Table of Contents

 

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, 2004

Commission File No. 001-12257

 

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

 

California   95-221-1612

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

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.   x

 

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 and non-voting common equity held by non-affiliates of the Registrant at June 30, 2004 was approximately $1,294,000,000 (based upon the closing sales price on the New York Stock Exchange for such date, as reported by the Wall Street Journal).

 

At February 28, 2005, the Registrant had issued and outstanding an aggregate of 54,539,318 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 11, 2005 are incorporated herein by reference into Part III hereof.

 



Table of Contents

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 2004, private passenger automobile insurance and commercial automobile insurance accounted for 86.6% and 4.2%, respectively, of the Company’s total gross premiums written. The percentage of gross automobile insurance premiums written during 2004 by state was 76.2% in California, 9.6% in Florida, 4.6% in New Jersey, 4.3% in Texas and 5.3% 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 9.2% of gross premiums written in 2004, of which approximately 59% was in the homeowners line.

 

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 2004, all of the Company’s subsidiaries actively writing insurance, except American Mercury Insurance Company (“AMI”), American Mercury Lloyds Insurance Company (“AML”) and Mercury Indemnity Company of America (“MIDAM”) maintained a 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 2004 net premiums written, maintained an A.M. Best rating of A- (Excellent). MIDAM, which writes business in New Jersey, is currently not rated due to insufficient operating experience.

 

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 opened a 130,000 square foot office building in Rancho Cucamonga, California in September 2003, which is used to support the Company’s recent growth and future expansion. The Company purchased a 157,000 square foot office building in St. Petersburg, Florida in January 2005, which currently houses the East Region corporate office. 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 4,300 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 with or furnished to the Securities and Exchange Commission (“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 request to the Company’s Chief Financial Officer, Mercury General Corporation, 4484 Wilshire Boulevard, Los Angeles, California 90010.

 

Organization

 

Mercury General, an insurance holding company, is the parent of Mercury Casualty Company (“MCC”), a California automobile insurer founded in 1961 by George Joseph, Mercury General’s Chief Executive Officer.

 

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Including MCC, Mercury General has eighteen subsidiaries. The Company’s insurance operations are conducted through the following insurance company subsidiaries:

 

Company Name


  

Date Formed or
Acquired


  

Primary States


Mercury Casualty Company (“MCC”)

   January 1961   

California

Arizona

Florida

Nevada

New York

Virginia

Mercury Insurance Company (“MIC”)

   November 1972    California

California Automobile Insurance Company (“CAIC”)

   June 1975    California

Mercury Insurance Company of Illinois (“MIC IL”)

   August 1989    Illinois

Mercury Insurance Company of Georgia (“MIC GA”)

   March 1989    Georgia

Mercury Indemnity Company of Georgia (“MID GA”)

   November 1991    Georgia

Mercury National Insurance Company (“MNIC”)

   December 1991   

Illinois

Michigan

American Mercury Insurance Company (“AMI”)

   December 1996   

Oklahoma

Florida

Georgia

Texas

American Mercury Lloyds Insurance Company (“AML”)

   December 1996    Texas

Mercury County Mutual Insurance Company (“MCM”)

   September 2000    Texas

Mercury Insurance Company of Florida (“MIC FL”)

   August 2001   

Florida

Pennsylvania

Mercury Indemnity Company of America (“MIDAM”)

   August 2001    New Jersey

 

Mercury Select Management Company, Inc. (“MSMC”), a Texas corporation serves as the attorney-in-fact for AML. The Company operates Concord Insurance Services, Inc. (“Concord”), a Texas insurance agency headquartered in Houston, Texas. MCM, a mutual insurance company organized under Chapter 17 of the Texas Insurance Code, is managed and controlled by the Company through a management agreement.

 

Management services are provided to Mercury General’s subsidiaries by Mercury Insurance Services, LLC (“MISLLC”), a subsidiary of MCC. Mercury General and its subsidiaries 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, excluding MSMC, MISLLC and Concord, are referred to as the “Insurance Companies.” The term “California Companies” refers to MCC, MIC and CAIC.

 

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 database 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, 2004, “good drivers” (as defined by the California Insurance Code) accounted for approximately 78% of all voluntary private passenger automobile policies in force in California, while higher risk categories accounted for approximately 22%. The private passenger automobile renewal rate in California (the rate of acceptance of offers to renew) averages approximately 96%. The Company also offers homeowners, commercial property and commercial automobile and mechanical breakdown insurance in California.

 

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In states outside of California, the Company offers non-standard, standard and preferred private passenger automobile insurance. Private passenger automobile policies in force for non-California operations represented approximately 24% of total private passenger automobile policies in force at December 31, 2004. In addition the Company offers mechanical breakdown insurance in all states outside of California and homeowners insurance in Florida, Illinois, Oklahoma and Georgia.

 

Production and Servicing of Business

 

The Company sells its policies through more than 4,200 independent agents and brokers, of which approximately 1,000 are located in each of California and Florida. The remainder are located in Georgia, Illinois, Texas, Oklahoma, New York, New Jersey, Virginia, Pennsylvania, Arizona, Nevada and Michigan. 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 contracted by the Company.

 

Other than one broker that produced approximately 14%, 16% and 16% during 2004, 2003, and 2002, respectively, of the Company’s 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 2004, total commissions incurred were approximately 17% of net premiums written.

 

The Company’s advertising budget is allocated among television, newspaper, internet 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 independent 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 it intends to maintain or possibly expand the current level of advertising in 2005. During 2004, the Company incurred approximately $26 million in advertising expense. “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 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 Company’s 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.

 

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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,

     2004

    2003

   2002

     (Amounts in thousands)

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

   $ 786,156     $ 664,889    $ 516,592

Incurred losses and loss adjustment expenses:

                     

Provision for insured events of the current year

     1,640,197       1,447,986      1,242,060

(Decrease) increase in provision for insured events of prior years

     (57,943 )     4,065      26,183
    


 

  

Total incurred losses and loss adjustment expenses

     1,582,254       1,452,051      1,268,243
    


 

  

Payments:

                     

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

     1,020,154       892,658      759,165

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

     461,649       438,126      360,781
    


 

  

Total payments

     1,481,803       1,330,784      1,119,946
    


 

  

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

     886,607       786,156      664,889

Reinsurance recoverable

     14,137       11,771      14,382
    


 

  

Gross liability at end of year

   $ 900,744     $ 797,927    $ 679,271
    


 

  

 

The decrease in the provision for insured events of prior years in 2004 relates largely to a decrease in the estimated inflation rates on the 2002 and 2003 accident years on bodily injury coverage for California automobile insurance. For 2003 and 2002, the increase 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.

 

During the third quarter of 2004, the state of Florida was ravaged by four hurricanes. The Company has estimated that its pre-tax losses resulting from these hurricanes is approximately $22 million. The estimate is based upon the total number of claims reported and the number of unreported claims anticipated as a result of the hurricanes. This compares with pre-tax losses of approximately $16 million incurred from the California firestorms in 2003.

 

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,

     2004

   2003

   2002

     (Amounts in thousands)

Reserves reported on a SAP basis

   $ 886,607    $ 786,156    $ 664,889

Reinsurance recoverable

     14,137      11,771      14,382
    

  

  

Reserves reported on a GAAP basis

   $ 900,744    $ 797,927    $ 679,271
    

  

  

 

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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 1994 through 2004. 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 amount represents the estimated 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, 2004.

 

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,

     1994

    1995

    1996

    1997

    1998

    1999

    2000

    2001

    2002

  2003

  2004

     (Amounts in thousands)

Net reserves for losses and loss adjustment expenses paid (cumulative) as of:

   $ 223,392     $ 250,990     $ 311,754     $ 386,270     $ 385,816     $ 418,800     $ 463,803     $ 516,592     $ 664,889   $ 786,156   $ 886,607

One year later

     145,664       167,226       206,390       247,310       263,805       294,615       321,643       360,781       438,126     461,649      

Two years later.

     198,967       225,158       291,552       338,016       366,908       403,378       431,498       491,243       591,054            

Three years later.

     214,403       248,894       316,505       369,173       395,574       429,787       462,391       528,052                    

Four years later

     219,596       253,708       324,337       379,233       402,000       439,351       476,072                            

Five years later

     220,852       255,688       329,109       381,696       405,910       446,223                                    

Six years later

     221,771       257,041       329,825       383,469       409,853                                            

Seven years later

     222,912       256,654       330,883       386,427                                                    

Eight years later

     222,492       257,292       333,634                                                            

Nine years later

     223,113       260,056                                                                    

Ten years later

     225,371                                                                            

Net reserves re-estimated as of:

                                                                                  

One year later

     216,684       247,122       324,572       376,861       393,603       442,437       480,732       542,775       668,954     728,213      

Two years later.

     222,861       254,920       329,210       378,057       407,047       449,094       481,196       549,262       660,705            

Three years later.

     221,744       257,958       327,749       383,588       410,754       446,242       483,382       546,667                    

Four years later

     222,957       257,196       329,339       386,522       409,744       449,325       482,905                            

Five years later

     221,947       256,395       332,570       385,770       410,982       448,813                                    

Six years later

     221,942       257,692       332,939       386,883       411,046                                            

Seven years later

     223,215       258,743       333,720       386,952                                                    

Eight years later

     224,276       259,467       334,096                                                            

Nine years later

     225,019       260,091                                                                    

Ten years later

     225,373                                                                            

Net cumulative redundancy (deficiency)

     (1,981 )     (9,101 )     (22,342 )     (682 )     (25,230 )     (30,013 )     (19,102 )     (30,075 )     4,184     57,943      

 

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     As of December 31,

 
     1995

    1996

    1997

    1998

    1999

    2000

    2001

    2002

    2003

    2004

 
     (Amounts in thousands)  

Gross liability—end of year

   253,546     336,685     409,061     405,976     434,843     492,220     534,926     679,271     797,927     900,744  

Reinsurance recoverable

   (2,556 )   (24,931 )   (22,791 )   (20,160 )   (16,043 )   (28,417 )   (18,334 )   (14,382 )   (11,771 )   (14,137 )
    

 

 

 

 

 

 

 

 

 

Net liability—end of year

   250,990     311,754     386,270     385,816     418,800     463,803     516,592     664,889     786,156     886,607  
    

 

 

 

 

 

 

 

 

 

Gross re-estimated liability – latest

   269,760     361,598     411,836     432,670     465,953     512,968     566,516     677,168     744,171        

Re-estimated recoverable – latest

   (9,669 )   (27,502 )   (24,884 )   (21,624 )   (17,140 )   (30,063 )   (19,849 )   (16,463 )   (15,958 )      
    

 

 

 

 

 

 

 

 

     

Net re-estimated liability – latest

   260,091     334,096     386,952     411,046     448,813     482,905     546,667     660,705     728,213        
    

 

 

 

 

 

 

 

 

     

Gross cumulative redundancy (deficiency)

   (16,214 )   (24,913 )   (2,775 )   (26,694 )   (31,110 )   (20,748 )   (31,590 )   2,103     53,756        
    

 

 

 

 

 

 

 

 

     

 

The Company’s loss reserves estimated at December 31, 2003 produced a redundancy of approximately $58 million which was reflected in the financial statements as a reduction to the 2004 calendar year incurred losses. The Company attributes most of this redundancy to a change in the inflation rate assumptions used to establish reserves on the bodily injury coverage for California private passenger automobile insurance on the 2002 and 2003 accident years.

 

At year-end 2003, the Company had assumed bodily injury severity inflation on California private passenger automobile insurance of 9% on the 2001 accident year, 6% on the 2002 accident year and 7% on the 2003 accident year. At year-end 2004, these assumptions were reduced to 8% for 2001, 1% for 2002 and 1% for 2003. The Company reduced the inflation rate assumptions based on factors that emerged during 2004 including moderating to decreasing average amounts paid on closed claims in the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage of time as more claims from an accident period are closed.

 

The change in these inflation assumptions accounted for approximately $41 million of the decrease in the expected ultimate loss on the reserves established at December 31, 2003. Each percentage point change in the inflation rate assumption accounts for approximately $2.5 million of the redundancy on the 2002 accident year losses and approximately $5 million on the 2003 accident year losses. The effect is greater on the latter accident year because the lowering of the rate for accident year 2002 has a compounding effect on accident year 2003.

 

The remainder of the redundancy on the 2003 accident year primarily occurred in the Company’s California homeowners line of business and Florida personal automobile line of business. California homeowners had approximately $6 million in reserve redundancy and Florida personal automobile had approximately $8 million in reserve redundancy.

 

For calendar year 2002, the Company’s previously estimated loss reserves produced a small redundancy which was reflected in the following years losses. This redundancy was primarily the result of changing bodily injury severity inflation assumptions for the 2002 accident year as discussed above.

 

For calendar years 1998 through 2001, 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.

 

For calendar year 1997, the Company’s previously estimated loss reserves produced a small deficiency indicating that the Company was reasonably accurate in establishing the initial reserve for that year.

 

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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.

 

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,

 
     2004

    2003

    2002

    2001

    2000

 

Loss Ratio

   62.6 %   67.7 %   72.8 %   73.2 %   72.2 %

Expense Ratio

   26.4     25.9     25.6     26.0     26.4  
    

 

 

 

 

Combined Ratio

   89.0 %   93.6 %   98.4 %   99.2 %   98.6 %
    

 

 

 

 

Industry combined ratio (all writers) (1)

   93.3 %(2)   97.9 %   103.7 %   107.4 %   108.0 %

Industry combined ratio (excluding direct writers) (1)

   (N.A. )   98.4 %   103.7 %   106.0 %   108.7 %

(1)   Source: A.M. Best, Aggregates & Averages (2001 through 2004), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends).
(2)   Source: A.M. Best, “Best’s Review, January 2005, 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,

 
     2004

    2003

    2002

    2001

    2000

 

Loss Ratio

   62.6 %   67.7 %   72.8 %   73.2 %   72.2 %

Expense Ratio

   26.6     26.3     26.0     26.4     26.3  
    

 

 

 

 

Combined Ratio

   89.2 %   94.0 %   98.8 %   99.6 %   98.5 %
    

 

 

 

 

 

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Premiums to Surplus Ratio

 

The following table shows, for the periods indicated, the Insurance Companies’ statutory ratios of net premiums written to policyholders’ surplus. 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,

     2004

   2003

   2002

   2001

   2000

     (Amounts in thousands, except ratios)

Net premiums written

   $ 2,646,704    $ 2,268,778    $ 1,865,046    $ 1,442,886    $ 1,272,447

Policyholders’ surplus

   $ 1,361,072    $ 1,169,427    $ 1,014,935    $ 1,045,104    $ 954,753

Ratio

     1.9 to 1      1.9 to 1      1.8 to 1      1.4 to 1      1.3 to 1

 

Risk-Based Capital

 

The NAIC employs a risk-based capital formula for casualty insurance companies that establishes 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, 2004. Each of the Insurance Companies’ policyholders’ surplus 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 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.

 

    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 statutory 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.

 

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Investments and Investment Results

 

The Company’s investments 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 that 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. 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,

     2004

   2003

   2002

     Amortized Market    Amortized Market    Amortized Market
     Cost

   Value

   Cost

   Value

   Cost

   Value

     (Amounts in thousands)

Taxable bonds

   $ 533,715    $ 536,261    $ 350,750    $ 356,181    $ 198,994    $ 185,643

Tax-exempt state and municipal bonds

     1,623,147      1,700,932      1,492,873      1,576,606      1,352,616      1,433,242

Sinking fund preferred stocks

     8,093      8,118      12,460      12,522      14,150      13,986
    

  

  

  

  

  

Total fixed maturity investments

     2,164,955      2,245,311      1,856,083      1,945,309      1,565,760      1,632,871

Equity investments incl. perpetual preferred stocks

     210,553      254,362      223,113      264,393      233,297      230,981

Short-term cash investments

     421,369      421,369      329,812      329,812      286,806      286,806
    

  

  

  

  

  

Total investments

   $ 2,796,877    $ 2,921,042    $ 2,409,008    $ 2,539,514    $ 2,085,863    $ 2,150,658
    

  

  

  

  

  

 

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. Declines in value considered to be temporary are charged as unrealized losses to shareholders’ equity as accumulated other comprehensive income. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” and Note 2 of Notes to Consolidated Financial Statements.

 

At year-end, approximately 58% of the Company’s total investment portfolio, at market values, and 76% of its total fixed maturity investments, at market values, were invested in investment grade tax-exempt revenue and municipal bonds. Shorter duration sinking fund preferred stocks and collateralized mortgage obligations represented approximately 8.7% of the Company’s total investment portfolio, at market values, and 11.4% of its total fixed maturity investments, at market values, at December 31, 2004. The average Standard & Poor’s rating of the Company’s bond holdings was AA at December 31, 2004. Holdings of lower than investment grade bonds constitute approximately 1.7% of total invested assets.

 

The nominal average maturity of the overall bond portfolio, including collateralized mortgage obligations and short-term cash investments, was 11.3 years at December 31, 2004, which reflects a heavier portfolio mix in investment grade tax-exempt revenue and municipal bonds. The call-adjusted average maturity of the overall bond

 

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portfolio was shorter, approximately 4.0 years, because holdings are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified duration of the overall bond portfolio reflecting anticipated early calls was 3.2 years at December 31, 2004, including collateralized mortgage obligations with modified durations of approximately 1.6 years and short-term cash investments that carry no duration. 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.

 

Equity holdings consist 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 Company writes covered call options through listed exchanges and over-the-counter with the intent of generating additional income or return on capital. The total investment under the covered call program in 2004 was approximately $30 million. The Company as a writer of an option bears the market risk of an unfavorable change in the price of the security underlying the written option.

 

The following table summarizes the investment results of the Company for the five years ended December 31, 2004:

 

     Year ended December 31,

 
     2004(1)

    2003(1)

    2002(1)

    2001(1)

    2000(1)

 
     (Amounts in thousands)  

Average invested assets (includes short-term cash investments(2))

   $ 2,662,224     $ 2,310,966     $ 2,035,279     $ 1,828,455     $ 1,710,176  

Net investment income:

                                        

Before income taxes

     109,681       104,520       113,083       114,511       106,466  

After income taxes

     95,897       93,318       99,071       98,909       95,154  

Average annual yield on investments:

                                        

Before income taxes

     4.1 %     4.5 %     5.6 %     6.3 %     6.2 %

After income taxes

     3.6 %     4.0 %     4.9 %     5.4 %     5.6 %

Net realized investment gains (losses) after income taxes(3)

     16,292       7,285       (45,768 )     4,233       2,564  

Net (decrease) increase in un-realized gains/losses on all investments after income taxes

   $ (4,284 )   $ 42,693     $ 25,165     $ (13,896 )   $ 70,342  

(1)   Includes MCM for the last three months of 2000 and the full year in 2001, 2002, 2003 and 2004.
(2)   Fixed maturities and equities at cost.
(3)   Includes investment write-downs, net of tax benefit, that the Company considered to be other than temporary of $0.6 million in 2004, $5.9 million in 2003 and $46.6 million in 2002. There were no investment write-downs in 2000 and 2001.

 

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

 

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have larger volumes of business and greater financial resources than the Company. Based on the most recent regularly published statistical compilations of premiums written, the Company in 2003 was the third largest writer of private passenger automobile insurance in California. All of the Company’s competitors having greater shares of the California market sell insurance through exclusive agents, rather than through independent agents and brokers.

 

The property and casualty insurance industry is highly cyclical, characterized by periods of high premium rates and shortages of underwriting capacity (“hard market”) followed by periods of severe price competition and excess capacity (“soft market”). In management’s view, 2003 and 2004 were periods of very good results for companies underwriting automobile insurance. As a result, many competitors have recently begun reducing rates and increasing advertising expenditures. The Company expects this to continue in 2005 and consequently the premium growth rate will likely decline from the levels seen in 2004 (17%) and 2003 (22%).

 

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

 

Effective January 8, 2005, the Company terminated a property per risk reinsurance treaty that had been in place with Swiss Re since January 1999, and replaced it with a similar treaty with Employers Reinsurance Corporation (“ERC”), which is rated A by A.M. Best. The new treaty, which covers commercial property and homeowners, provides first layer coverage of $250,000 in excess of $750,000 for each risk, second layer coverage of $1,000,000 in excess of $1,000,000 per risk and third layer coverage of $3,000,000 in excess of $2,000,000 per risk.

 

The Swiss Re treaty was terminated on a cut off basis meaning that Swiss Re will remain liable for losses occurring prior to the date of termination. The Swiss Re treaty provides first layer coverage of $250,000 in excess of $750,000, second layer coverage of $1,000,000 in excess of $1,000,000, third layer coverage of $3,000,000 in excess of $2,000,000 and fourth layer coverage of $5,000,000 in excess of $5,000,000.

 

Prior to October 1, 2004, the Company had in place a treaty reinsurance agreement with Swiss Re, where risks written under personal umbrella policies were ceded to Swiss Re on a quota share basis. Prior to May 1, 2003 the treaty was on a 100% quota share basis and provided $4 million coverage in excess of $1 million for each risk. Effective May 1, 2003, the treaty was replaced with a 33% quota share agreement for umbrella policies with coverage amounts up to but not exceeding $2 million. Effective October 1, 2004, the umbrella coverage was terminated. The Company has chosen to end the treaty on a run-off basis meaning that the treaty will remain active for one year after the termination date with policies incepting September 30, 2004 and prior being covered per the treaty terms. Policies incepting on October 1, 2004 and after will not have any reinsurance coverage.

 

At December 31, 2004, the Company did not maintain catastrophe insurance but has determined that such coverage is warranted for certain coverages written in Florida and Georgia. Effective April 1, 2005, the Company expects to enter into a property catastrophe excess of loss reinsurance agreement that will cover all property and automobile physical damage (comprehensive peril only) coverages in those two states. The treaty is with a group of reinsurers and Lloyd’s underwriters and has two layers. The first layer provides coverage of $30,000,000 in excess

 

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of $70,000,000 and the second layer is for $50,000,000 in excess of $100,000,000. For all layers, the Company will retain 5% of the limit. Policies written in all other states do not have catastrophe coverage, as the Company believes it has adequate capitalization to absorb catastrophe losses in those states. The Company periodically reviews its requirements for catastrophic reinsurance particularly in areas that are prone to catastrophes.

 

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.

 

ERC reinsures AMI through working layer treaties for property and casualty losses in excess of $500,000 up to $3 million. AMI has other reinsurance treaties and facultative arrangements in place for various smaller lines of business.

 

MCM maintains 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 any reinsurers are unable to perform their obligations under the reinsurance treaty, the Company will 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, the establishment of capital and surplus requirements and standards of solvency, restrictions on dividend payments and transactions with affiliates. The regulations of 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 the California Insurance Code and the California Code of Regulations with respect to rating, underwriting and claims handling practices. The most recent examination covered a compliance review of the activities of the Company’s Special Investigation Unit commencing in October 2004. The report on the examination is pending finalization by the California DOI.

 

In February 2004, the California DOI issued a Notice of Non-Compliance (“NNC”) to the California Companies based on the trial court ruling in the Robert Krumme litigation. The NNC alleges that the California Companies willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumer’s insurance broker. The California Companies filed a Notice of Defense which is based on the same grounds that formed the Company’s defense in the Robert Krumme case. The administrative proceeding has been stayed at the California DOI’s request until a resolution is reached on the Robert Krumme case. Settlement negotiations have commenced in order to resolve the matter, including reimbursement of costs to the DOI and the payment of a monetary penalty. No specific discussions have taken place regarding the amount of any monetary penalty, except that the DOI has indicated that a monetary penalty would be required. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The Company is unable to estimate the ultimate amount of the monetary penalty therefore no adjustment for the potential monetary penalty is recorded in the financial statements. See “Item 3. Legal Proceedings.”

 

The Insurance Companies outside California are subject to the regulatory powers of the DOIs of the various states in which they operate. Those powers are similar to the regulatory powers in California enumerated above. Generally, the regulations relate primarily to standards of solvency and are designed for the benefit of policyholders and not of insurance company shareholders.

 

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In California, Georgia, New York, New Jersey, Pennsylvania and Nevada, insurance rates require prior approval from the State DOI, while Illinois, Texas, Virginia, Arizona and Michigan 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.”

 

Persistency discounts predate the Proposition 103 rate regulations. They represent discounts on policy rates extended to consumers based on the number of consecutive years insurance coverage has existed. In 1990, in response to Proposition 103’s allowance of optional rating factors promulgated by the California Insurance Commissioner (the “Commissioner”), the Commissioner issued regulations permitting persistency as a rating factor under the new rate regulations. No further definition of persistency discount was provided. In 1994, the Commissioner conducted a market conduct examination of the Company, after which he indicated he believed Mercury’s persistency discount, then awarded only to consumers serviced by the Company’s agents and brokers, was unfairly discriminatory. In response to that examination, in 1995 the Company filed, and secured approval, for a persistency discount awarded to insureds with continuous coverage with any insurer—what has come to be called “portable” persistency. This discount was consistently reapproved by the Commissioner until Commissioner Harry Low took the position that only “loyalty” persistency—that is, the kind of persistency discount the Company awarded prior to 1995—was allowable under Proposition 103.

 

The California DOI required all insurers offering persistency discounts to make class plan filings by January 15, 2003, removing the portability of the persistency discounts. These class plans were never implemented because Senate Bill 841 was enacted during 2003 amending the California Insurance Code to allow insurers to offer products with portable persistency discounts. In January 2004, this legislation was overturned through judicial proceedings in the Los Angeles Superior Court. The Company intervened in the original proceedings and expects appellate review of this ruling to be heard in the second quarter of 2005. The outcome of such action is uncertain; however, in the meantime, the Company is allowed to maintain its existing portable persistency discounts. The changes made during the class plan filing indicated that removing persistency discounts is 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 and would cause many existing customers’ rates to change. However, this impact, if any, is undeterminable.

 

On October 20, 2004, the Commissioner proposed regulations which require greater disclosure of the commissions that brokers may receive from insurance companies for selling insurance policies. The proposed regulations are designed to protect consumers from undisclosed commissions and would penalize any broker who places his or her own financial or other interest above that of a client. Under the proposed regulations, brokers and agents would be required to disclose “all material facts” regarding third party compensation. Brokers would also be required to provide their clients insurance quotes from the best available insurer. The Company believes that this proposed regulation, if enacted, will not have a material impact on its business since the Company is a leading provider of competitively-priced insurance in the California marketplace.

 

The California DOI conducted a financial examination of the California Companies as of December 31, 2003. The exam resulted in no material findings or recommendations. The state of Florida conducted financial examinations of MIC FL and MIDAM as of December 31, 2002 and again as of December 31, 2003 as required by Florida statute for a start-up company. The exam as of December 31, 2002 resulted in no material findings or recommendations. The report on examination for the period ending December 31, 2003 is pending finalization. The Georgia DOI is conducting a financial examination of MIC GA and MID GA as of December 31, 2003. The report is not yet available.

 

The operations of the Company are dependent on the laws of the states 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 2004 and 2003, those contributions amounted to $534,800 and $789,600, 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.

 

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During 2004, the Company spent substantial management time and resources in anticipation of the attestation by its independent auditor of management’s report with respect to its internal controls over financial reporting as required by Section 404 (“SOX 404”) of the Sarbanes-Oxley Act of 2002. As part of its readiness preparation, the Company engaged the services of consultants from a large international consulting firm and consultants from a Big Four accounting firm. The Company estimates that its total expenditures will be approximately $2 million (including audit fees) relating to the readiness preparation and the attestation by its independent auditor of management’s report of its internal controls over financial reporting. The Company expects SOX 404 related costs will be lower in 2005.

 

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. 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. Insurance subsidiaries in the other states are also subject to the provisions of similar insurance guaranty associations. 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. There were no material assessments levied against the Company during 2004.

 

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 Company’s admitted assets or 25% of statutory 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 California 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 California 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.

 

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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. 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 California DOI approved a rate decrease of 28.3% effective February 1, 1999. The California DOI approved rate increases of 15.5% and 10.3% on new and renewal assigned risk business effective November 1, 2003 and November 19, 2004, respectively. While the number of the Company’s assignments increased in 2002 and 2003, its total assignments decreased slightly in 2004. In 2004, assigned risks represented 0.2% of total automobile direct premiums written and 0.2% of total automobile direct premium earned. The Company attributes the low level of assignments to the competitive voluntary market. Many of the other states in which the Company conducts business offer similar programs to that of California. These programs are not a significant contributor to the business written in those states.

 

Automobile Insurance Rating Factor Regulations

 

California Proposition 103 requires that property and casualty insurance rates be approved by the California 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 specifies 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 California Insurance Commissioner to have a substantial relationship to risk of loss and adopted by regulation. The statute further provides 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 California Insurance Commissioner uses rating factor regulations which are designed to implement the Proposition 103 guidelines. The Company’s rate plan was approved by the California Insurance Commissioner and operates under these rating factor regulations.

 

California Financial Responsibility Law

 

California 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. In addition, California 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.

 

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 CEA. The Company receives a small fee for placing business with the CEA.

 

 

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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 29, 2004, is approximately $47 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 required insurers to 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, the Company does not insure a high concentration of commercial 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. Less than five percent of the Company’s commercial property policyholders purchased this coverage in 2004.

 

EXECUTIVE OFFICERS OF THE COMPANY

 

The following table sets forth certain information concerning the executive officers of the Company as of February 15, 2005:

 

Name


   Age

  

Position


George Joseph

   83    Chairman of the Board and Chief Executive Officer

Gabriel Tirador

   40    President and Chief Operating Officer

Bruce E. Norman

   56    Senior Vice President—Marketing

Jack Dougherty

   41    Vice President—Eastern Region

Maria Fitzpatrick

   47    Vice President and Chief Information Officer

Christopher Graves

   39    Vice President and Chief Investment Officer

Kenneth G. Kitzmiller

   58    Vice President—Underwriting

Rick McCathron

   33    Vice President—Western Region

Joanna Y. Moore

   49    Vice President and Chief Claims Officer

Peter Simon

   45    Vice President and Chief Technology Officer

Theodore R. Stalick

   41    Vice President and Chief Financial Officer

Charles Toney

   43    Vice President and Chief Actuary

Judy A. Walters

   58    Vice President—Corporate Affairs and Secretary

 

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 50 years’ experience in the property and casualty insurance business.

 

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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 15 years experience in the property and casualty insurance industry and is a Certified Public Accountant.

 

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 MCC 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.

 

Mr. Dougherty, Vice President—Eastern Region, joined the Company in 1998 where he served as the General Manager for the Company’s Florida operations. He was named to his current position in April 2004. In this position, Mr. Dougherty is responsible for all aspects of the Company’s operations east of the Mississippi River. As General Manager of the Florida operations, Mr. Dougherty was responsible for the marketing, underwriting and claims functions within Florida.

 

Ms. Fitzpatrick, Vice President and Chief Information Officer, joined the Company in February 2004, and is responsible for information technology operations. Prior to joining Mercury, she served as the Senior Vice President—Chief Information Officer for Pacificare Health Systems from 2000 to 2003 and Vice President of Systems Development at Pacificare Health Systems since 1996.

 

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. Kitzmiller, Vice President—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 California underwriting activities of the Company since early 1996.

 

Mr. McCathron, Vice President—Western Region, joined the Company in the underwriting department in 1993. He was named to his current position in April 2004. In this position, Mr. McCathron is responsible for all aspects of the Company’s operations west of the Mississippi River, excluding California. Mr. McCathron has served in various positions and responsibilities since joining the Company.

 

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. Simon, Vice President and Chief Technology Officer, has been employed by the Company since 1980. He was appointed to his current position in October 2003. Prior to this appointment, Mr. Simon served as a Vice President in the Information Systems Department since December 1999.

 

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.

 

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.

 

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.

 

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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 MCC. The Company occupies approximately 95% of the building and leases the remaining office space to others.

 

The Company owns a 130,000 square foot office building in Rancho Cucamonga, California that opened in September 2003. This space is 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.

 

In January 2005, the Company purchased a 157,000 square foot office building in St. Petersburg, Florida. This building currently houses the Company’s East Region corporate offices and seven outside tenants. In the future, the Company plans to expand into the spaces occupied by the outside tenants as their lease terms end.

 

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.

 

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 in cases where the Company is able to estimate its potential exposure and it is probable that the court will rule against the Company. The Company vigorously defends actions against it, 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 asserted an 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 asserted 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 sought an elimination of the broker fees and restitution of previously paid broker fees. In April 2003, the court ruled that the brokers involved in the suit were in fact agents of the Company; however, the court also held that the Company was not responsible for retroactive restitution. The court issued an injunction on May 16, 2003 that prevents the Company from either (a) selling auto or homeowners insurance through any producer that is not appointed as an agent under Insurance Code, Section 1704, (b) selling auto or homeowners insurance through any producer that charges broker fees and (c) engaging in comparative rate advertising and failing to disclose the possibility that a broker fee may be charged. The Company appealed, which had the effect of staying all but the advertising aspects of the court’s injunction. After the trial court decision, the Company changed its comparative rate advertising and now discloses the possibility that broker fees may be charged. In October 2004, the California Court of Appeals upheld the judgment of the trial court and denied the Company’s request for rehearing. On January 19, 2005, the California Supreme Court denied the Company’s petition to review the decision rendered by the California Court of Appeals.

 

Following the decision by the California Supreme Court not to review the California Court of Appeals’ ruling, representatives of the Company held discussions with representatives of the plaintiffs and of the California DOI regarding changes to the Company’s business practices that have been or may be implemented in response to the

 

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case. As a result of these discussions, a stipulation was filed jointly by the plaintiffs and the Company to extend the stay of the trial court’s injunction that was in place during the appeals process. The Company filed a Motion to Vacate the trial court’s injunction on the basis that the Company has implemented material changes in its relationship with broker-agents. A hearing is scheduled on March 24, 2005 in the Superior Court of the State of California regarding the Company’s Motion to Vacate. The Company is unable to estimate the impact, if any, should it be required to appoint its brokers as agents.

 

In February 2004, the California DOI issued a Notice of Non-Compliance (“NNC”) to the California Companies based on the trial court ruling in the Robert Krumme litigation. The NNC alleges that the California Companies willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumer’s insurance broker. The California Companies filed a Notice of Defense which is based on the same grounds that formed the Company’s defense in the Robert Krumme case. The administrative proceeding has been stayed at the California DOI’s request until a resolution is reached on the Robert Krumme case. Settlement negotiations have commenced in order to resolve the matter including reimbursement of costs to the DOI and the payment of a monetary penalty. No specific discussions have taken place regarding the amount of monetary penalty, except that the DOI has indicated that a monetary penalty would be required. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The Company is unable to estimate the ultimate amount of the monetary penalty therefore no adjustment for the potential monetary penalty is recorded in the financial statements.

 

In Kate Steinbeck vs. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company (Orange County Superior Court), filed October 7, 2004, the plaintiff alleges that billing service fees charged in connection with installment payments made by insureds constitute premium and that Section 381 of the California Insurance Code bars the charging of premium not specified in the policy. The Complaint states claims for breach of contract, violations of the California Unfair Competition Law, violation of the California Consumer Legal Remedies Act, and common count claims for unjust enrichment and money had and received under this theory. The Complaint also seeks class action status, unspecified damages and restitution, injunctive relief, and unspecified attorneys’ fees. On January 19, 2005, the Company filed a Demurrer to the Complaint seeking its dismissal with prejudice for failure to state a claim and a Motion to Strike Certain Allegations in the Complaint. The latter motion seeks to strike the class and representative allegations in the Complaint in the event the Demurrer is not sustained with prejudice as to all of the plaintiff’s alleged individual causes of actions. The Demurrer and Motion to Strike are currently scheduled to be heard in April 2005. The Company believes that its actions are in compliance with both industry practice and California law and intends to vigorously defend this case. The Company can not predict the ultimate outcome at this stage of the proceedings.

 

Sam Donabedian, individually, and on behalf of those similarly situated vs. Mercury Insurance Company (Los Angeles Superior Court), filed April 20, 2001, involves a dispute over insurance rates/premiums charged to the plaintiff and the legality of persistency discounts. The action was dismissed when the Company’s Demurrer to the plaintiff’s First Amended Complaint was sustained without leave to amend. The dismissal of this case was appealed and then overruled by an Appellate Court on the basis that there are factual issues as to whether the persistency discounts as applied comply with the Company’s class plan and the California Insurance Code. The California Supreme Court declined to grant review. The plaintiff filed a Second Amended Complaint in December 2004, which specifically alleges that the Company violated California Business and Professional Code 17200 et seq. and California Civil Code Section 1750 et seq. and that it breached the implied covenant of good faith and fair dealing. The Second Amended Complaint seeks relief in the form of an injunction to cease the alleged unfair business acts, notification to policyholders of the alleged acts, unspecified restitution and monetary damages including punitive damages and unspecified attorney’s fees and costs. The plaintiff filed a Third Amended Complaint in February 2005 which was substantially the same as the Second Amended Complaint. The Company filed Demurrers to the Amended Complaints. A hearing is scheduled for April 22, 2005. No trial date has been scheduled and the Plaintiff has not filed a motion seeking to certify the putative class. The Company intends to vigorously defend this case. Since the case is in its early stages, the Company is not able to determine the potential outcome of this matter and potential liability exposure.

 

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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, involves a dispute over whether the Company’s use of certain automated database vendors to help determine the value of total loss claims is proper. The plaintiff (along with plaintiffs in other coordinated cases against other insurers) is seeking class certification and unspecified damages for breach of contract and bad faith, including punitive damages, restitution, an injunction preventing us from using valuation software and unspecified attorneys’ fees and costs. In 2003, the court granted the Company’s motion to stay the action pending compliance with a contractual arbitration provision. The arbitration was completed in August 2004 and the award in the Company’s favor has been confirmed by the court in January 2005. Based upon the arbitration result and other defenses, the Company intends to challenge the pleadings and seek dismissal. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of an unfavorable outcome at the present time.

 

In Marissa Goodman, on her own behalf and on behalf of all others similarly situated v. Mercury Insurance Company (Los Angeles Superior 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. The 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. The plaintiff is seeking unspecified actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with two other similar cases, and also with ten other cases relating to total loss claims. The Company and the other defendants were successful on demurrer. The plaintiffs filed a Second Amended Complaint on June 28, 2004 which was substantially the same as the original complaint. The Company has answered the Second Amended Complaint and will file a Motion for Summary Judgment as to the claims of Ms. Goodman. The Company expects the Motion to be heard in May 2005. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of an unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.

 

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—General,” 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.

 

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PART II

 

Item 5.    Market for the Registrant’s Common Equity, Related Security Holder Matters and Issuer Purchase of Equity Securities

 

Price Range of Common Stock

 

The Company’s 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

2003

             

1st Quarter

   $ 39.05    $ 33.50

2nd Quarter

   $ 48.59    $ 37.82

3rd Quarter

   $ 47.40    $ 42.05

4th Quarter

   $ 50.30    $ 44.78
     High

   Low

2004

             

1st Quarter

   $ 53.24    $ 46.29

2nd Quarter

   $ 53.40    $ 47.70

3rd Quarter

   $ 53.27    $ 46.95

4th Quarter

   $ 60.26    $ 47.60

 

The closing price of the Company’s common stock on February 28, 2005 was $54.86.

 

Dividends

 

Since the public offering of its common stock in November 1985, the Company has paid regular quarterly dividends on its common stock. During 2004 and 2003, the Company paid dividends on its common stock of $1.48 per share and $1.32 per share, respectively. On January 28, 2005, the Board of Directors declared a $0.43 quarterly dividend payable on March 31, 2005 to stockholders of record on March 15, 2005.

 

The common stock dividend rate has increased at least once each year since dividends were initiated in January, 1986. 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. For example, California 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 the state restrictions, the direct insurance subsidiaries of the Company are entitled to pay dividends to Mercury General during 2005 of up to approximately $235 million without prior regulatory approval. See “Item 1. Business—Regulation—Holding Company Act,” and Note 8 of Notes to Consolidated Financial Statements. Assembly Bill 263, signed into law in September 2004, established a dividend received deduction of 80% for tax years 1997 through 2007 and an 85% dividend received deduction after 2007 on the dividends the Company receives from its insurance company subsidiaries. The effect of this law on the Company will be to create a tax liability on dividends paid from the insurance subsidiaries to Mercury General. The amount of this liability is not expected to be significant.

 

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Shareholders of Record

 

The approximate number of holders of record of the Company’s common stock as of February 28, 2005 was 209. The approximate number of beneficial holders as of February 28, 2005 was 11,000.

 

Item 6.    Selected Consolidated Financial Data

 

     Year Ended December 31,

     2004

   2003

   2002

    2001

    2000

     (Amounts in thousands, except per share data)

Income Data:

                                    

Earned premiums

   $ 2,528,636    $ 2,145,047    $ 1,741,527     $ 1,380,561     $ 1,249,259

Net investment income

     109,681      104,520      113,083       114,511       106,466

Net realized investment gains (losses)

     25,065      11,207      (70,412 )     6,512       3,944

Other

     4,775      4,743      2,073       5,396       6,349
    

  

  


 


 

Total revenues

     2,668,157      2,265,517      1,786,271       1,506,980       1,366,018
    

  

  


 


 

Losses and loss adjustment expenses

     1,582,254      1,452,051      1,268,243       1,010,439       901,781

Policy acquisition cost

     562,553      473,314      378,385       301,670       268,657

Other operating expenses

     111,285      91,295      74,875       62,335       59,733

Interest

     4,222      3,056      4,100       7,727       7,292
    

  

  


 


 

Total expenses

     2,260,314      2,019,716      1,725,603       1,382,171       1,237,463
    

  

  


 


 

Income before income taxes

     407,843      245,801      60,668       124,809       128,555

Income tax expense (benefit)

     121,635      61,480      (5,437 )     19,470       19,189
    

  

  


 


 

Net Income

   $ 286,208    $ 184,321    $ 66,105     $ 105,339     $ 109,366
    

  

  


 


 

Per Share Data:

                                    

Basic earnings per share

   $ 5.25    $ 3.39    $ 1.22     $ 1.94     $ 2.02
    

  

  


 


 

Diluted earnings per share

   $ 5.24    $ 3.38    $ 1.21     $ 1.94     $ 2.02
    

  

  


 


 

Dividends paid

   $ 1.48    $ 1.32    $ 1.20     $ 1.06     $ .96
    

  

  


 


 

     December 31,

     2004

   2003

   2002

    2001

    2000

     (Amounts in thousands, except per share data)

Balance Sheet Data:

                                    

Total investments

   $ 2,921,042    $ 2,539,514    $ 2,150,658     $ 1,936,171     $ 1,794,961

Premiums receivable

     284,690      231,277      186,446       143,612       123,070

Total assets

     3,609,743      3,119,766      2,645,296       2,316,540       2,142,263

Losses and loss adjustment expenses

     900,744      797,927      679,271       534,926       492,220

Unearned premiums

     799,679      681,745      560,649       434,720       377,813

Notes payable

     124,743      124,714      128,859       129,513       107,889

Deferred income tax liability (asset)

     30,606      17,808      (17,004 )     (1,252 )     8,336

Shareholders’ equity

     1,459,548      1,255,503      1,098,786       1,069,711       1,032,905

Book value per share

     26.77      23.07      20.21       19.72       19.08

 

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

 

Overview

 

Mercury General Corporation and its subsidiaries (collectively, the “Company”) is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents and brokers in thirteen states. The Company also offers homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile and commercial property insurance. Private passenger automobile lines of insurance accounted for approximately 87% of the $2.6 billion of the Company’s gross premiums written in 2004, with approximately 76% of the private passenger automobile premiums written in California.

 

This overview discusses some of the relevant factors that management considers in evaluating the Company’s performance, prospects and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of the management discussion and analysis, the Company’s financial statements and notes thereto and all other items contained within this Annual Report on Form 10-K.

 

Economic and Industry Wide Factors

 

    Regulatory—The insurance industry is subject to strict state regulation and oversight and is governed by the laws of each state in which each insurance company operates. State regulators generally have substantial power and authority over insurance companies including, in some states, approving rate changes and rating factors and establishing minimum capital and surplus requirements. In many states, the insurance commissioner is an elected office and newly-elected commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners. In California, the Company’s largest market, the current commissioner took office in January 2003. It is uncertain how any regulatory changes implemented by the California insurance commissioner, or the insurance commissioner in any other state in which the Company operates, will be resolved and how it will impact the Company’s operations.

 

    Cost uncertainty—Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned. Consequently, significant assumptions are made when establishing insurance rates and loss reserves. While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analysis shows that they are needed.

 

    Inflation—The largest cost component for automobile insurers are losses which include medical costs and replacement automobile parts and labor repair costs. There has recently been significant variation in the overall increases in medical cost inflation and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates are higher or lower than anticipated. The Company currently estimates low single digit inflation rates on bodily injury coverages for its major California personal automobile lines for the 2003 and 2004 accident years. The inflation rate for these accident years is the most difficult to estimate because there remain many open claims. Should actual inflation be higher the Company could be under reserved for its losses and profit margins would be lower.

 

    Loss Frequency—Another component of overall loss costs is loss frequency, which is the number of claims per risks insured. There has been a long-term trend of declining loss frequency in the personal automobile insurance industry, which has benefited the industry as a whole. However, it is unknown if loss frequency in the future will continue to decline, remain flat or increase.

 

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    Underwriting Cycle and Competition—The property and casualty insurance industry is highly cyclical, with periods of rising premium rates and shortages of underwriting capacity (“hard market”) followed by periods of substantial price competition and excess capacity (“soft market”). The Company has historically seen premium growth in excess of 20% during hard markets, whereas premium growth rates during soft markets have historically been in the single digits. Many of the Company’s major competitors announced better operating results in 2003 and throughout 2004. This typically signals a softening in the market, and consequently, the Company experienced a decline in the rate of growth of its policies in force in California during 2004. However, this slowing in growth in California was offset by continued growth in recently entered states such as New Jersey. The Company anticipates a further slowing of the growth rate in 2005.

 

Revenues, Income and Cash Generation

 

The Company generates its revenues through the sale of insurance policies, primarily covering personal automobiles and homeowners. These policies are sold through independent agents and brokers who receive a commission on average of 17% of net premiums written for selling and servicing the policies.

 

The Company believes that it has a more thorough underwriting process which gives the Company an advantage over its competitors. The Company views its broker and agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins. See “Item 3. Legal Proceedings,” and Note 10 of the Notes to Consolidated Financial Statements.

 

The Company also generates revenue from its investment portfolio, which was approximately $2.9 billion at the end of 2004. This investment portfolio generated nearly $110 million in pre-tax investment income during 2004. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.

 

The Company’s results and growth have allowed it to consistently generate positive cash flow from operations, which was $469 million in 2004. The Company’s cash flow from operations has exceeded $100 million every year since 1994 and has been positive for over 20 years. Cash flows from operations has been used to pay shareholder dividends and to help support growth.

 

Opportunities, Challenges and Risks

 

The Company currently underwrites personal automobile insurance in thirteen states: nine states entered into in previous years, California, Florida, Texas, Oklahoma, Georgia, Illinois, New York, Virginia and New Jersey, and four states entered during 2004, Arizona, Pennsylvania, Michigan and Nevada. The Company expects to continue its growth by expanding into new states in future years with the objective of achieving greater geographic diversification, so that non-California premiums eventually account for as much as half of the Company’s total premiums.

 

There are, however, challenges and risks involved in entering each new state, including establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems and finding qualified agents to represent the Company. The Company entered four new states during 2004 and believes that it has sufficient expertise to manage these challenges and risks to continue its expansion into additional new states. The Company does not expect to enter into any new states in 2005.

 

The Company is also subject to risks inherent in its business, which include but are not limited to the following:

 

    A catastrophe, such as a major wildfire, earthquake or hurricane can cause a significant amount of loss to the Company in a very short period of time.

 

    A major regulatory change, could make it more difficult for the Company to generate new business.

 

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    A sharp upward increase in market interest rates or an equity market crash could cause a significant loss to the Company’s investment portfolio.

 

To the extent that it is within the Company’s control, the Company seeks to manage these risks in order to mitigate the effect that major events would have on the Company’s financial position.

 

The Company is currently developing a Next Generation (“NextGen”) computer system to replace its existing legacy systems that currently reside on Hewlett Packard 3000 mainframe computers. The NextGen system is being designed to be a multi-state, multi-line system that is expected to enable the Company to enter new states more rapidly, as well as respond to legislative and regulatory changes more easily than the Company’s current system. The NextGen system is in the final stages of development and is expected to be placed in operation during 2005. The NextGen system is expected to cost approximately $20 million and to provide a significant positive benefit to the Company. As with any large scale technology implementation, risks associated with system implementation can occur that could significantly impact the operations of the Company, although management has expended planning and development efforts to mitigate these risks.

 

General

 

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. In management’s view, 2003 and 2004 were periods of very good results for companies underwriting automobile insurance. As a result, the automobile insurance market is presently extremely competitive with competitors reducing rates and increasing advertising expenditures. The Company expects this trend to continue in 2005 and consequently expects that the premium growth rate will likely decline from the levels seen in 2004 (17%) and 2003 (22%).

 

The Company operates primarily in the state of California, which was the only state in which it produced business prior to 1990. The Company has since expanded its operations into the following states: Georgia (1990), Illinois (1990), Oklahoma (1996), Texas (1996), Florida (1998), Virginia (2001), New York (2001) and New Jersey (2003). In 2004, the Company began writing private passenger automobile insurance in Arizona (April), Pennsylvania (June), Michigan (October) and Nevada (December).

 

During 2004, approximately 76% of the Company’s total net premiums written were derived from California as compared to 83% in 2003. The decrease is the result of a greater portion of business written outside of California. The Company has established a diversification goal where by 2008 half of all business will be produced outside of California.

 

The process for implementing rate changes varies by state, with California, Georgia, New York, New Jersey, Pennsylvania and Nevada requiring prior approval from the DOI before a rate can be implemented. Illinois, Texas, Virginia, Arizona and Michigan 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.”

 

During 2004, the Company had no rate increases in California and implemented automobile rate increases in only two of the twelve non-California states. The Company believes that its rates will remain competitive in the marketplace. During 2004, 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. During 2004, the Company incurred approximately $26 million in advertising expense.

 

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The California Insurance Commissioner (the “Commissioner”) uses 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 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 is participating in technical workshops conducted by the Commissioner to develop evidence regarding two alternatives for changing the way the weighting and relevance of territories is determined in the rate making process. The outcome of this matter is uncertain and the impact to the Company cannot be determined at this time.

 

Persistency discounts predate the Proposition 103 rate regulations. They represent discounts on policy rates extended to consumers based on the number of consecutive years insurance coverage has existed. In 1990, in response to Proposition 103’s allowance of optional rating factors promulgated by the Commissioner, the Commissioner issued regulations permitting persistency as a rating factor under the new rate regulations. No further definition of persistency discount was provided. In 1994, the Commissioner conducted a market conduct examination of the Company, after which he indicated he believed Mercury’s persistency discount, then awarded only to consumers serviced by the Company’s agents and brokers, was unfairly discriminatory. In response to that examination, in 1995 the Company filed, and secured approval, for a persistency discount awarded to insureds with continuous coverage with any insurer—what has come to be called “portable” persistency. This discount was consistently reapproved by the Commissioner until Commissioner Harry Low took the position that only “loyalty” persistency—that is, the kind of persistency discount the Company awarded prior to 1995—was allowable under Proposition 103.

 

The California DOI required all insurers offering persistency discounts to make class plan filings by January 15, 2003, removing the portability of the persistency discounts. The Company’s class plans were never implemented because Senate Bill 841 was enacted during 2003 amending the California Insurance Code to allow insurers to offer products with portable persistency discounts. However, in January 2004, this legislation was overturned through judicial proceedings in the Los Angeles Superior Court. The Company intervened in the original proceedings and expects appellate review of this ruling to be heard in the second quarter of 2005. The outcome of such action is uncertain; however, in the meantime, the Company is allowed to maintain its existing portable persistency discounts. The changes made during the class plan filing indicated that removing persistency discounts is 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 and would cause many existing customer’s rates to change. However, the impact of eliminating persistency discounts, if any, is undeterminable.

 

On October 20, 2004, the Commissioner proposed regulations which require greater disclosure of the commissions that brokers may receive from insurance companies for selling insurance policies. The proposed regulations are designed to protect consumers from undisclosed commissions and would penalize any broker who places his or her own financial or other interest above that of a client. Under the proposed regulations, brokers and agents would be required to disclose “all material facts” regarding third party compensation. Brokers would also be required to provide their clients insurance quotes from the best available insurer. The Company believes that this proposed regulation, if enacted, will not have a material impact on its business since the Company is a leading provider of competitively-priced insurance in the California marketplace.

 

On June 25, 2003, the California State Board of Equalization (“SBE”) upheld Notices of Proposed Assessments (“NPAs”) issued against the Company for tax years 1993 through 1996. In these NPAs, the California Franchise Tax Board (“FTB”) disallowed a portion of the Company’s expenses related to management services provided to its insurance company subsidiaries on grounds that such expenses were allocable to the Company’s tax-deductible dividends from such subsidiaries. The SBE decision also resulted in a smaller disallowance of the Company’s interest expense deductions than was proposed by the FTB in those years. The Company filed a petition for rehearing with the SBE and a rehearing was granted. The rehearing is expected to be held in the spring of 2005.

 

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The Company believes that the deduction of the expenses related to management services provided to its insurance company subsidiaries is meritorious and that this is further supported by the SBE’s decision to grant a rehearing on the matter. The potential net liability on the franchise tax issues in 1993 through 1996, after federal tax benefit, amounts to approximately $9 million. The Company has established a tax liability of approximately $1 million for the issues related to these tax years.

 

On September 29, 2004, California Governor Arnold Schwarzenegger signed into law Assembly Bill 263 (“AB 263”). The law resolves an issue raised by the FTB where they interpreted a legal ruling (“Ceridian”) to eliminate a dividends received deduction (“DRD”) taken by insurance companies. AB 263 provides for an 80% DRD for tax years 1997 through 2007 and an 85% DRD for tax years after 2007. The Company intends to refile its 1997 through 2003 tax returns based on the DRD established by AB 263. The tax liability for this item is included in the tax liabilities at December 31, 2004.

 

The Company is also involved in proceedings incidental to its insurance business. See “Item 3. Legal Proceedings,” and Note 10 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.

 

The Company performs its own loss reserve analysis and also engages the services of an independent actuary to assist in the estimation of loss reserves. The Company and the actuary do not calculate a range of loss reserve estimates but rather calculate a point estimate. Management reviews the underlying factors and assumptions that serve as the basis for preparing the reserve estimate. These include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information. At December 31, 2004, the Company recorded its point estimate of approximately $901 million in loss and loss adjustment expense reserves which includes approximately $259 million of incurred but not reported (“IBNR”) loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs which may differ from case estimates, unreported claims which occurred on or prior to December 31, 2004 and estimated future payments for reopened-claims reserves. 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’s loss reserves estimated at December 31, 2003 produced a redundancy of $58 million which was reflected in the financial statements as a reduction to the 2004 calendar year incurred losses. The Company attributes most of this redundancy to a change in the inflation rate assumptions used to establish reserves on the bodily injury coverage for California private passenger automobile insurance on the 2002 and 2003 accident years.

 

At year-end 2003, the Company had assumed bodily injury severity inflation on California private passenger automobile insurance of 9% on the 2001 accident year, 6% on the 2002 accident year and 7% on the 2003 accident year. At year-end 2004, these assumptions were reduced to 8% for 2001, 1% for 2002 and 1% for 2003. The Company reduced the inflation rate assumptions based on factors that emerged during 2004 including moderating to decreasing average amounts paid on closed claims in the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage of time as more claims from an accident period are closed.

 

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The change in these inflation assumptions accounted for approximately $41 million of the decrease in the expected ultimate loss on the reserves established at December 31, 2003. Each percentage point change in the inflation rate assumption accounts for approximately $2.5 million of the redundancy on the 2002 accident year losses and approximately $5 million on the 2003 accident year losses. The effect is greater on the latter accident year because the lowering of the rate for accident year 2002 has a compounding effect on accident year 2003.

 

The remainder of the redundancy primarily occurred in the Company’s California homeowners line of business and Florida personal automobile line of business. California homeowners had approximately $6 million in reserve redundancy and Florida personal automobile had approximately $8 million in reserve redundancy.

 

At December 31, 2004, the Company assumed bodily injury inflation rates of approximately 1% on the 2002, 2003 and 2004 accident years for the California automobile lines of business. The Company estimates that each percentage point change in the inflation rate assumption would impact these accident years by approximately $2.5 million individually with a compounding effect if adjusted for multiple accident years. For example, if all years were changed by 1%, 2002 would be affected by $2.5 million, 2003 by $5 million and 2004 by $7.5 million for a total of approximately $15 million.

 

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, that is, in proportion to the amount of insurance protection provided. 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 (loss), 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 Statement 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 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-

 

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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, 2004, the Company had on its books approximately $7.3 million in goodwill related to the 1999 acquisition of Concord and approximately $5.2 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.

 

Results of Operations

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Premiums earned in 2004 of $2,528.6 million increased 17.9% from the corresponding period in 2003. Net premiums written in 2004 of $2,646.7 million increased 16.7% over amounts written in 2003. The premium increases were principally attributable to increased policy sales in the California, Florida and New Jersey automobile lines of business and the California homeowners line of business.

 

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Net premiums written is a statutory measure used to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of premiums written that are recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned (000s) for the years ended December 31, 2004 and 2003, respectively:

 

     2004

   2003

Net premiums written

   $ 2,646,704    $ 2,268,778

Increase in unearned premiums

     118,068      123,731
    

  

Earned premiums

   $ 2,528,636    $ 2,145,047
    

  

 

The loss ratio (GAAP basis) in 2004 (loss and loss adjustment expenses related to premiums earned) was 62.6% in 2004 compared with 67.7% in 2003. The lower loss ratio is largely attributable to improved loss frequency on automobile claims and California homeowners claims. Automobile loss frequencies can be affected by many factors including seasonal travel, weather and fluctuations in gasoline prices. The Florida hurricanes negatively impacted the 2004 loss ratio by 0.9% compared to the 0.7% negative impact that the Southern California firestorms had on the 2003 loss ratio. Furthermore, positive development on prior accident years reduced the 2004 loss ratio by 2.3% and adverse development on prior accident years increased the 2003 loss ratio by 0.2%.

 

The expense ratio (GAAP basis) in 2004 (policy acquisition costs and other operating expenses related to premiums earned) was 26.6% compared with 26.3% in 2003. The increase in the expense ratio is primarily due to an increase in advertising expense and profitability related bonuses.

 

The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 89.2% in 2004 compared with 94.0% in 2003 which indicates that the Company’s underwriting performance contributed $272.5 million to the Company’s income before income taxes of $407.8 million during 2004 versus contributing $128.4 million to the Company’s income before income tax of $245.8 million in 2003.

 

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Investment income in 2004 was $109.7 million compared with $104.5 million in 2003. The after-tax yield on average investments of $2,662.2 million (cost basis) was 3.6%, compared with 4.0% on average investments of $2,311.0 million (cost basis) in 2003. The effective tax rate on investment income was 12.6% in 2004, compared to 10.7% in 2003. The higher tax rate in 2004 reflects a shift in the mix of the Company’s portfolio from non-taxable to taxable securities. Proceeds from the sale of bonds which matured or were called in 2004 totaled $363.4 million, compared to $442.5 million in 2003. Assuming market interest rates remain the same, the Company expects approximately $583 million of bonds to mature or be called in 2005. The proceeds will be reinvested into securities meeting the Company’s investment profile.

 

Net realized investment gains in 2004 were $25.1 million, compared with net realized gains of $11.2 million in 2003. Included in the net realized investment gains are investment write-downs of $0.9 million in 2004 and $9.1 million in 2003 that the Company considered to be other-than-temporarily impaired.

 

The income tax provision of $121.6 million in 2004 represented an effective tax rate of 29.8% compared to an effective tax rate of 25.0% in 2003. The higher rate is primarily attributable to an increased proportion of underwriting income taxed at the full corporate rate of 35% in contrast with investment income which includes tax exempt interest and tax sheltered dividend income.

 

Net income in 2004 was $286.2 million or $5.24 per share (diluted) compared with $184.3 million or $3.38 per share (diluted), in 2003. Diluted per share results are based on 54.6 million average shares in 2004 and 54.5 million average shares in 2003. Basic per share results were $5.25 in 2004 and $3.39 in 2003. Included in net income are net realized investment gains, net of income tax expense, of $0.30 and $0.13 per share (diluted and basic) in 2004 and 2003, respectively.

 

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

 

Premiums earned in 2003 of $2,145.0 million increased 23.2% from the corresponding period in 2002. Net premiums written in 2003 of $2,268.8 million increased 21.6% over amounts written in 2002. The premium increases were principally attributable to increased policy sales and rate increases in the California, Florida and Texas automobile lines and the California homeowners’ insurance lines of business.

 

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Net premiums written is a statutory measure used to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of premiums written that are recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned (000s) for the years ended December 31, 2003 and 2002, respectively:

 

     2003

   2002

Net premiums written

   $ 2,268,778    $ 1,865,046

Increase in unearned premiums

     123,731      123,519
    

  

Earned premiums

   $ 2,145,047    $ 1,741,527
    

  

 

The loss ratio (GAAP basis) in 2003 (loss and loss adjustment expenses related to premiums earned) was 67.7% in 2003 compared with 72.8% in 2002. The lower loss ratio is largely attributable to rate increases implemented in 2003 and improved loss frequency on automobile claims as well as California homeowners claims. Automobile loss frequencies can be affected by many factors including seasonal travel, weather and fluctuations in gasoline prices. The Southern California firestorms negatively impacted the loss ratio by 0.7% in 2003. Furthermore, adverse development on prior accident years loss reserves increased the 2003 loss ratio by 0.2% and the 2002 loss ratio by 1.5%.

 

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The expense ratio (GAAP basis) in 2003 (policy acquisition costs and other operating expenses related to premiums earned) was 26.3% compared with 26.0% in 2002. The increase in the expense ratio is primarily due to higher profitability related bonus accruals.

 

The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 94.0% in 2003 compared with 98.8% in 2002 which indicates that the Company’s underwriting performance contributed $128.4 million to the Company’s income before income taxes of $245.8 million during 2003 versus contributing $20.0 million to the Company’s income before income tax of $60.7 million in 2002.

 

Investment income in 2003 was $104.5 million, compared with $113.1 million in 2002. The after-tax yield on average investments of $2,311.0 million (cost basis) was 4.04%, compared with 4.87% on average investments of $2,035.3 million (cost basis) in 2002. The effective tax rate on investment income was 10.7% in 2003, compared to 12.4% in 2002. The lower tax rate in 2003 reflects a shift in the mix of the Company’s portfolio from taxable to non-taxable issues. Bonds matured and called in 2003 totaled $442.5 million, compared to $119.5 million in 2002.

 

Net realized investment gains in 2003 were $11.2 million, compared with net realized losses of $70.4 million in 2002. Included in the net realized investment gains (losses) are investment write-downs of $9.1 million in 2003 and $71.7 million in 2002 that the Company considered to be other-than-temporarily impaired.

 

The income tax provision of $61.5 million in 2003 represented an effective tax rate of 25.0% which compares with an effective tax rate of 14.7% in 2002 after excluding the effect of net realized investment gains (losses) in both years. The higher rate is primarily attributable to the increased proportion of underwriting income which is taxed at the full corporate rate of 35% in contrast with investment income which includes tax exempt interest and tax sheltered dividend income.

 

Net income in 2003 was $184.3 million or $3.38 per share (diluted), compared with $66.1 million or $1.21 per share (diluted), in 2002. Diluted per share results are based on 54.5 million average shares in 2003 and 2002. Basic per share results were $3.39 in 2003 and $1.22 in 2002. Included in net income in 2003 are net realized investment gains, net of income tax expense, of $0.13 per share (diluted and basic) which positively impacted the 2003 results compared to net realized investment losses, net of income tax benefit, of $0.84 per share (diluted and basic) which negatively impacted the 2002 results.

 

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, the Insurance Companies are entitled to pay, without extraordinary approval, dividends of approximately $235 million in 2005. The actual amount of dividends paid from the Insurance Companies to Mercury General during 2004 was $99 million. As of December 31, 2004, Mercury General also had approximately $31 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 the Insurance Companies are premiums, sales and maturity of invested assets and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments.

 

Through the Insurance Companies, the Company has generated positive cash flow from operations for over twenty consecutive years and in excess of $100 million every year since 1994. During this same period, the Company has not been required to liquidate any of its fixed maturity investments to settle claims or other liabilities.

 

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Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. Combined with cash and short term investments of $445.1 million at December 31, 2004, the Company believes its cash flows from operations are adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

 

Net cash provided from operating activities in 2004 was $468.7 million, an increase of $24.2 million over the same period in 2003. This increase was primarily due to the growth in premiums reflecting increases in both policy sales and rates partially offset by an increase in loss and loss adjustment expenses paid in 2004. The Company has utilized the cash provided from operating activities primarily to increase its investment in fixed maturity securities, the purchase and development of information technology such as the Next Generation computer system and the payment of dividends to its shareholders. Excess cash was invested in short-term cash investments. Funds derived from the sale, redemption or maturity of fixed maturity investments of $760.2 million, were primarily reinvested by the Company in high grade fixed maturity securities.

 

The market value of all investments held at market as “Available for Sale” exceeded amortized cost of $2,796.9 million at December 31, 2004 by $124.2 million. That net unrealized gain, reflected in shareholders’ equity, net of applicable tax effects, was $80.5 million at December 31, 2004, compared with $84.8 million at December 31, 2003.

 

At December 31, 2004, the average rating of the $2,237.2 million bond portfolio at market (amortized cost $2,156.9 million) was AA, the same average rating at December 31, 2003. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At December 31, 2004, bond holdings rated below investment grade totaled $50.4 million at market (cost $48.1 million) representing 1.7% of total investments. This compares to approximately $52.8 million at market (cost $53.3 million) representing 2% of total investments at December 31, 2003.

 

The following table sets forth the composition of the investment portfolio of the Company as of December 31, 2004:

 

    

Amortized

cost


  

Market

value


     (Amounts in thousands)

Fixed maturity securities:

             

U.S. government bonds and agencies

   $ 153,770    $ 153,584

Municipal bonds

     1,637,514      1,715,488

Mortgage-backed securities

     253,408      250,963

Corporate bonds

     112,170      117,158

Redeemable preferred stock

     8,093      8,118
    

  

     $ 2,164,955    $ 2,245,311
    

  

Equity securities:

             

Common Stock:

             

Public utilities

   $ 74,106    $ 102,616

Banks, trusts and insurance companies

     14,286      17,865

Industrial and other

     69,096      77,590

Non-redeemable preferred stock

     53,065      56,291
    

  

     $ 210,553    $ 254,362
    

  

 

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The following table illustrates the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2004.

 

     Less than 12 months

   12 months or more

   Total

     Unrealized
Losses


  

Fair

Value


   Unrealized
Losses


  

Fair

Value


   Unrealized
Losses


  

Fair

Value


     (Amounts in thousands)

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

   $ 629    $ 103,672    $ —      $ —      $ 629    $ 103,672

Obligations of states and political subdivisions

     2,202      294,441      1,945      30,322      4,147      324,763

Corporate securities

     287      34,560      37      4,167      324      38,727

Mortgage-backed securities

     3,560      178,676      58      3,869      3,618      182,545

Redeemable preferred stock

     8      1,230      93      1,008      101      2,238
    

  

  

  

  

  

Subtotal, debt securities

     6,686      612,579      2,133      39,366      8,819      651,945

Equity securities

     1,554      86,640      920      10,014      2,474      96,654
    

  

  

  

  

  

Total temporarily impaired securities

   $ 8,240    $ 699,219    $ 3,053    $ 49,380    $ 11,293    $ 748,599
    

  

  

  

  

  

 

The Company monitors its investments closely. If an unrealized loss is determined to be other than temporary it is written off as a realized loss through the Consolidated Statement of Income. The Company’s methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s intent to hold the investment for a period of time sufficient to allow the Company to recover its costs. The Company recognized $0.9 million and $9.1 million in realized losses as other-than-temporary declines to its investment securities during 2004 and 2003, respectively.

 

At December 31, 2004, the Company had a net unrealized gain on all investments of $124.2 million before income taxes which is comprised of unrealized gains of $135.5 million offset by unrealized losses of $11.3 million. Unrealized losses represent 0.4% of total investments at amortized cost. Of these unrealized losses, approximately $8.8 million relate to fixed maturity investments and the remaining $2.5 million relate to equity securities. Approximately $10.6 million of the unrealized losses are represented by a large number of individual securities with unrealized losses of less than 20% of each security’s amortized cost. Of these, the most significant unrealized losses relate to two municipal bonds with unrealized losses of approximately $0.6 million and $0.4 million, respectively, representing market value declines of 19% and 16% of amortized cost. The remaining $0.7 million represents unrealized losses that exceed 20% of amortized costs. The Company has concluded that the gross unrealized losses of $11.3 million at December 31, 2004 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.

 

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The following table presents the “aging” of pre-tax unrealized losses on investments that exceed 20% of amortized costs as of December 31, 2004:

 

     Aging of Unrealized Losses

     Amortized
Cost


  

0-6

Months


 

6-12

Months


   Over 12
Months


     (Amounts in thousands)

Fixed Maturities:

                          

Investment grade

     —        —       —        —  

Non-Investment grade

     —        —       —        —  

Equity securities

   $ 2,681    $ —     $ 435    $ 245

Aged unrealized losses as a % of amortized cost:

                          

Investment grade securities

                          

20-50% below amortized cost

            —               

Over 50% below amortized cost

            —               

Equity securities

                          

20-50% below amortized cost

             80%             

Over 50% below amortized cost

             20%             

 

The unrealized losses of $0.7 million in the table above relate to four equity securities whose individual unrealized losses range from $0.1 million to $0.2 million. Based upon the Company’s analysis of these securities which includes third party analyst estimates, the unrealized losses on these equity securities are treated as temporary declines.

 

During 2004, the Company recognized approximately $26.0 million in net realized gains from the disposal (sale, call or maturity) of securities which is comprised of realized gains of $33.1 million offset by realized losses of $7.1 million. These realized losses were derived from the disposal of securities with a total amortized cost of approximately $207.9 million. Of the total realized losses, approximately $4.5 million relates to securities held as of December 2003 with an average realized loss of approximately $15,000 and no loss on any one individual security exceeding $0.4 million.

 

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 Securities and Exchange Commission 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 the interest in 2004 and 2003 when the effective interest rate was 3.3% and 2.2%, respectively. However, if the LIBOR interest rate increases in the future as it did during 2004, the Company will incur higher interest expense in the future. The swap is accounted for as a fair value hedge under SFAS No. 133. See “Item 7A. Quantitative and Qualitative Disclosures About Market Risk.”

 

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 that generate cash flow through the sale of lower yielding tax-exempt bonds 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 has been purchased since 2000.

 

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The NAIC utilizes a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements that are compared to the Company’s actual capital level. 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. The Company has calculated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2004. Each of the Insurance Companies’ policyholders’ statutory surplus exceeded the highest level of minimum required capital.

 

The Company has no direct investment in real estate that it does not utilize for operations. In January 2005, the Company completed the acquisition of a 157,000 square foot office building which houses the Company’s Eastern Region operations, a portion of which was previously leased by the Company. The purchase price of $24,888,000 included cash in the amount of $13,638,000 and the assumption of a secured promissory note in the amount of $11,250,000.

 

The Company is currently developing a Next Generation (“NextGen”) computer system to replace its existing legacy systems that currently reside on Hewlett Packard 3000 mainframe computers. The NextGen system is being designed to be a multi-state, multi-line system that is expected to enable the Company to enter new states more rapidly, as well as respond to legislative and regulatory changes more easily than the Company’s current system. The NextGen system is in the final stages of development and is expected to be placed in operation during 2005. The NextGen system is expected to cost approximately $20 million and to provide a significant positive benefit to the Company.

 

The Company has obligations to make future payments under contracts and credit-related financial instruments and commitments. At December 31, 2004, 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)

   $ 188,439    $ 9,063    $ 27,188    $ 18,125    $ 134,063

Lease Obligations

     25,725      6,984      12,187      5,884      670

Losses and loss adjustment expense reserves

     900,744      583,887      278,696      26,438      11,723
    

  

  

  

  

Total Contractual Obligations

   $ 1,114,908    $ 599,934    $ 318,071    $ 50,447    $ 146,456
    

  

  

  

  

 

Notes to Contractual Obligations Table:

 

The amount of interest included in the Company’s debt obligations was calculated using the fixed rate of 7.25% on the senior notes issued August 2001. The Company is party to an interest rate swap of its fixed rate obligations on its senior notes for a floating rate of six month LIBOR plus 107 basis points. Using the effective annual interest rate of 3.3% in 2004, the total contractual obligations on debt would be $154 million with $4.1 million due within 1 year, $12.4 million due between 1 and 3 years, $8.3 million due in years 4 and 5 and $129.2 million due beyond 5 years. However, interest rates are currently near a 40 year low and are likely to rise in the future.

 

The Company’s outstanding debt contains various terms, conditions and covenants which, if violated by the Company, would result in a default under the debt and could result in the acceleration of the Company’s payment obligations thereunder.

 

Unlike many other forms of contractual obligations, loss and loss adjustment expense (“LAE”) reserves do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total loss and LAE reserve payments to be made by period, as shown above, are estimates.

 

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In January 2005, the Company acquired a 157,000 square foot office building that houses its Eastern Region operations. The Company paid cash in the amount of $13,638,000 and assumed a secured promissory note in the amount of $11,250,000. Had this acquisition occurred in 2004, the table above would have reflected the following additional Contractual Obligations: Total – $13.1 million; Within 1 Year – $0.5 million; 1-3 Years – $12.6 million.

 

The Company places all new and renewal earthquake coverage offered with its homeowners policies through the California Earthquake Authority (“CEA”). 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 29, 2004 is approximately $47 million.

 

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 $1,361.1 million at December 31, 2004, and net premiums written for the twelve months ended on that date of $2,646.7 million, the ratio of premium writings to surplus was approximately 1.9 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, 2004 comprised 77% of total investments at market value. Tax-exempt bonds represent 76% of the fixed maturity investments with the remaining amount consisting of sinking fund preferred stocks and taxable bonds. Equity securities account for 9% of total investments at market value. The remaining 14% 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 utilizes 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 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 historical investment philosophy resulted in a portfolio with a moderate duration. However, due to the current interest rate environment, management has taken steps 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 has declined to 3.2 years at December 31, 2004 compared to 3.8 years and 4.4 years at December 31, 2003 and 2002, respectively. Given a hypothetical parallel increase of 100 basis points in interest rates, the fair value of the bond portfolio at December 31, 2004 would decrease by approximately $72 million.

 

At December 31, 2004, the Company’s strategy for common equity investments is an active strategy which focuses on current income with a secondary focus on capital appreciation. The value of the common equity investments consists of $198.1 million in common stocks and $56.3 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.

 

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At December 31, 2004, the duration on the Company’s non-sinking fund preferred stock portfolio was 13.3 years. This implies that an upward parallel shift in the yield curve by 100 basis points would reduce the asset value at December 31, 2004 by approximately $7.5 million, everything else remaining the same.

 

The common equity portfolio, representing approximately 7% 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. 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 common stock holdings was 0.76. 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 $30 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 December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (“SFAS No. 123R”) that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity instrument issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees;” the principles that the Company currently employs to account and report its employee stock option awards. SFAS No. 123R is effective for the first interim reporting period that begins after June 15, 2005. The Company will implement this standard in the third quarter of 2005. The Company estimates that the impact of implementing this standard will result in an annual decrease in net income of approximately $0.01 per diluted share, which is disclosed in Note 1 of the Notes to Consolidated Financial Statements.

 

There were no other accounting standards issued during 2004 that are expected to have a material impact on the Company’s consolidated 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, 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, the level of investment yields we are able to obtain with our investments in comparison to recent yields and the market risk associated with our investment portfolio, the cyclical and general competitive nature of the property and casualty insurance industry

 

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Table of Contents

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, and 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.

 

Quarterly Data

 

Summarized quarterly financial data for 2004 and 2003 is as follows (in thousands except per share data):

 

     Quarter Ended

     March 31

   June 30

   Sept. 30

   Dec. 31

2004

                           

Earned premiums

   $ 591,937    $ 620,432    $ 648,165    $ 668,102

Income before income taxes

   $ 96,285    $ 111,051    $ 88,875    $ 111,632

Net income

   $ 68,816    $ 78,134    $ 65,129    $ 74,129

Basic earnings per share

   $ 1.26    $ 1.43    $ 1.20    $ 1.36

Diluted earnings per share

   $ 1.26    $ 1.43    $ 1.19    $ 1.36

Dividends declared per share

   $ .37    $ .37    $ .37    $ .37

2003

                           

Earned premiums

   $ 500,666    $ 525,072    $ 546,638    $ 572,671

Income before income taxes

   $ 54,771    $ 57,060    $ 67,663    $ 66,307

Net income

   $ 42,108    $ 43,372    $ 49,615    $ 49,226

Basic earnings per share

   $ .77    $ .80    $ .91    $ .90

Diluted earnings per share

   $ .77    $ .80    $ .91    $ .90

Dividends declared per share

   $ .33    $ .33    $ .33    $ .33

 

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Table of Contents

Item 8.    Financial Statements and Supplementary Data

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Reports of Independent Registered Public Accounting Firm

   41

Consolidated Financial Statements:

    

Consolidated Balance Sheets as of December 31, 2004 and 2003

   43

Consolidated Statements of Income for Each of the Years in the Three-Year Period Ended December 31, 2004

   44

Consolidated Statements of Comprehensive Income for Each of the Years in the Three-Year Period Ended December 31, 2004

   45

Consolidated Statements of Shareholders’ Equity for Each of the Years in the Three-Year Period Ended December 31, 2004

   46

Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2004

   47

Notes to Consolidated Financial Statements

   48

 

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

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, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight Board (United States). 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, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 11, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

/s/    KPMG LLP

 

Los Angeles, California

March 11, 2005

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors

Mercury General Corporation:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting as set forth in Item 9a, that Mercury General Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercury General Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Mercury General Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2004 and 2003, 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, 2004, and our report dated March 11, 2005 expressed an unqualified opinion on those consolidated financial statements.

 

/s/    KPMG LLP

 

Los Angeles, California

March 11, 2005

 

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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

December 31,

Amounts expressed in thousands, except share amounts

 

ASSETS


         
     2004

   2003

Investments:

             

Fixed maturities available for sale (amortized cost $2,164,955 in 2004 and $1,856,083 in 2003)

   $ 2,245,311    $ 1,945,309

Equity securities available for sale (cost $210,553 in 2004 and $223,113 in 2003)

     254,362      264,393

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

     421,369      329,812
    

  

Total investments

     2,921,042      2,539,514

Cash

     23,714      36,964

Receivables:

             

Premiums receivable

     284,690      231,277

Premium notes

     23,702      22,620

Accrued investment income

     28,855      26,585

Other

     30,415      18,612
    

  

Total receivables

     367,662      299,094

Deferred policy acquisition costs

     174,840      146,951

Fixed assets, net

     88,645      79,286

Other assets

     33,840      17,957
    

  

Total assets

   $ 3,609,743    $ 3,119,766
    

  

LIABILITIES AND SHAREHOLDERS’ EQUITY


         

Losses and loss adjustment expenses

   $ 900,744    $ 797,927

Unearned premiums

     799,679      681,745

Notes payable

     124,743      124,714

Loss drafts payable

     82,245      79,960

Accounts payable and accrued expenses

     138,836      99,389

Current income tax

     10,123      11,441

Deferred income tax

     30,606      17,808

Other liabilities

     63,219      51,279
    

  

Total liabilities

     2,150,195      1,864,263
    

  

Commitments and contingencies

             

Shareholders’ equity:

             

Common stock without par value or stated value:

             

Authorized 70,000,000 shares; issued and outstanding 54,514,693 shares in 2004 and 54,424,128 in 2003

     60,206      57,453

Accumulated other comprehensive income

     80,549      84,833

Retained earnings

     1,318,793      1,113,217
    

  

Total shareholders’ equity

     1,459,548      1,255,503
    

  

Total liabilities and shareholders’ equity

   $ 3,609,743    $ 3,119,766
    

  

 

See accompanying notes to consolidated financial statements.

 

 

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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

Three years ended December 31,

Amounts expressed in thousands, except per share data

 

     2004

   2003

   2002

 

Revenues:

                      

Earned premiums

   $ 2,528,636    $ 2,145,047    $ 1,741,527  

Net investment income

     109,681      104,520      113,083  

Net realized investment gains (losses)

     25,065      11,207      (70,412 )

Other

     4,775      4,743      2,073  
    

  

  


Total revenues

     2,668,157      2,265,517      1,786,271  
    

  

  


Expenses:

                      

Losses and loss adjustment expenses

     1,582,254      1,452,051      1,268,243  

Policy acquisition costs

     562,553      473,314      378,385  

Other operating expenses

     111,285      91,295      74,875  

Interest

     4,222      3,056      4,100  
    

  

  


Total expenses

     2,260,314      2,019,716      1,725,603  
    

  

  


Income before income taxes

     407,843      245,801      60,668  

Income tax expense (benefit)

     121,635      61,480      (5,437 )
    

  

  


Net income

   $ 286,208    $ 184,321    $ 66,105  
    

  

  


Basic earnings per share

   $ 5.25    $ 3.39    $ 1.22  
    

  

  


Diluted earnings per share

   $ 5.24    $ 3.38    $ 1.21  
    

  

  


 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

Three Years ended December 31,

Amounts expressed in thousands

 

     2004

    2003

    2002

 

Net income

   $ 286,208     $ 184,321     $ 66,105  

Other comprehensive income (loss), before tax:

                        

Unrealized gains (losses) on securities:

                        

Unrealized holding gains (losses) arising during period

     14,127       71,502       (30,623 )

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

     (20,701 )     (5,790 )     69,303  
    


 


 


Other comprehensive income (loss), before tax

     (6,574 )     65,712       38,680  

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

     4,955       25,046       (10,741 )

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

     (7,245 )     (2,027 )     24,256  
    


 


 


Comprehensive income, net of tax

   $ 281,924     $ 227,014     $ 91,270  
    


 


 


 

 

 

See accompanying notes to consolidated financial statements.

 

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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

Three years ended December 31,

Amounts expressed in thousands

 

     2004

    2003

    2002

 

Common stock, beginning of year

   $ 57,453     $ 55,933     $ 53,955  

Proceeds of stock options exercised

     2,188       1,331       1,581  

Tax benefit on sales of incentive stock options

     565       189       389  

Release of common stock by the ESOP

     —         —         8  
    


 


 


Common stock, end of year

     60,206       57,453       55,933  
    


 


 


Accumulated other comprehensive income, beginning of year

     84,833       42,140       16,975  

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

     (4,284 )     42,693       25,165  
    


 


 


Accumulated other comprehensive income, end of year

     80,549       84,833       42,140  
    


 


 


Unearned ESOP compensation, beginning of year

     —         —         (1,000 )

Amortization of unearned ESOP compensation

     —         —         1,000  
    


 


 


Unearned ESOP compensation, end of year

     —         —         —    
    


 


 


Retained earnings, beginning of year

     1,113,217       1,000,713       999,781  

Net income

     286,208       184,321       66,105  

Dividends paid to shareholders

     (80,632 )     (71,817 )     (65,173 )
    


 


 


Retained earnings, end of year

     1,318,793       1,113,217       1,000,713  
    


 


 


Total shareholders’ equity

   $ 1,459,548     $ 1,255,503     $ 1,098,786  
    


 


 


 

 

See accompanying notes to consolidated financial statements.

 

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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Three Years Ended December 31,

Amounts expressed in thousands

 

    2004

    2003

    2002

 

Cash flows from operating activities:

                       

Net income

  $ 286,208     $ 184,321     $ 66,105  

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

                       

Depreciation

    16,192       16,126       10,233  

Net realized investment (gains) losses

    (25,065 )     (11,207 )     70,412  

Bond amortization (accretion), net

    7,797       2,883       (6,982 )

Increase in premiums receivable

    (53,413 )     (44,831 )     (42,834 )

Increase in premium notes receivable

    (1,082 )     (859 )     (4,505 )

(Decrease) increase in reinsurance recoveries

    (8,772 )     2,736       (955 )

Increase in deferred policy acquisition costs

    (27,889 )     (27,916 )     (25,744 )

Increase in unpaid losses and loss adjustment expenses

    102,817       118,656       144,345  

Increase in unearned premiums

    117,934       121,096       114,929  

Increase in premiums collected in advance

    12,019       7,305       7,558  

Increase in loss drafts payable

    2,285       15,614       10,717  

Decrease (increase) in accrued income taxes, excluding deferred tax on change in unrealized gain

    13,698       16,601       (27,003 )

Increase in accounts payable and accrued expenses

    39,447       38,119       14,632  

Other, net

    (13,513 )     5,808       11,654  
   


 


 


Net cash provided from operating activities

    468,663       444,452       342,562  

Cash flows from investing activities:

                       

Fixed maturities available for sale:

                       

Purchases

    (1,076,940 )     (854,883 )     (480,335 )

Sales

    396,815       122,212       327,464  

Calls or maturities

    363,372       442,465       119,460  

Equity securities available for sale:

                       

Purchases

    (247,401 )     (217,681 )     (207,535 )

Sales

    278,346       228,588       216,565  

(Increase) decrease in receivable from securities

    (716 )     6,709       (1,246 )

Increase in short-term cash investments

    (91,557 )     (43,006 )     (214,855 )

Purchase of fixed assets

    (26,185 )     (35,015 )     (29,389 )

Sale of fixed assets

    797       1,418       2,241  
   


 


 


Net cash used in investing activities

  $ (403,469 )   $ (349,193 )   $ (267,630 )

Cash flows from financing activities:

                       

Net payments under credit arrangements

  $ —       $ —       $ (1,000 )

Dividends paid to shareholders

    (80,632 )     (71,817 )     (65,173 )

Proceeds from stock options exercised

    2,188       1,331       1,581  

Payments on ESOP loan

    —         (1,000 )     (1,000 )
   


 


 


Net cash used in financing activities

    (78,444 )     (71,486 )     (65,592 )
   


 


 


Net (decrease) increase in cash

    (13,250 )     23,773       9,340  

Cash:

                       

Beginning of the year

    36,964       13,191       3,851  
   


 


 


End of the year

  $ 23,714     $ 36,964     $ 13,191  
   


 


 


 

See accompanying notes to consolidated financial statements.

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

December 31, 2004 and 2003

 

(1)    Significant Accounting Policies

 

Principles of Consolidation and Presentation

 

The Company operates as a private passenger automobile insurer selling policies through a network of independent agents and brokers in thirteen states. The Company also offers homeowners insurance, commercial automobile and property insurance, mechanical breakdown insurance, commercial and dwelling fire insurance and umbrella insurance. The private passenger automobile lines of insurance exceeded 87% of the Company’s net premiums written in 2004, 2003 and 2002, with approximately 76%, 84% and 86% of the private passenger automobile premiums written in the state of California during 2004, 2003 and 2002, respectively.

 

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 National Insurance Company (formerly known as Mercury Indemnity Company of Illinois), Mercury Indemnity Company of America (formerly known as Mercury Indemnity Company of Florida), Mercury Insurance Services, LLC (MISLLC), American Mercury Insurance Company (AMIC), Mercury Select Management Company, Inc. (MSMC) (formerly known as AFI Management Company, Inc.), 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, MSMC. MCM is not owned by the Company, but is controlled through a management contract and therefore its results are included in the consolidated financial statements. The consolidated 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 MSMC, 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. Fixed maturities at amortized cost to first call date are adjusted for anticipated prepayments. Mortgage-backed securities at amortized cost are adjusted for anticipated prepayment

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

using the prospective method. 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.

 

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. The terms of the note 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 consolidated balance sheets are goodwill of $7.3 million and other intangible assets of $5.2 million. The Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), 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 or more frequently if circumstances indicate potential impairment. The fair values 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 during the three years ended December 31, 2004.

 

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.

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

Net premiums written during 2004, 2003 and 2002 were $2,646,704,000, $2,268,778,000 and $1,865,046,000, respectively.

 

One broker produced direct premiums written of approximately 14%, 16% and 16% of the Company’s total direct premiums written during 2004, 2003 and 2002, respectively. No other agent or broker accounted for more than 2% of direct premiums written.

 

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 down payment 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 expense 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 stated at cost and 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.

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

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 13 of the Notes to Consolidated Financial Statements contains the required disclosures which make up the calculation of basic and diluted earnings per share.

 

Segment Reporting

 

Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” 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, will be required to pay losses in their entirety in the event that the reinsurers are unable to discharge their obligations under the reinsurance agreements.

 

Supplemental Cash Flow Information

 

Interest paid during 2004, 2003 and 2002, was $3,329,000, $3,087,000 and $6,435,000, respectively. Income taxes paid were $107,277,000 in 2004, $44,697,000 in 2003 and $21,154,000 in 2002.

 

The tax benefit realized on stock options exercised and included in cash provided from operations in 2004, 2003 and 2002 was $565,000, $189,000 and $389,000, respectively.

 

In 2003, notes payable with a discounted value of $4,315,000 were canceled in accordance with terms of a Purchase and Sale Agreement between the Company and Employers Reinsurance Corporation.

 

Reclassifications

 

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

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

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” (“SFAS No. 123”) and amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”.

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition of SFAS No. 123:

 

     Year Ended December 31,

 
     2004

    2003

    2002

 
     (Amounts in thousands, except per share)  

Net income, as reported

   $ 286,208     $ 184,321     $ 66,105  

Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effect

     (549 )     (560 )     (485 )
    


 


 


Proforma net income

   $ 285,659     $ 183,761     $ 65,620  
    


 


 


Earnings per share:

                        

Basic–as reported

   $ 5.25     $ 3.39     $ 1.22  
    


 


 


Basic–pro forma

   $ 5.24     $ 3.38     $ 1.21  
    


 


 


Diluted–as reported

   $ 5.24     $ 3.38     $ 1.21  
    


 


 


Diluted–pro forma

   $ 5.23     $ 3.37     $ 1.21  
    


 


 


 

Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004, 2003 and 2002: dividend yield of 2.5 percent in 2004, 2.8 percent in 2003 and 3.2 percent for 2002, expected volatility of 29.4 percent in 2004, 35.0 percent in 2003 and 33.6 percent in 2002 and expected lives of 6 years for all years. The risk-free interest rates used were 3.9 percent for options granted in 2004, 3.2 percent for options granted during 2003 and 4.4 percent for the options granted during 2002.

 

Recently Issued Accounting Standards

 

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (“SFAS No. 123R”) that will require compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity instrument issued. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. SFAS No. 123R replaces Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” the principles that the Company currently employs to account and report its employee stock option awards. SFAS No. 123R is effective for the first interim reporting period that begins after June 15, 2005. The Company will implement this standard in the third quarter of 2005. The Company believes that the impact of implementing this standard will result in an annual decrease in net income of approximately $0.01 per diluted share.

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

There were no other accounting standards issued during 2004 that are expected to have a material impact on the Company’s consolidated financial statements.

 

(2)    Investments and Investment Income

 

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

 

     Year ended December 31,

     2004

   2003

   2002

     (Amounts in thousands)

Interest and dividends on fixed maturities

   $ 95,340    $ 87,586    $ 95,124

Dividends on equity securities

     10,963      14,752      15,478

Interest on short-term cash investments

     4,796      3,339      2,951
    

  

  

Total investment income

     111,099      105,677      113,553

Investment expense

     1,418      1,157      470
    

  

  

Net investment income

   $ 109,681    $ 104,520    $ 113,083
    

  

  

 

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

 

     Year ended December 31,

 
     2004

    2003

   2002

 
     (Amounts in thousands)  

Net realized investment gains (losses):

                       

Fixed maturities

   $ (82 )   $ 3,198    $ (34,550 )

Equity securities

     25,147       8,009      (35,862 )
    


 

  


     $ 25,065     $ 11,207    $ (70,412 )
    


 

  


 

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,

 
     2004

    2003

    2002

 
     (Amounts in thousands)  

Fixed maturities available for sale:

                        

Gross realized gains

   $ 474     $ 4,529     $ 11,807  

Gross realized losses

     (1,316 )     (1,161 )     (12,894 )
    


 


 


Net

   $ (842 )   $ 3,368     $ (1,087 )
    


 


 


Equity securities available for sale:

                        

Gross realized gains

   $ 29,863     $ 15,216     $ 7,622  

Gross realized losses

     (4,259 )     (4,128 )     (6,561 )
    


 


 


Net

   $ 25,604     $ 11,088     $ 1,061  
    


 


 


 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

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,

 
     2004

    2003

   2002

 
     (Amounts in thousands)  

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

                       

Fixed maturities available for sale

   $ (8,869 )   $ 22,114    $ 40,858  

Income tax expense (benefit)

     (3,104 )     7,740      14,300  
    


 

  


     $ (5,765 )   $ 14,374    $ 26,558  
    


 

  


Equity securities

   $ 2,530     $ 43,598    $ (2,178 )

Income tax expense (benefit)

     876       15,279      (785 )
    


 

  


     $ 1,654     $ 28,319    $ (1,393 )
    


 

  


 

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

 

     December 31,

 
     2004

    2003

 
     (Amounts in thousands)  

Fixed maturities available for sale:

                

Unrealized gains

   $ 89,175     $ 96,884  

Unrealized losses

     (8,819 )     (7,658 )

Tax effect

     (28,124 )     (31,229 )
    


 


     $ 52,232     $ 57,997  
    


 


Equity securities available for sale:

                

Unrealized gains

   $ 46,284     $ 43,885  

Unrealized losses

     (2,474 )     (2,605 )

Tax effect

     (15,334 )     (14,444 )
    


 


     $ 28,476     $ 26,836  
    


 


 

The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2004 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

   $ 153,770    $ 446    $ 632    $ 153,584

Obligations of states and political subdivisions

     1,637,514      82,121      4,147      1,715,488

Mortgage-backed securities

     253,408      1,172      3,617      250,963

Corporate securities

     112,170      5,311      323      117,158

Redeemable preferred stock

     8,093      125      100      8,118
    

  

  

  

Totals

   $ 2,164,955    $ 89,175    $ 8,819    $ 2,245,311
    

  

  

  

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2003 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

   $ 96,821    $ 654    $ 333    $ 97,142

Obligations of states and political subdivisions

     1,502,974      90,674      5,250      1,588,398

Mortgage-backed securities

     161,621      1,060      1,131      161,550

Corporate securities

     82,207      4,162      672      85,697

Redeemable preferred stock

     12,460      334      272      12,522
    

  

  

  

Totals

   $ 1,856,083    $ 96,884    $ 7,658    $ 1,945,309
    

  

  

  

 

The following table illustrates the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2004.

 

     Less than 12 months

   12 months or more

   Total

    

Unrealized

Losses


   Fair Value

   Unrealized
Losses


   Fair
Value


   Unrealized
Losses


   Fair Value

     (Amounts in thousands)

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

   $ 629    $ 103,672    $ —      $ —      $ 629    $ 103,672

Obligations of states and political subdivisions

     2,202      294,441      1,945      30,322      4,147      324,763

Corporate securities

     287      34,560      37      4,167      324      38,727

Mortgage-backed securities

     3,560      178,676      58      3,869      3,618      182,545

Redeemable preferred stock

     8      1,230      93      1,008      101      2,238
    

  

  

  

  

  

Subtotal, debt securities

     6,686      612,579      2,133      39,366      8,819      651,945

Equity securities

     1,554      86,640      920      10,014      2,474      96,654
    

  

  

  

  

  

Total temporarily impaired securities

   $ 8,240    $ 699,219    $ 3,053    $ 49,380    $ 11,293    $ 748,599
    

  

  

  

  

  

 

The Company monitors its investments closely. If an unrealized loss is determined to be other than temporary it is written off as a realized loss through the consolidated statements of income. The Company’s methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s intent to hold the investment for a period of time sufficient to allow the Company to recover its costs.

 

At December 31, 2004, the Company had a net unrealized gain on all investments of $124.2 million before income taxes which is comprised of unrealized gains of $135.5 million offset by unrealized losses of $11.3 million. Unrealized losses represent 0.4% of total investments at amortized cost. The Company’s investment portfolio includes approximately 400 securities in a gross unrealized loss position. Of these unrealized losses, approximately

 

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

$8.8 million relate to fixed maturity investments and the remaining $2.5 million relate to equity securities. Approximately $10.6 million of the unrealized losses are represented by a large number of individual securities with unrealized losses of less than 20% of each security’s amortized cost. Of these, the most significant unrealized losses relate to two municipal bonds with unrealized losses of approximately $0.6 million and $0.4 million, respectively, representing market value declines of 19% and 16% of amortized cost. The remaining $0.7 million represents unrealized losses that exceed 20% of amortized costs. The Company has concluded that the gross unrealized losses of $11.3 million at December 31, 2004 are 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 December 31, 2004, bond holdings rated below investment grade were 1.7% of total investments. The average Standard and Poor’s rating of the bond portfolio was AA. The amortized cost and estimated market value of fixed maturities available for sale at December 31, 2004 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Amortized
Cost


   Estimated
Market Value


     (Amounts in thousands)

Fixed maturities available for sale:

             

Due in one year or less

   $ 72,502    $ 72,549

Due after one year through five years

     175,691      177,909

Due after five years through ten years

     486,972      506,740

Due after ten years

     1,176,382      1,237,150

Mortgage-backed securities

     253,408      250,963
    

  

     $ 2,164,955    $ 2,245,311
    

  

 

(3)    Fixed Assets

 

A summary of fixed assets follows:

 

     December 31,

 
     2004

    2003

 
     (Amounts in thousands)  

Land

   $ 12,232     $ 12,308  

Buildings

     49,782       46,362  

Furniture and equipment

     110,654       90,292  

Leasehold improvements

     2,104       1,603  
    


 


       174,772       150,565  

Less accumulated depreciation

     (86,127 )     (71,279 )
    


 


Net fixed assets

   $ 88,645     $ 79,286  
    


 


 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

(4)    Deferred Policy Acquisition Costs

 

Policy acquisition costs incurred and amortized are as follows:

 

     Year ended December 31,

 
     2004

    2003

    2002

 
     (Amounts in thousands)  

Balance, beginning of year

   $ 146,951     $ 119,035     $ 93,291  

Costs deferred during the year

     590,442       501,230       404,129  

Amortization charged to expense

     (562,553 )     (473,314 )     (378,385 )
    


 


 


Balance, end of year

   $ 174,840     $ 146,951     $ 119,035  
    


 


 


 

(5)    Notes Payable

 

The Company had outstanding debt at December 31, 2004 of $124.7 million. The debt consists of the proceeds from an August 7, 2001 public debt offering where the Company issued $125 million of senior notes payable under a $300 million shelf registration filed with the Securities and Exchange Commission 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. The notes mature on August 15, 2011. The Company incurred debt issuance costs of approximately $1.3 million, inclusive of underwriter’s fees. These costs are deferred and then amortized as a component of interest expense over the term of the notes. The notes were issued at a slight discount at 99.723%, making the effective annualized interest rate including debt issuance costs approximately 7.44%. At December 31, 2004, the book value of the debt was $124.7 million and the fair market value was $141.3 million based upon quotations received from securities dealers.

 

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 agreement terminates on August 15, 2011 and includes an early termination option exercisable by either party on the fifth anniversary or each subsequent anniversary by providing sufficient notice, as defined. The swap significantly reduced interest expense in 2002, 2003 and 2004, but does expose the Company to higher interest expense in future periods, should LIBOR rates increase. The effective annualized interest rate in 2004 was 3.3%. The swap is accounted for as a fair value hedge under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.”

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

(6)    Income Taxes

 

The Company and its subsidiaries file a consolidated Federal income tax return. The provision for income tax expense (benefit) consists of the following components:

 

     Year ended December 31,

 
     2004

   2003

   2002

 
     (Amounts in thousands)  

Federal

                      

Current

   $ 101,259    $ 49,299    $ 23,593  

Deferred

     9,916      11,606      (29,271 )
    

  

  


     $ 111,175    $ 60,905    $ (5,678 )
    

  

  


State

                      

Current

   $ 5,257    $ 374    $ 237  

Deferred

     5,203      201      4  
    

  

  


     $ 10,460    $ 575    $ 241  
    

  

  


Total

                      

Current

   $ 106,516    $ 49,673    $ 23,830  

Deferred

     15,119      11,807      (29,267 )
    

  

  


Total

   $ 121,635    $ 61,480    $ (5,437 )
    

  

  


 

The income tax provision reflected in the consolidated statements of income is less than the expected federal income tax on income before income taxes as shown in the table below:

 

     Year ended December 31,

 
     2004

    2003

    2002

 
     (Amounts in thousands)  

Computed tax expense at 35%

   $ 142,745     $ 86,030     $ 21,234  

Tax-exempt interest income

     (26,288 )     (26,967 )     (27,656 )

Dividends received deduction

     (2,509 )     (2,734 )     (3,065 )

Reduction of losses incurred deduction for 15% of income on securities purchased after August 7, 1986

     4,193       4,322       4,689  

Other, net

     3,494       829       (639 )
    


 


 


Income tax expense (benefit)

   $ 121,635     $ 61,480     $ (5,437 )
    


 


 


 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

The temporary differences that give rise to a significant portion of the deferred tax asset (liability) relate to the following:

 

     December 31,

 
     2004

    2003

 
     (Amounts in thousands)  

Deferred tax assets

                

20% of net unearned premium

   $ 59,400     $ 47,670  

Discounting of loss reserves and salvage and subrogation recoverable for tax purposes

     15,681       16,957  

Write-down of impaired investments

     6,466       18,281  

Capital loss carryforwards

     3,814       838  

Other deferred tax assets

     1,830       1,409  
    


 


Total gross deferred tax assets

     87,191       85,155  
    


 


Deferred tax liabilities

                

Deferred acquisition costs

     (61,194 )     (51,433 )

Tax liability on net unrealized gain on securities carried at market value

     (43,363 )     (45,673 )

Tax depreciation in excess of book depreciation

     (5,715 )     (169 )

Accretion on bonds

     (447 )     (57 )

Undistributed earnings of insurance subsidiaries

     (3,250 )     —    

Other deferred tax liabilities

     (3,828 )     (5,631 )
    


 


Total gross deferred tax liabilities

     (117,797 )     (102,963 )
    


 


Net deferred tax liabilities

   $ (30,606 )   $ (17,808 )
    


 


 

Realization of deferred tax assets is dependent on generating sufficient taxable income prior to their expiration. Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized.

 

On June 25, 2003, the California State Board of Equalization (“SBE”) upheld Notices of Proposed Assessments (“NPAs”) issued against the Company for tax years 1993 through 1996. In these NPAs, the California Franchise Tax Board (“FTB”) disallowed a portion of the Company’s expenses related to management services provided to its insurance company subsidiaries on grounds that such expenses were allocable to the Company’s tax-deductible dividends from such subsidiaries. The SBE decision also resulted in a smaller disallowance of the Company’s interest expense deductions than was proposed by the FTB in those years. The Company filed a petition for rehearing with the SBE and a rehearing was granted. The rehearing is expected to be held in the spring of 2005.

 

The Company believes that the deduction of the expenses related to management services provided to its insurance company subsidiaries is meritorious and that this is further supported by the SBE’s decision to grant a rehearing on the matter. The potential net liability on the franchise tax issues in 1993 through 1996, after federal tax benefit, amounts to approximately $9 million. The Company has recorded a tax liability of approximately $1 million for the issues related to these tax years.

 

On September 29, 2004, California Governor Arnold Schwarzenegger signed into law Assembly Bill 263 (“AB 263”). The law resolves an issue raised by the FTB where they interpreted a legal ruling (“Ceridian”) to eliminate a dividends received deduction (“DRD”) taken by insurance companies. AB 263 provides for an 80% DRD for tax

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

years 1997 through 2007 and an 85% DRD for tax years after 2007. The Company intends to refile its 1997 through 2003 tax returns based on the DRD established by AB 263. The tax liability for this item is included in the tax liabilities at December 31, 2004.

 

(7)    Reserves for Losses and Loss Adjustment Expenses

 

Activity in the reserves for losses and loss adjustment expenses is summarized as follows:

 

     Year ended December 31,

 
     2004

    2003

    2002

 
     (Amounts in thousands)  

Gross reserves for losses and loss adjustment expenses at beginning of year

   $ 797,927     $ 679,271     $ 534,926  

Less reinsurance recoverable

     (11,771 )     (14,382 )     (18,334 )
    


 


 


Net reserves, beginning of year

     786,156       664,889       516,592  

Incurred losses and loss adjustment expenses related to:

                        

Current year

     1,640,197       1,447,986       1,242,060  

Prior years

     (57,943 )     4,065       26,183  
    


 


 


Total incurred losses and loss adjustment expenses

     1,582,254       1,452,051       1,268,243  
    


 


 


Loss and loss adjustment expense payments related to:

                        

Current year

     1,020,154       892,658       759,165  

Prior years

     461,649       438,126       360,781  
    


 


 


Total payments

     1,481,803       1,330,784       1,119,946  
    


 


 


Net reserves for losses and loss adjustment expenses at end of year

     886,607       786,156       664,889  

Reinsurance recoverable

     14,137       11,771       14,382  
    


 


 


Gross reserves, end of year

   $ 900,744     $ 797,927     $ 679,271  
    


 


 


 

The decrease in the provision for insured events of prior years in 2004 relates largely to a decrease in the estimated inflation rates on the 2002 and 2003 accident years on bodily injury coverage for California automobile insurance. For 2003 and 2002, the increase 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.

 

During the third quarter of 2004, the state of Florida was ravaged by four hurricanes. The Company estimated that its pre-tax losses resulting from these hurricanes is approximately $22 million. The estimate is based upon the total number of claims reported and the number of unreported claims anticipated as a result of the hurricanes. This compares with the pre-tax losses of approximately $16 million incurred from the California firestorms in 2003.

 

(8)    Dividend Restrictions

 

The Insurance Companies are subject to the financial capacity guidelines established by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For 2005, the direct insurance subsidiaries of the Company are permitted to

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

December 31, 2004 and 2003

 

pay approximately $235 million in dividends to the Company without the prior approval of the Insurance Commissioner of the state of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay dividends. During 2004 and 2003, the Insurance Companies paid dividends to Mercury General Corporation of $99.0 million and $76.0 million, respectively.

 

(9)    Statutory Balances and Accounting Practices

 

The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include primarily those published as statements of Statutory Accounting Principles by the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2004, there were no material permitted statutory accounting practices utilized by the Insurance Companies.

 

The Insurance Companies’ statutory net income, as reported to regulatory authorities, was $270,466,000, $168,118,000 and $14,792,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The statutory policyholders’ surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 2004 and 2003 was $1,361,072,000 and $1,169,427,000, respectively.

 

The Company has estimated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2004 according to the formula issued by the NAIC. Each of the Insurance Companies’ policyholders’ surplus exceeded the highest level of minimum required capital.

 

(10)    Commitments and Contingencies

 

The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2012. Total rent expense under these lease agreements was $6,921,000, $6,150,000 and $4,815,000 for the years ended December 31, 2004, 2003