, including AML and MCM, but excluding AFIMC, AMMGA, MISLLC and Concord, are referred to as the Insurance Companies. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant assumptions in the preparation of these consolidated financial statements relate to loss and loss adjustment expenses. Actual results could differ from those estimates.

 

Investments

 

Fixed maturities available for sale include those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. Fixed maturities available for sale, which include bonds and sinking fund preferred stocks, are carried at market. Investments in equity securities, which include common stocks and non-redeemable preferred stocks, are carried at market. Short-term cash investments are carried at cost, which approximates market.

 

In most cases, the market valuations were drawn from standard trade data sources. In no case were any valuations made by the Company’s management. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date.

 

Temporary unrealized investment gains and losses on securities available for sale are credited or charged directly to shareholders’ equity as accumulated other comprehensive income, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statements of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method.

 

 

43


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

The Company writes covered call options through listed exchanges and over-the-counter. When the Company writes an option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security or currency in determining whether the Company has realized a gain or loss. The Company as writer of an option bears the market risk of an unfavorable change in the price of the security underlying the written option.

 

Fair Value of Financial Instruments

 

Under Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 of the Notes to Consolidated Financial Statements and were drawn from standard trade data sources such as market and broker quotes. The carrying value of receivables, accounts payable and other liabilities is equivalent to the estimated fair value of those items. The notes payable are carried at their book value which is calculated as the principal less unamortized discount on the senior debt and the discounted value of future payments on the Employers Reinsurance Corporation note in the MCM transaction. The terms of the notes are discussed in Note 5 of the Notes to Consolidated Financial Statements.

 

Goodwill and Other Intangible Assets

 

Goodwill and other intangible assets represent the excess of the purchase price of acquired businesses over the fair value of net assets acquired using the purchase method of accounting. Included in the Company’s balance sheet are goodwill of $7.3 million and other intangible assets of $9.3 million. The Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”, as of January 1, 2002. The goodwill and other intangible assets were determined to have an indefinite useful life and in accordance with SFAS No. 142 are not amortized, but tested for impairment annually. The fair value of goodwill and other intangibles are measured annually based upon projected discounted operating cash flows using a market rate of interest to discount the cash flows. No impairment was recorded at December 31, 2002. Prior to January 2002, the Company amortized these assets over their expected useful lives and recorded amortization expense for goodwill and other intangible assets of $1.9 million in 2001 and $1.2 million in 2000.

 

Premium Income Recognition

 

Insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are computed on a monthly pro rata basis. Unearned premiums are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets.

 

Net premiums written during 2002, 2001 and 2000 were $1,865,046,000, $1,442,886,000, and $1,272,447,000, respectively.

 

One broker produced direct premiums written of approximately 16%, 17% and 18% of the Company’s total direct premiums written during 2002, 2001 and 2000, respectively. No other agent or broker accounted for more than 2% of direct premiums written.

 

44


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

 

Premium Notes

 

Premium notes receivable represent the balance due to the Company from policyholders who elect to finance their premiums over the policy term. The Company requires both a downpayment and monthly payments as part of its financing program. Premium finance fees are charged to policyholders who elect to finance premiums. The fees are charged at rates that vary with the amount of premium financed. Premium finance fees are recognized over the term of the premium note based upon the effective yield.

 

Deferred Policy Acquisition Costs

 

Acquisition costs related to unearned premiums, which consist of commissions, premium taxes and certain other underwriting costs, which vary directly with and are directly related to the production of business, are deferred and amortized to income ratably over the terms of the policies. Deferred acquisition costs are limited to the amount which will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses and the servicing costs that will be incurred as the premiums are earned. The Company does not defer advertising expenses.

 

Losses and Loss Adjustment Expenses

 

The liability for losses and loss adjustment expenses is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period, plus estimates, based upon past experience, of ultimate developed costs which may differ from case estimates and of unreported claims. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of reinsurance recoverable is included in other receivables.

 

Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.

 

Depreciation

 

Buildings and furniture and equipment are depreciated over 30-year and 3-year to 10-year periods, respectively, on a combination of straight-line and accelerated methods. Automobiles are depreciated over 5 years, using an accelerated method.

 

Earnings per Share

 

Earnings per share is presented in accordance with the provisions of Statement of Financial Accounting Standards No. 128, “Earnings per Share”, which requires presentation of basic and diluted earnings per share for all publicly traded companies. Note 14 of the Notes to Consolidated Financial Statements contains the required disclosures which make up the calculation of basic and diluted earnings per share.

 

45


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

 

Segment Reporting

 

Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”), establishes standards for the way information about operating segments is reported in financial statements. The Company does not have any operations that require separate disclosure as operating segments.

 

Income Taxes

 

The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and expected benefits of utilizing net operating loss and credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled and reflected in the financial statements in the period enacted.

 

Reinsurance

 

Liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The ceded amounts are immaterial and are carried in other assets and other receivables. Earned premiums are stated net of deductions for ceded reinsurance.

 

The Insurance Companies, as primary insurers, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements.

 

Statements of Cash Flows

 

Interest paid during 2002, 2001 and 2000, was $6,435,000, $4,610,000 and $7,357,000, respectively. Income taxes paid were $21,154,000 in 2002, $20,089,000 in 2001 and $14,609,000 in 2000.

 

The tax benefit realized on stock options exercised and included in cash provided from operations in 2002, 2001 and 2000 was $389,000, $587,000 and $549,000, respectively.

 

In 2001, debt issuance costs of $1,345,000 were paid in connection with the public debt offering of $125 million of senior notes payable.

 

In 2000, notes payable with a discounted value of $5,889,000 were issued as part of the consideration for the right to manage and control MCM (See Note 8 in Notes to Consolidated Financial Statements).

 

Stock-Based Compensation

 

The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”. Disclosure of stock-based compensation determined in accordance with SFAS No. 148 is presented in Note 13 in Notes to Consolidated Financial Statements.

 

46


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

 

Reclassifications

 

Certain reclassifications have been made to the prior year balances to conform to the current year presentation.

 

Recently Issued Accounting Standards

 

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs and it applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees. Under SFAS No. 143, a company is required to 1) record an existing legal obligation associated with the retirement of a tangible long-lived asset as a liability when incurred and the amount of the liability be initially measured at fair value, 2) recognize subsequent changes in the liability that result from (a) the passage of time and (b) revisions in either the timing or amount of estimated cash flows and 3) upon initially recognizing a liability for an asset retirement obligation, an entity shall capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, with earlier application encouraged. The adoption of SFAS No. 143 will not have a material impact on the financial statements.

 

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). The objectives of SFAS No. 144 are to address significant issues relating to the implementation of SFAS Statement No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS No. 121”) and to develop a single accounting model based on the framework established in SFAS No. 121 for long-lived assets to be disposed of by sale whether previously held and used or newly acquired. Even though SFAS No. 144 supersedes SFAS No. 121, it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 supersedes the accounting and reporting provisions of Accounting Principles Board Opinion No. 30 “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” (“APB No. 30”) for segments of a business to be disposed of. However, SFAS No. 144 retains the requirement of APB No. 30 that entities report discontinued operations separately from continuing operations and extends that reporting requirement to “a component of an entity” that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as “held for sale”. SFAS No. 144 also amends the guidance of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to eliminate the exception to consolidation for a temporarily controlled subsidiary. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The adoption of SFAS No. 144 did not have a material effect on the Company’s earnings or financial position.

 

In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No. 145”). The objectives of SFAS No. 145 are to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS No. 145 related to the rescission of Statement 4 are applicable to fiscal years beginning after May 15, 2002. The provisions related to Statement 13 are applicable to transactions occurring

 

47


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

after May 15, 2002. All other provisions of SFAS No. 145 are applicable to financial statements issued on or after May 15, 2002. Management of the Company anticipates that the adoption of SFAS No. 145 will not have a material effect on the Company’s earnings or financial position.

 

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Terminations Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred as opposed to the date of an entity’s commitment to an exit plan as required under EITF 94-3. SFAS No. 146 also requires that measurement of the liability associated with exit or disposal activities be at fair value. SFAS No. 146 is effective for the Company for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 is not expected to have a material impact on the Company’s financial statements.

 

In October 2002, the FASB issued SFAS No. 147, “Acquisition of Certain Financial Institutions” (“SFAS No. 147”), which addresses the financial accounting and reporting for the acquisition of all or a part of a financial institution, except for transactions between two or more mutual enterprises. Under SFAS No. 147, the acquisition of all or part of a financial institution that meets the definition of a business combination shall be accounted for by the purchase method in accordance with SFAS No. 141, Business Combinations. SFAS No. 147 also provides guidance on accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises. SFAS No. 147 is effective for acquisitions for which the date of acquisition is on or after October 1, 2002. The provisions related to accounting for the impairment or disposal of acquired long-term customer-relationship intangible assets, including those acquired in transactions between two or more mutual enterprises are effective on October 1, 2002. Management of the Company anticipates that the adoption of SFAS No. 147 is not expected to have a material impact on the Company’s financial statements.

 

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. This Interpretation also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee. The provisions related to the disclosure requirements to be made by a guarantor are effective for financial statements of interim and annual reporting periods ending after December 15, 2002. The provisions related to the recognition of a liability and initial measurement shall be applied prospectively to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. Management of the Company anticipates that the adoption of this Interpretation is not expected to have a material impact on the Company’s financial statements.

 

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS No. 148”) which amends SFAS Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). The objective of SFAS No. 148 is to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 does not change the provisions of SFAS No. 123 that permit entities to continue to apply the intrinsic value method of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The

 

48


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

Company continues to maintain its accounting for stock-based compensation in accordance with APB No. 25, but has adopted the disclosure provisions of SFAS No. 148 (See Note 13 in Notes to Consolidated Financial Statements).

 

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51” (“FIN No. 46”). FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. FIN No. 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated. The implementation of FIN No. 46 is not expected to have a material impact on the Company’s financial statements.

 

(2)    Investments and Investment Income

 

A summary of net investment income is shown in the following table:

 

    

Year ended December 31,


    

2002


  

2001


  

2000


    

(Amounts in thousands)

Interest and dividends on fixed maturities

  

$

95,124

  

$

95,187

  

$

86,644

Dividends on equity securities

  

 

15,478

  

 

17,080

  

 

17,136

Interest on short-term cash investments

  

 

2,951

  

 

3,295

  

 

3,380

    

  

  

Total investment income

  

 

113,553

  

 

115,562

  

 

107,160

Investment expense

  

 

470

  

 

1,051

  

 

694

    

  

  

Net investment income

  

$

113,083

  

$

114,511

  

$

106,466

    

  

  

 

A summary of net realized investment gains (losses) is as follows:

 

    

Year ended December 31,


    

2002


    

2001


  

2000


    

(Amounts in thousands)

Net realized investment gains (losses):

                      

Fixed maturities

  

$

(34,550

)

  

$

4,561

  

$

549

Equity securities

  

 

(35,862

)

  

 

1,951

  

 

3,395

    


  

  

    

$

(70,412

)

  

$

6,512

  

$

3,944

    


  

  

 

49


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

 

Gross gains and losses realized on the sales of investments (excluding calls and other than temporarily impaired securities) are shown below:

 

    

Year ended December 31,


 
    

2002


    

2001


    

2000


 
    

(Amounts in thousands)

 

Fixed maturities available for sale:

                          

Gross realized gains

  

$

11,807

 

  

$

5,558

 

  

$

1,740

 

Gross realized losses

  

 

(12,894

)

  

 

(1,608

)

  

 

(908

)

    


  


  


Net

  

$

(1,087

)

  

$

3,950

 

  

$

832

 

    


  


  


Equity securities available for sale:

                          

Gross realized gains

  

$

7,622

 

  

$

5,205

 

  

$

5,259

 

Gross realized losses

  

 

(6,561

)

  

 

(2,760

)

  

 

(1,621

)

    


  


  


Net

  

$

1,061

 

  

$

2,445

 

  

$

3,638

 

    


  


  


 

A summary of the net increase (decrease) in unrealized investment gains and losses less applicable income tax expense (benefit), is as follows:

 

    

Year ended December 31,


    

2002


    

2001


    

2000


    

(Amounts in thousands)

Net increase (decrease) in net unrealized investment gains and losses:

                        

Fixed maturities available for sale

  

$

40,858

 

  

$

(19,324

)

  

$

77,288

Income tax expense (benefit)

  

 

14,300

 

  

 

(6,763

)

  

 

27,051

    


  


  

    

$

26,558

 

  

$

(12,561

)

  

$

50,237

    


  


  

Equity securities

  

$

(2,178

)

  

$

(2,055

)

  

$

30,930

Income tax expense (benefit)

  

 

(785

)

  

 

(720

)

  

 

10,825

    


  


  

    

$

(1,393

)

  

$

(1,335

)

  

$

20,105

    


  


  

 

50


MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2002 and 2001

 

 

Accumulated unrealized gains and losses on securities available for sale is as follows:

 

    

December 31,


 
    

2002


    

2001


 
    

(Amounts in thousands)

Fixed maturities available for sale:

                 

Unrealized gains

  

$

94,032

 

  

$

56,541

 

Unrealized losses

  

 

(26,921

)

  

 

(30,288

)

Tax effect

  

 

(23,488

)

  

 

(9,188

)

    


  


    

$

43,623

 

  

$

17,065

 

    


  


Equity securities available for sale:

                 

Unrealized gains

  

$

8,860

 

  

$

15,898

 

Unrealized losses

  

 

(11,176

)

  

 

(16,036

)

Tax effect

  

 

833

 

  

 

48

 

    


  


    

$

(1,483

)

  

$

(90

)

    


  


Net unrealized investment gains (classified as accumulated other comprehensive income on the balance sheet)

  

$

42,140

 

  

$

16,975

 

    


  


 

The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2002 are as follows:

 

    

Amortized

Cost


  

Gross

Unrealized

Gains


  

Gross

Unrealized

Losses


  

Estimated

Market

Value


    

(Amounts in thousands)

U.S. Treasury securities and obligations of U.S. government corporations and agencies

  

$

84,644

  

$

1,492

  

$

56

  

$

86,080

Obligations of states and political subdivisions

  

 

1,361,852

  

 

89,005

  

 

7,856

  

 

1,443,001

Corporate securities

  

 

105,114

  

 

3,245

  

 

18,555

  

 

89,804

Redeemable preferred stock

  

 

14,150

  

 

290

  

 

454

  

 

13,986

    

  

  

  

Totals

  

$

1,565,760

  

$

94,032