Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended June 30, 2010

Commission File No. 001-12257

 

 

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

California   95-2211612

(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

 

 

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   x     No   ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

Non-accelerated filer

 

¨   (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

Indicate by check mark whether the Registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act).    Yes   ¨     No   x

At July 31, 2010, the Registrant had issued and outstanding an aggregate of 54,793,483 shares of its Common Stock.

 

 

 


Table of Contents

MERCURY GENERAL CORPORATION

INDEX TO FORM 10-Q

 

         Page

PART I – FINANCIAL INFORMATION

  

Item 1

 

Financial Statements

   3
 

Consolidated Balance Sheets as of June 30, 2010 and December 31, 2009

   3
 

Consolidated Statements of Operations for the Three Months Ended June 30, 2010 and 2009

   4
 

Consolidated Statements of Operations for the Six Months Ended June 30, 2010 and 2009

   5
 

Consolidated Statements of Comprehensive Income for the Three Months Ended June 30, 2010 and 2009

   6
 

Consolidated Statements of Comprehensive Income for the Six Months Ended June 30, 2010 and 2009

   7
 

Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2010 and 2009

   8
 

Condensed Notes to Consolidated Financial Statements

   9

Item 2

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   20

Item 3

 

Quantitative and Qualitative Disclosures about Market Risks

   36

Item 4

 

Controls and Procedures

   38

PART II – OTHER INFORMATION

  

Item 1

 

Legal Proceedings

   38

Item 1A

 

Risk Factors

   38

Item 2

 

Unregistered Sales of Equity Securities and Use of Proceeds

   39

Item 3

 

Defaults upon Senior Securities

   39

Item 4

 

Removed and Reserved

   39

Item 5

 

Other Information

   39

Item 6

 

Exhibits

   39

SIGNATURES

   40

 

2


Table of Contents

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

ASSETS     
     June 30, 2010     December 31, 2009  
     (unaudited)        

Investments, at fair value:

    

Fixed maturities trading (amortized cost $2,639,612; $2,673,079)

   $ 2,698,711      $ 2,704,561   

Equity securities trading (cost $339,978; $308,941)

     278,653        286,131   

Short-term investments (cost $104,400; $156,126)

     103,740        156,165   
                

Total investments

     3,081,104        3,146,857   

Cash

     219,466        185,505   

Receivables:

    

Premiums receivable

     271,866        262,278   

Premium notes

     8,046        14,510   

Accrued investment income

     37,294        37,405   

Other

     11,059        13,689   
                

Total receivables

     328,265        327,882   

Deferred policy acquisition costs

     173,894        175,866   

Fixed assets, net

     200,999        201,862   

Current income taxes

     5,464        27,268   

Deferred income taxes

     43,772        36,139   

Goodwill

     42,850        42,850   

Other intangible assets, net

     63,418        66,823   

Other assets

     22,638        21,581   
                

Total assets

   $ 4,181,870      $ 4,232,633   
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

Losses and loss adjustment expenses

   $ 999,777      $ 1,053,334   

Unearned premiums

     844,853        844,540   

Notes payable

     269,964        271,397   

Accounts payable and accrued expenses

     128,757        114,469   

Other liabilities

     152,515        177,947   
                

Total liabilities

     2,395,866        2,461,687   
                

Commitments and contingencies

    

Shareholders’ equity:

    

Common stock without par value or stated value:

    

Authorized 70,000,000 shares; issued and outstanding 54,793,483; 54,776,958

     73,466        72,589   

Additional paid-in capital

     36        0   

Accumulated other comprehensive loss

     (797     (597

Retained earnings

     1,713,299        1,698,954   
                

Total shareholders’ equity

     1,786,004        1,770,946   
                

Total liabilities and shareholders’ equity

   $ 4,181,870      $ 4,232,633   
                

See accompanying Condensed Notes to Consolidated Financial Statements.

 

3


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

     Three Months Ended June 30,
     2010     2009

Revenues:

    

Net premiums earned

   $ 642,717      $ 659,211

Net investment income

     36,475        36,212

Net realized investment (losses) gains

     (27,713     99,862

Other

     2,180        694
              

Total revenues

     653,659        795,979
              

Expenses:

    

Losses and loss adjustment expenses

     439,609        445,463

Policy acquisition costs

     126,325        136,359

Other operating expenses

     70,516        51,364

Interest

     1,851        1,879
              

Total expenses

     638,301        635,065
              

Income before income taxes

     15,358        160,914

Income tax (benefit) expense

     (2,459     46,467
              

Net income

   $ 17,817      $ 114,447
              

Net income per share:

    

Basic

   $ 0.33      $ 2.09

Diluted

   $ 0.32      $ 2.07

Weighted average shares outstanding:

    

Basic

     54,788        54,770

Diluted

     54,833        55,320

Dividends declared per share

   $ 0.59      $ 0.58

See accompanying Condensed Notes to Consolidated Financial Statements.

 

4


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

     Six Months Ended June 30,
     2010     2009

Revenues:

    

Net premiums earned

   $ 1,283,331      $ 1,325,274

Net investment income

     72,361        74,126

Net realized investment (losses) gains

     (5,669     181,176

Other

     3,473        2,361
              

Total revenues

     1,353,496        1,582,937
              

Expenses:

    

Losses and loss adjustment expenses

     870,231        889,755

Policy acquisition costs

     255,307        283,890

Other operating expenses

     127,840        104,850

Interest

     3,470        3,425
              

Total expenses

     1,256,848        1,281,920
              

Income before income taxes

     96,648        301,017

Income tax expense

     17,652        89,917
              

Net income

   $ 78,996      $ 211,100
              

Net income per share:

    

Basic

   $ 1.44      $ 3.85

Diluted

   $ 1.44      $ 3.83

Weighted average shares outstanding:

    

Basic

     54,786        54,769

Diluted

     54,821        55,166

Dividends declared per share

   $ 1.18      $ 1.16

See accompanying Condensed Notes to Consolidated Financial Statements.

 

5


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Three Months Ended June 30,
     2010     2009

Net income

   $ 17,817      $ 114,447

Other comprehensive (loss) income, before tax:

    

(Losses) gains on hedging instrument

     (156     490
              

Other comprehensive (loss) income, before tax

     (156     490

Income tax (benefit) expense related to (losses) gains on hedging instrument

     (55     172
              

Comprehensive income, net of tax

   $ 17,716      $ 114,765
              

See accompanying Condensed Notes to Consolidated Financial Statements.

 

6


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

     Six Months Ended June 30,
     2010     2009

Net income

   $ 78,996      $ 211,100

Other comprehensive (loss) income, before tax:

    

(Losses) gains on hedging instrument

     (309     502
              

Other comprehensive (loss) income, before tax

     (309     502

Income tax (benefit) expense related to (losses) gains on hedging instrument

     (108     176
              

Comprehensive income, net of tax

   $ 78,795      $ 211,426
              

See accompanying Condensed Notes to Consolidated Financial Statements.

 

7


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

     Six Months Ended June 30,  
     2010     2009  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 78,996      $ 211,100   

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

    

Depreciation and amortization

     17,081        17,418   

Net realized investment losses (gains)

     5,669        (181,176

Bond (accretion) amortization, net

     (1,201     2,218   

Excess tax benefit from exercise of stock options

     (42     (3

(Increase) decrease in premiums receivable

     (9,588     12,223   

Decrease (increase) in premium notes receivable

     6,464        (1,711

Decrease in deferred policy acquisition costs

     1,972        18,873   

Decrease in unpaid losses and loss adjustment expenses

     (53,557     (63,505

Increase (decrease) in unearned premiums

     313        (16,945

Decrease in current and deferred income taxes

     14,322        103,818   

Increase in accounts payable and accrued expenses

     16,763        19,119   

Decrease in trading securities in nature, net of realized gains and losses

     0        3,209   

Share-based compensation

     396        367   

Decrease in other payables

     (25,695     (12,840

Other, net

     151        (5,802
                

Net cash provided by operating activities

     52,044        106,363   

CASH FLOWS FROM INVESTING ACTIVITIES

    

Fixed maturities available-for-sale in nature:

    

Purchases

     (188,227     (232,116

Sales

     74,220        123,275   

Calls or maturities

     150,636        111,710   

Equity securities available-for-sale in nature:

    

Purchases

     (105,791     (143,665

Sales

     75,411        155,652   

Net increase in payable for securities

     135        4,127   

Net decrease in short-term investments

     51,743        110,268   

Purchase of fixed assets

     (15,307     (20,656

Sale and write-off of fixed assets

     66        357   

Business acquisition, net of cash acquired

     0        (115,488

Other, net

     3,165        2,784   
                

Net cash provided by (used in) investing activities

     46,051        (3,752

CASH FLOWS FROM FINANCING ACTIVITIES

    

Dividends paid to shareholders

     (64,651     (63,533

Excess tax benefit from exercise of stock options

     42        3   

Proceeds from stock options exercised

     475        233   

Proceeds from bank loan

     0        120,000   
                

Net cash (used in) provided by financing activities

     (64,134     56,703   
                

Net increase in cash

     33,961        159,314   

Cash:

    

Beginning of the year

     185,505        35,396   
                

End of year

   $ 219,466      $ 194,710   
                

SUPPLEMENTAL CASH FLOW DISCLOSURE

    

Interest paid

     3,257      $ 3,689   

Income taxes paid (received)

     3,330      $ (13,903

Net realized gains (losses) from sale of investments

     4,978      $ (42,877

See accompanying Condensed Notes to Consolidated Financial Statements.

 

8


Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. General

Consolidation and Basis of Presentation

The condensed consolidated financial statements include the accounts of Mercury General Corporation and its subsidiaries (referred to herein collectively as the Company). The subsidiaries are as follows:

 

Insurance Companies   

Mercury Casualty Company

  

Mercury National Insurance Company

Mercury Insurance Company

California Automobile Insurance Company

California General Underwriters Insurance Company, Inc.

Mercury Insurance Company of Illinois

Mercury Insurance Company of Georgia

Mercury Indemnity Company of Georgia

  

American Mercury Insurance Company

American Mercury Lloyds Insurance Company (1)

Mercury County Mutual Insurance Company (2)

Mercury Insurance Company of Florida

Mercury Indemnity Company of America

Non-Insurance Companies   

Mercury Select Management Company, Inc. (1)

American Mercury MGA, Inc.

Concord Insurance Services, Inc.

Mercury Insurance Services LLC

  

Mercury Group, Inc.

AIS Management LLC

Auto Insurance Specialists LLC (“AIS”)

PoliSeek Insurance Solutions, Inc.

 

(1)

American Mercury Lloyds Insurance Company is not owned but is controlled by the Company through its attorney-in-fact, Mercury Select Management Company, Inc.

(2)

Mercury County Mutual Insurance Company is not owned but is controlled by the Company through a management contract.

The condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions have been eliminated.

The financial data of the Company included herein has been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature necessary to present fairly the Company’s financial position at June 30, 2010 and the results of operations, comprehensive income, and cash flows for the periods presented have been made. Operating results and cash flows for the six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

Use of Estimates

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 revenues and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these condensed consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates (See Note 1 “Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009).

 

9


Table of Contents

2. Recently Issued Accounting Standards

In February 2010, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard related to subsequent events, which amends the earlier FASB standard to address certain implementation issues related to an entity’s requirement to perform and disclose subsequent events procedures. The new standard requires Securities and Exchange Commission (“SEC”) filers to evaluate subsequent events through the date the financial statements are issued and exempts SEC filers from disclosing the date through which subsequent events have been evaluated. The Company adopted the new standard which became effective for the interim reporting period ended March 31, 2010. The adoption of the new standard did not have a material impact on the Company’s condensed consolidated financial statements.

In January 2010, the FASB issued a new standard related to fair value measurements and disclosures, which amends the earlier FASB standard to add new requirements for disclosures about transfers into and out of Levels 1 and 2 fair value measurements and separate disclosures about purchases, sales, issuances, and settlements related to Level 3 fair value measurements. The new standard also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure the fair value. The Company adopted the new accounting standard which became effective for the interim reporting period ended March 31, 2010, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of the new standard did not have a material impact on the Company’s condensed consolidated financial statements.

 

10


Table of Contents

3. Fair Value of Financial Instruments

The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. Due to their short-term maturity, the carrying value of receivables and accounts payable approximate their fair market values. The following table presents estimated fair values of financial instruments at June 30, 2010 and December 31, 2009.

 

     June 30, 2010    December 31, 2009
     (Amounts in thousands)

Assets

     

Investments

   $ 3,081,104    $ 3,146,857

Interest rate swap agreements

   $ 7,018    $ 8,472

Liabilities

     

Interest rate swap agreements

   $ 3,526    $ 2,364

Equity contracts

   $ 801    $ 1,043

Secured notes

   $ 138,628    $ 138,103

Unsecured notes

   $ 128,750    $ 130,666

Methods and assumptions used in estimating fair values are as follows:

Investments

The Company applies the fair value option to all available-for-sale, fixed maturity, equity securities, and short-term investments as of the time the eligible item is first recognized. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Interest rate swap agreements

The fair value of interest rate swap agreements reflects the estimated amounts that the Company would pay or receive at June 30, 2010 and December 31, 2009 in order to terminate the contracts based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract. For additional disclosures regarding methods and assumptions used in estimating fair values of interest rate swap agreements, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Equity contracts

The fair value of equity contracts is based on quoted prices for identical instruments in active markets. For additional disclosures regarding methods and assumptions used in estimating fair values of equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Secured notes

The fair value of the Company’s $120 million and $18 million secured notes is estimated based on assumptions and inputs, such as reset rates, for similarly termed notes that are observable in the market.

Unsecured note

The fair value of the Company’s publicly traded $125 million unsecured note is based on the unadjusted quoted price for similar notes in active markets.

 

11


Table of Contents

4. Fair Value Option

Gains and losses due to changes in fair value for items measured at fair value pursuant to application of the fair value option are included in net realized investment (losses) gains in the Company’s consolidated statements of operations, while interest and dividend income on the investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as expansion of use of fair value measurement consistent with the long-term measurement objectives of the FASB for accounting for financial instruments.

The following table presents (losses) gains due to changes in fair value for items measured at fair value pursuant to application of the fair value option:

 

     Three Months Ended June 30,    Six Months Ended June 30,  
     2010     2009    2010     2009  
           (Amounts in thousands)        

Fixed maturity securities

   $ 14,350      $ 46,419    $ 27,617      $ 147,434   

Equity securities

     (44,241     77,198      (38,516     66,919   

Short-term investments

     (646     0      (699     (3
                               

Total

   $ (30,537   $ 123,617    $ (11,598   $ 214,350   
                               

5. Fair Value Measurement

The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price). Accordingly, when market observable data is not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value are categorized based on the level of judgment associated with inputs used to measure fair value and the level of market observability, as follows:

 

Level 1

 

Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.

Level 2

 

Pricing inputs are other than quoted prices in active markets, which are based on the following:

 

•   Quoted prices for similar assets or liabilities in active markets;

 

•   Quoted prices for identical or similar assets or liabilities in non-active markets; or

 

•   Either directly or indirectly observable inputs as of the reporting date and fair value is determined through the use of models or other valuation methods

Level 3

 

Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.

In certain cases, inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset or liability.

The Company uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3. The Company recognizes transfers between levels at either the actual date of the event or a change in circumstances that caused the transfer.

 

12


Table of Contents

Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities

The Company’s fair value measurements are based on a combination of the market approach and the income approach. The market approach utilizes market transaction data for the same or similar instruments. The income approach is based on a discounted cash flow methodology, where expected cash flows are discounted to present value.

The Company obtained unadjusted fair values on approximately 98% of its portfolio from an independent pricing service. For approximately 2% of its portfolio, the Company obtained specific unadjusted broker quotes from at least one knowledgeable outside security broker to determine the fair value.

Level 1 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure realistic fair values are used in pricing the investment portfolio.

U.S. government bonds and agencies : Priced using unadjusted quoted market prices for identical assets in active markets.

Common stock/Other : Comprised of actively traded, exchange listed U.S. and international equity securities and valued based on unadjusted quoted prices for identical assets in active markets.

Money market instruments : Valued based on unadjusted quoted prices for identical assets.

Equity contracts : Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.

Level 2 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.

Municipal securities : Valued based on models or matrices using inputs including quoted prices for identical or similar assets in active markets.

Mortgage-backed securities : Comprised of securities that are collateralized by residential mortgage loans. Valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. At June 30, 2010 and December 31, 2009, the Company had no holdings in commercial mortgage-backed securities.

Corporate securities/Short-term bonds : Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.

Non-redeemable preferred stock : Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.

Interest rate swap agreements : Valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.

Level 3 Measurements - Fair values of financial assets are based on discounted cash flow price modeling performed by management with inputs that are both unobservable and significant to the overall fair value measurement, including any items in which the evaluated prices obtained elsewhere were deemed to be of a distressed trading level.

Municipal securities : Comprised of certain distressed municipal securities for which valuation is based on models that are widely accepted in the financial services industry and require projections of future cash flows that are not market observable. Included in this category are $1.4 million of auction rate securities (“ARS”).

Collateralized debt obligations : Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.

The Company’s total financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment (losses) gains in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.

 

13


Table of Contents

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2010 and December 31, 2009, and indicate the fair value hierarchy based on the inputs and the valuation techniques utilized by the Company to determine such fair value:

 

     June 30, 2010
     Level 1    Level 2    Level 3    Total
          (Amounts in thousands)     

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 8,904    $ 0    $ 0    $ 8,904

Municipal securities

     0      2,477,037      1,357      2,478,394

Mortgage-backed securities

     0      76,770      0      76,770

Corporate securities

     0      87,058      0      87,058

Collateralized debt obligations

     0      0      47,585      47,585

Equity securities:

           

Common stock:

           

Public utilities

     23,738      0      0      23,738

Banks, trusts and insurance companies

     13,890      0      0      13,890

Industrial and other

     227,109      0      0      227,109

Non-redeemable preferred stock

     0      13,916      0      13,916

Short-term bonds

     0      14,410      0      14,410

Money market instruments

     89,330      0      0      89,330

Interest rate swap agreements

     0      7,018      0      7,018
                           

Total assets at fair value

   $ 362,971    $ 2,676,209    $ 48,942    $ 3,088,122
                           

Liabilities

           

Equity contracts

   $ 801    $ 0    $ 0    $ 801

Interest rate swap agreements

     0      3,526      0      3,526
                           

Total liabilities at fair value

   $ 801    $ 3,526    $ 0    $ 4,327
                           
     December 31, 2009
     Level 1    Level 2    Level 3    Total
          (Amounts in thousands)     

Assets

           

Fixed maturity securities:

           

U.S. government bonds and agencies

   $ 8,977    $ 1,003    $ 0    $ 9,980

Municipal securities

     0      2,437,744      3,322      2,441,066

Mortgage-backed securities

     0      114,408      0      114,408

Corporate securities

     0      91,634      0      91,634

Collateralized debt obligations

     0      0      47,473      47,473

Equity securities:

           

Common stock:

           

Public utilities

     28,780      0      0      28,780

Banks, trusts and insurance companies

     13,291      0      0      13,291

Industrial and other

     230,406      0      0      230,406

Non-redeemable preferred stock

     0      13,654      0      13,654

Short-term bonds

     0      6,039      0      6,039

Money market instruments

     150,126      0      0      150,126

Interest rate swap agreements

     0      8,472      0      8,472
                           

Total assets at fair value

   $ 431,580    $ 2,672,954    $ 50,795    $ 3,155,329
                           

Liabilities

           

Equity contracts

   $ 1,043    $ 0    $ 0    $ 1,043

Interest rate swap agreements

     0      2,364      0      2,364
                           

Total liabilities at fair value

   $ 1,043    $ 2,364    $ 0    $ 3,407
                           

 

14


Table of Contents

When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3).

The following tables presents a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at June 30, 2010 and 2009.

 

     Three Months Ended June 30,
     2010     2009
     Municipal
Securities
    Collateralized Debt
Obligations
    Municipal
Securities
    Collateralized Debt
Obligations

Beginning Balance

   $ 1,797      $ 54,531      $ 3,264      $ 0

Realized (losses) gains included in earnings

     (440     (2,355     792        0

Purchase, issuances, and settlements

     0        (4,591     (1,200     0
                              

Ending Balance

   $ 1,357      $ 47,585      $ 2,856      $ 0
                              

The amount of total (losses) gains for the period included in earnings attributable to assets still held at June 30, 2010 and 2009

   $ (440   $ (2,355   $ 457      $ 0
                              
     Six Months Ended June 30,
     2010     2009
     Municipal
Securities
    Collateralized Debt
Obligations
    Municipal
Securities
    Collateralized Debt
Obligations

Beginning Balance

   $ 3,322      $ 47,473      $ 2,984      $ 0

Realized (losses) gains included in earnings

     (375     4,703        1,078        0

Purchase, issuances, and settlements

     (1,590     (4,591     (1,206     0
                              

Ending Balance

   $ 1,357      $ 47,585      $ 2,856      $ 0
                              

The amount of total (losses) gains for the period included in earnings attributable to assets still held at June 30, 2010 and 2009

   $ (351   $ 4,703      $ 701      $ 0
                              

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the six months ended June 30, 2010 and 2009.

At June 30, 2010, the Company did not have any nonrecurring measurements of nonfinancial assets or nonfinancial liabilities.

6. Derivative Financial Instruments

The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts on various equity securities are entered into to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are entered into to manage the interest rate risk associated with the Company’s loans with fixed or floating rates.

On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on the $120 million credit facility, which was used for the acquisition of AIS, for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is not designated as a hedge and changes in the fair value are adjusted through the consolidated statement of operations in the period of change.

        Effective January 2, 2002, the Company entered into an interest rate swap on the $125 million 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 is designated as a fair value hedge and qualifies for the shortcut method as the hedge is deemed to have no ineffectiveness. The fair market value of the interest rate swap was $7.0 million as of June 30, 2010, and has been recorded in other assets in the consolidated

 

15


Table of Contents

balance sheets with a corresponding increase in notes payable. The Company includes the gain or loss on the hedged item in the same line item, other revenue, as the offsetting loss or gain on the related interest rate swaps as follows:

 

     Three Months Ended June 30,
     2010    2009

Income Statement Classification

   Gain (Loss)
on Swap
    Gain (Loss)
on Loan
   Gain (Loss)
on Swap
    Gain (Loss)
on Loan
           (Amounts in thousands)      

Other revenue

   $ (961   $ 961    $ (2,472   $ 2,472
     Six Months Ended June 30,
     2010    2009

Income Statement Classification

   Gain (Loss)
on Swap
    Gain (Loss)
on Loan
   Gain (Loss)
on Swap
    Gain (Loss)
on Loan
    

(Amounts in thousands)

Other revenue

   $ (1,454   $ 1,454    $ (3,871   $ 3,871

On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate on the $18 million bank loan for a fixed rate of 3.75%, resulting in a total fixed rate of 4.25%. The swap agreement terminates on March 1, 2013. The swap is designated as a cash flow hedge. The fair market value of the interest rate swap was $1.2 million as of June 30, 2010, and has been reported as a component of other comprehensive income and amortized into earnings over the life of the hedged transaction. The interest rate swap was determined to be highly effective, and no amount of ineffectiveness was recorded in earnings during the six months ended June 30, 2010 and 2009.

Fair value amounts, and gains and losses on derivative instruments

The following tables present the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains and losses in the consolidated statements of operations:

 

     Asset Derivatives    Liability Derivatives  
     June 30, 2010    December 31, 2009    June 30, 2010     December 31, 2009  

Hedging derivatives

          

Interest rate contracts - Other assets (liabilities)

   $ 7,018    $ 8,472    $ (1,227   $ (918
                              

Non-hedging derivatives

          

Interest rate contracts - Other liabilities

   $ 0    $ 0    $ (2,299   $ (1,446

Equity contracts - Short-term investments (Other liabilities)

     0      0      (801     (1,043
                              

Total non-hedging derivatives

   $ 0    $ 0    $ (3,100   $ (2,489
                              

Total derivatives

   $ 7,018    $ 8,472    $ (4,327   $ (3,407
                              

 

16


Table of Contents

The Effect of Derivative Instruments on the Statements of Operations

for Three Months and Six Months Ended June 30, 2010 and 2009

 

     (Loss) Recognized in Income  
     Three Months Ended June 30,     Six Months Ended June 30,  

Derivatives Contracts for Fair Value Hedges

   2010     2009     2010     2009  
    

(Amounts in thousands)

 

Interest rate contract - Interest expense

   $ (1,641   $ (1,629   $ (3,482   $ (3,348
     (Loss) Gain Recognized in
Other Comprehensive Income
 
     Three Months Ended June 30,     Six Months Ended June 30,  

Derivatives Contracts for Cash Flow Hedges

   2010     2009     2010     2009  
    

(Amounts in thousands)

 

Interest rate contract - Other comprehensive income

   $ (156   $ 490      $ (309   $ 502   
     Gain (Loss) Recognized in Income  
     Three Months Ended June 30,     Six Months Ended June 30,  

Derivatives Not Designated as Hedging Instruments

   2010     2009     2010     2009  
    

(Amounts in thousands)

 

Interest rate contract - Other revenue

   $ (189   $ 1,469      $ (853   $ (663

Equity contracts - Net realized investment gains

     2,721        2,971        3,295        6,409   
                                

Total

   $ 2,532      $ 4,440      $ 2,442      $ 5,746   
                                

There were no gains or losses on derivative instruments designated as cash flow hedges reclassified from accumulated other comprehensive income into earnings during the three or six months ended June 30, 2010 and 2009.

Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy that is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset diversification throughout various industries. For additional disclosures regarding equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

 

17


Table of Contents

7. Goodwill and Other Intangible Assets

There were no changes in the carrying amount of goodwill for the six months ended June 30, 2010. Goodwill is reviewed for impairment on an annual basis and more often if potential impairment indicators exist. No impairment indications were identified during any of the periods presented.

The following table presents the components of other intangible assets as of June 30, 2010 and December 31, 2009.

 

     Gross Carrying
Amount
   Accumulated
Amortization
    Net Carrying
Amount
     (Amounts in thousands)

As of June 30, 2010:

       

Customer relationships

   $ 51,640    $ (7,318   $ 44,322

Trade names

     15,400      (963     14,437

Software and technology

     4,850      (1,058     3,792

Favorable leases

     1,725      (858     867
                     

Total intangible assets, net

   $ 73,615    $ (10,197   $ 63,418
                     

As of December 31, 2009:

       

Customer relationships

   $ 51,640    $ (4,872   $ 46,768

Trade names

     15,400      (642     14,758

Software and technology

     4,850      (705     4,145

Favorable leases

     1,725      (573     1,152
                     

Total intangible assets, net

   $ 73,615    $ (6,792   $ 66,823
                     

Intangible assets are amortized on a straight-line basis over their weighted-average lives. Intangible assets amortization expense was $1.7 million for the three months ended June 30, 2010 and $3.4 million for the six months ended June 30, 2010. The following table presents the estimated future amortization expense related to intangible assets as of June 30, 2010:

 

Year Ending December 31,

   Amortization Expense
     (Amounts in thousands)

Remainder of 2010

   $ 3,407

2011

     6,358

2012

     6,144

2013

     5,969

2014

     5,964

Thereafter

     35,576
      

Total

   $ 63,418
      

8. Share-Based Compensation

The Company accounts for share-based compensation using the modified prospective transition method. Under this method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the estimated grant-date fair value. Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the estimated grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of four or five years for options granted prior to 2008 and four years for options granted subsequent to January 1, 2008, for only those shares expected to vest. The fair value of stock option awards is estimated using the Black-Scholes option pricing model with inputs for grant-date assumptions and weighted-average fair values.

 

18


Table of Contents

Under its 2005 Equity Participation Plan (the “Plan”), the Compensation Committee of the Company’s Board of Directors granted to Gabriel Tirador, the Company’s Chief Executive Officer, 10,000 shares of restricted stock on March 23, 2010. The restricted stock vests at the end of a three-year performance period, and then only if, and to the extent that, the Company’s cumulative underwriting income during such three-year performance period achieves the threshold performance levels established by the Compensation Committee.

The fair value of the restricted share grant was determined based on the market price on the date of grant. Compensation cost has been recognized based on the assumption that performance goals will be achieved. If such goals are not met, no compensation cost would be recognized and any recognized compensation cost would be reversed.

9. Income Taxes

The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return once a more likely than not threshold has been met. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement is recognized in the financial statements.

There was a $3.2 million decrease to the total amount of unrecognized tax benefits related to tax uncertainties during the six months ended June 30, 2010. The decrease was the result of a change in management’s assessment of the technical merits of tax positions taken in an earlier period based on management’s best judgment given the facts, circumstances, and information available at the reporting date. The Company does not expect any further changes in unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months. The Company recognizes interest and penalties related to unrecognized tax benefits as part of income tax expense.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2006 through 2008 for federal taxes and 2001 through 2008 for California state taxes. The Company is under examination by the Internal Revenue Service for tax years 2005 through 2008. The examination is in its early stage, and no issues have been raised.

The Company is currently under examination by the California Franchise Tax Board (“FTB”) for tax years 2001 through 2005. The taxing authority has proposed significant adjustments to the Company’s California tax liabilities. An unfavorable ruling against the Company may have a material impact on the Company’s results of operations in the period of such ruling. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail on this matter.

Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting basis and the respective tax basis of the Company’s assets and liabilities, and expected benefits of utilizing net operating loss, capital loss, and tax-credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established.

At June 30, 2010, the Company’s deferred income taxes were in a net asset position partly due to a combination of ordinary and capital deferred tax benefits. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generating sufficient taxable income of the appropriate nature within the carryback and carryforward periods available under the tax law. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to maximize the full benefits of its deferred tax assets. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.

10. Contingencies

        A contingent consideration arrangement requires the Company to pay the former owner of AIS up to an undiscounted maximum amount of $34.7 million. The potential undiscounted amount of all future payments that the Company could be required to make under the contingent consideration arrangement is between $0 and $34.7 million. Based on the actual to date and the projected performance of the AIS business through December 31, 2010, the Company does not expect to pay any of the contingent consideration.

 

19


Table of Contents

That estimate of future performance is based on significant inputs that are not observable in the market, including management’s projections of future cash flows, which are considered Level 3 inputs. A key assumption in determining the estimated contingent consideration is a forecasted decline in revenues ranging from 5.0% to 8.0%. The estimates for the contingent consideration arrangement, the range of outcomes, and the assumptions used to develop the estimates have not changed since December 31, 2009.

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 which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. Additionally, from time to time, regulators may take actions to challenge the Company’s business practices. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations in the period of such ruling; however, none is expected to be material to the Company’s financial position. For a discussion of the Company’s pending material litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statements

Certain statements in this Quarterly Report on Form 10-Q or in other materials the Company has filed or will file with the SEC (as well as information included in oral statements or other written statements made or to be made by the Company) contain or may contain “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, the Company’s 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 the Company’s actual business, prospects, and results of operations to differ materially from the historical information contained in this Quarterly Report on Form 10-Q and from those that may be expressed or implied by the forward-looking statements contained in this Quarterly Report on Form 10-Q and in other reports or public statements made by the Company.

Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California and other states automobile insurance markets; the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies; the achievement of the synergies and revenue growth from the acquisition of AIS; the Company’s success in managing its business in states outside of California; the impact of potential third party “bad-faith” legislation, changes in legislation, regulations or new interpretation of existing regulations, tax position challenges by the FTB, and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in states where the Company operates; the investment yields the Company is able to obtain with its investments in comparison to recent yields and the market risks associated with the Company’s investment portfolio; 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, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters in the markets served by the Company; the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives; the Company’s ability to realize current deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other uncertainties, all of which are difficult to predict and many of which are beyond the Company’s 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 Quarterly Report on Form 10-Q or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report, or statement. Investors should also understand that it is not possible to predict or identify all factors and should not consider the risks

 

20


Table of Contents

set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company’s forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements. Any forward-looking statements should also be considered in light of the information provided in “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 and in Item 1A. Risk Factors in Part II - Other Information of this Quarterly Report on Form 10-Q.

OVERVIEW

A. General

The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, 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 Company’s ability to grow and retain business.

This section 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 management’s discussion and analysis, the Company’s condensed consolidated financial statements and notes thereto, and all other items contained within this Quarterly Report on Form 10-Q.

 

21


Table of Contents

B. Business

The Company is primarily engaged in writing automobile insurance through 13 insurance subsidiaries (“Insurance Companies”). The Company also writes homeowners, mechanical breakdown, fire, umbrella, and commercial automobile and property insurance. These policies are mostly sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling policies. The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its 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 than many competitors.

The Company operates primarily in the state of California, the only state in which it operated prior to 1990. The Company has since expanded its operations into the following states: Georgia and Illinois (1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001), New Jersey (2003), and Arizona, Pennsylvania, Michigan, and Nevada (2004). The direct premiums written during the six months ended June 30, 2010 and 2009 by state and line of business were:

 

     Six Months Ended June 30, 2010  
     (Amounts in thousands)  
     Private
Passenger Auto
    Commercial
Auto
    Homeowners     Other Lines     Total        

California

   $ 822,151      $ 32,536      $ 108,256      $ 27,762      $ 990,705      77.0

Florida

     76,046        6,915        6,290        3,106        92,357      7.2

Texas

     32,958        2,891        682        8,367        44,898      3.5

New Jersey

     43,164        —          348        211        43,723      3.4

Other states

     88,728        3,565        11,912        9,868        114,073      8.9
                                              

Total

   $ 1,063,047      $ 45,907      $ 127,488      $ 49,314      $ 1,285,756      100.0
                                              
     82.7     3.6     9.9     3.8     100.0  
    

Six Months Ended June 30, 2009

 
     (Amounts in thousands)  
     Private
Passenger Auto
    Commercial
Auto
    Homeowners     Other Lines     Total        

California

   $ 863,279      $ 36,481      $ 101,201      $ 26,549      $ 1,027,510      78.5

Florida

     70,169        7,535        6,986        3,208        87,898      6.7

Texas

     35,977        3,716        791        8,376        48,860      3.7

New Jersey

     40,467        —          —          48        40,515      3.1

Other states

     81,000        3,764        8,171        12,161        105,096      8.0
                                              

Total

   $ 1,090,892      $ 51,496      $ 117,149      $ 50,342      $ 1,309,879      100.0
                                              
     83.3     3.9     9.0     3.8     100.0  

C. Regulatory and Litigation Matters

The Department of Insurance (“DOI”) in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies domiciled in their respective states. The following table presents a summary of current financial and market conduct examinations:

 

State

  

Exam Type

  

Period Under Review

  

Status

IL

  

Financial

  

2005 to 2009

  

Fieldwork to begin during the third quarter of 2010.

TX

  

Financial

  

2005 to 2009

  

Fieldwork to begin in September, 2010.

FL

  

Financial

  

2005 to 2009

  

Fieldwork began on July 26, 2010.

TX

  

Market Conduct

  

Mar 2009 - Feb 2010

  

Fieldwork completed. Awaiting final report.

During the course of these examinations, the DOI generally reports findings to the Company; however, none of the findings reported to date is expected to be material to the Company’s financial position.

 

22


Table of Contents

On April 9, 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company based on a Report of Examination of the Rating and Underwriting Practices of such companies issued by the California DOI on February 18, 2010. The 2010 NNC includes allegations of 35 instances of noncompliance with applicable California insurance law and seeks to require that each of Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company change its rating and underwriting practices to rectify the alleged noncompliance and may also seek monetary penalties. On April 30, 2010, the Company submitted a Statement of Compliance and Notice of Defense to the 2010 NNC, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense does not establish to the satisfaction of the California DOI that the alleged noncompliance does not exist, and the matters described in the 2010 NNC are not otherwise able to be resolved informally with the California DOI. The Company denies the allegations in the 2010 NNC and believes that it has done nothing to warrant the monetary penalties cited in the 2010 NNC.

In March 2006, the California DOI issued an Amended Notice of Non-Compliance (“2004 NNC”) to the 2004 NNC originally issued in February 2004 alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. The California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee, which the California DOI contends is the use of an unapproved rate, rating plan or rating system. Further, the California DOI seeks to impose a penalty for each and every date on which the Company allegedly used a misleading advertisement alleged in the 2004 NNC. Finally, based upon the conduct alleged, the California DOI also contends that the Company acted fraudulently in violation of Section 704(a) of the California Insurance Code, which permits the California Commissioner of Insurance to suspend certificates of authority for a period of one year. The Company filed a Notice of Defense in response to the 2004 NNC. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company , denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. While a hearing before the administrative law judge had been set to start on September 14, 2009, the hearing has been vacated and continued to a future date to be determined. This matter has been the subject of five continuations since the original Notice of Non-Compliance was issued in 2004.

The Company supported the Continuous Coverage Auto Insurance Discount Act (“Proposition 17”), a California ballot initiative which did not pass. It would have provided for a portable persistency discount, allowing insurance companies to offer new customers discounts based on having continuous insurance coverage from any insurance company. Currently, the California DOI allows insurance companies to provide persistency discounts based on continuous coverage only with existing customers. The Company made financial contributions of $12.1 million, $0, and $3.5 million in the second quarter of 2010, the first quarter of 2010, and second half of 2009, respectively, related to this initiative. Despite the non-passage of Proposition 17, the Company believes it continues to offer a competitive product in California.

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 which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. Additionally, from time to time, regulators may take actions to challenge the Company’s business practices. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations in the period of such ruling; however, none is expected to be material to the Company’s financial position. For a discussion of the Company’s pending material litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

D. Critical Accounting Policies and Estimates

Reserves

Preparation of the Company’s condensed consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations because the longer the span between the incidence of a loss and the payment or settlement of a 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.

 

23


Table of Contents

The Company also engages an independent actuarial consultant to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultant for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count, and average severity methods described below. The Company also uses the paid loss development method to analyze losses and loss adjustment expense reserves as part of its reserve analysis. When deciding which method to use in estimating its reserves, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.

 

   

The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of business which have a long operating history.

 

   

The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.

 

   

The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves.

 

   

The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company uses this method for losses and loss adjustment expenses.

At June 30, 2010, the Company recorded its point estimate of approximately $999.8 million in losses and loss adjustment expenses liabilities which include approximately $299.4 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 June 30, 2010 and estimated future payments for reopened 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; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision.

The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. Conversely, if the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For the six months ended June 30, 2010, the Company reported favorable development of approximately $22 million on the 2009 and prior accident years’ losses and loss adjustment expense reserves which at December 31, 2009 totaled approximately $1.1 billion. The favorable development in 2010 is largely the result of re-estimates of accident year 2009 California bodily injury losses which have experienced both lower average severities and fewer late reported claims (claim count development) than was originally estimated at December 31, 2009.

For a further discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

 

24


Table of Contents

Premiums

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 consolidated 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, net of investment income. To the extent that any of the Company’s lines of business become unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business.

Investments

The Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-redeemable preferred stocks, is actively traded on national exchanges or trading markets, and is valued at the last transaction price on the balance sheet date.

Fair Value of Financial Instruments

The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values. All investments are carried on the consolidated balance sheet at fair value, as disclosed in Note 3 of Condensed Notes to Consolidated Financial Statements.

The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal government and agencies, certain corporate and other debt securities, corporate equity securities, and exchange traded funds. Approximately 98% of the fair value of the financial instruments held at June 30, 2010 is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary across different financial instruments. Observable market prices and pricing parameters in a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.

The Company may hold or acquire financial instruments that lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise are not actively quoted.

Income Taxes

At June 30, 2010, the Company’s deferred income taxes were in a net asset position materially due to unearned premiums, expense accruals, loss reserve discounting, and deferred tax recognition of capital losses. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established.

Management’s recoverability assessment of its deferred tax assets which are ordinary in character takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities which represent sources of future ordinary taxable income.

 

25


Table of Contents

Management’s recoverability assessment with regards to its capital deferred tax assets is based on estimates of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of which would contribute to the realization of deferred tax benefits. The Company expects to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a significant portion of the unrealized loss positions at period end, are not subject to default risk. Thus, the principal amounts are believed to be fully realizable at maturity. The Company has a long-term horizon for holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The Company also has unrealized gains in its investment portfolio which could be realized through asset dispositions, at management’s discretion. Further, the Company has the capability to generate additional realized capital gains by entering into a sale-leaseback transaction using one or more of its appreciated real estate holdings. Finally, the Company has an established history of generating capital gain premiums earned through its common stock call option program. Based on the continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and the Company’s favorable track record in generating net capital gains from this program in both upward and downward markets, management believes it will be able to generate sufficient amounts of capital gains from this program, if necessary, to recover recorded capital deferred tax assets.

The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations, as well as the reasonable expectation that its cash flow needs can be met in future periods without the forced sale of its investments. This capability will enable management to use its discretion in controlling the timing and amount of realized losses it generates during future periods. By prudent utilization of some or all of these actions, management believes that it has the ability and intent to generate capital gains, and minimize tax losses, in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.

The effective income tax rate for the year could be different from the effective tax rate for the three or six months ended June 30, 2010 and will be dependent on the Company’s profitability for the remainder of the year. The Company’s effective income tax rate can be affected by several factors. These generally include tax exempt investment income, other non-deductible expenses, investment gains and losses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate for the six months ended June 30, 2010 was 18.3%, compared to 29.9% for the same period in 2009. The decrease in the effective tax rate is mainly due to an increase in tax exempt investment income relative to taxable income. The Company’s effective tax rate for the period ended June 30, 2010 was lower than the statutory tax rate primarily as a result of tax exempt interest income earned, however, the effective tax rate for the entire year could differ than the rate for the six months.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets arise as a result of business acquisitions and consist of the excess of the cost of the acquisitions over the tangible and intangible assets acquired and liabilities assumed and identifiable intangible assets acquired. The Company annually evaluates goodwill for impairment using widely accepted valuation techniques to estimate the fair value of its reporting units. The Company also reviews its goodwill for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill may exceed its implied fair value. As of June 30, 2010, the fair value of the Company’s reporting units exceeds their carrying value.

Contingent Liabilities

The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the notes to the condensed consolidated financial statements where required. While it is not possible to know with certainty the ultimate outcome of contingent liabilities, an unfavorable result may have a material impact on the Company’s quarterly results of operations in the period of such determination; however, it is not expected to be material to the Company’s financial position.

 

26


Table of Contents

RESULTS OF OPERATIONS

Three Months Ended June 30, 2010 compared to Three Months Ended June 30, 2009

Revenue

Net premiums earned and net premiums written for the three months ended June 30, 2010 decreased approximately 2.5% and 1.0%, respectively, from the corresponding period in 2009. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting continuing soft market conditions.

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is 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:

 

     Three Months Ended June 30,
     2010    2009
     (Amounts in thousands)

Net premiums written

   $ 631,113    $ 637,405

Change in unearned premium

     11,604      21,806
             

Net premiums earned

   $ 642,717    $ 659,211
             

Expenses

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies’ loss ratio, expense ratio, and combined ratio determined in accordance with GAAP:

 

     Three Months Ended June 30,  
     2010     2009  

Loss ratio

   68.4   67.6

Expense ratio

   30.6   28.5
            

Combined ratio

   99.0   96.1
            

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The slight increase in the loss ratio for the three months ended June 30, 2010 is primarily due to lower average premiums earned per policy.

The expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The expense ratio increased primarily due to the decreased net premiums earned and the Company’s financial contributions of $12.1 million related to Proposition 17 for the three months ended June 30, 2010.

The combined ratio 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; and a combined ratio over 100% generally reflects unprofitable underwriting results.

Income tax (benefit) expense for the three months ended June 30, 2010 and 2009 was $(2.5) million and $46.5 million, respectively. The decrease resulted primarily from the losses on the investment portfolio compared to the period ended June 30, 2009. For the three months ended June 30, 2010, the reduction in tax expense includes approximately $3 million in net benefit arising from a lower accrual for tax uncertainties.

 

27


Table of Contents

Investments

The following table presents the investment results of the Company:

 

     Three Months Ended June 30,  
     2010     2009  
     (Amounts in thousands)  

Average invested assets at cost (1)

   $ 3,092,652      $ 3,195,308   

Net investment income:

    

Before income taxes

   $ 36,475      $ 36,212   

After income taxes

   $ 32,599      $ 32,557   

Average annual yield on investments:

    

Before income taxes

     4.7     4.5

After income taxes

     4.2     4.1

Net realized investment (losses) gains

   $ (27,713   $ 99,862   

 

(1)

Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

Included in net income are net realized investment losses of $27.7 million and net realized investment gains of $99.9 million for the three months ended June 30, 2010 and 2009, respectively. Net realized investment (losses) gains include losses of $30.5 million and gains of $123.6 million for the three months ended June 30, 2010 and 2009, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net losses for the three months ended June 30, 2010 arose from a $44.2 million decline in the market value of the Company’s equity securities offset by a $14.4 million increase in the market value of the Company’s fixed maturity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for the three months ended June 30, 2010. The primary cause of the losses on the Company’s equity securities was the overall decline in the equity markets, especially in the oil sector as a result of the oil spill in the Gulf of Mexico.

Net Income

Net income was $17.8 million or $0.32 per diluted share and $114.4 million or $2.07 per diluted share in the three months ended June 30, 2010 and 2009, respectively. Diluted per share results were based on a weighted average of 54.8 million shares and 55.3 million shares in the three months ended June 30, 2010 and 2009, respectively. Basic per share results were $0.33 and $2.09 in the three months ended June 30, 2010 and 2009, respectively. Included in net income per share were net realized investment (losses) gains, net of income taxes, of $(0.33) and $1.23 per basic share, and $(0.33) and $1.21 per diluted share in the three months ended June 30, 2010 and 2009, respectively.

Six Months Ended June 30, 2010 compared to Six Months Ended June 30, 2009

Revenue

Net premiums earned and net premiums written for the six months ended June 30, 2010 decreased approximately 3.2% and 1.9%, respectively, from the corresponding period in 2009. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting continuing soft market conditions.

 

28


Table of Contents

The following is a reconciliation of total Company net premiums written to net premiums earned:

 

     Six Months Ended June 30,
     2010     2009
     (Amounts in thousands)

Net premiums written

   $ 1,283,575      $ 1,308,297

Change in unearned premium

     (244     16,977
              

Net premiums earned

   $ 1,283,331      $ 1,325,274
              

Expenses

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies’ loss ratio, expense ratio, and combined ratio determined in accordance with GAAP:

 

     Six Months Ended June 30,  
     2010     2009  

Loss ratio

   67.8   67.2

Expense ratio

   29.9   29.3
            

Combined ratio

   97.7   96.5
            

The loss ratio was affected by favorable development of approximately $22 million and $38 million on prior accident years’ losses and loss adjustment expense reserves for the six months ended June 30, 2010 and 2009, respectively.

The expense ratio was affected by the Company’s financial contributions of $12.1 million related to Proposition 17 for the six months ended June 30, 2010, and the impact of the amortization of AIS deferred commissions paid prior to the acquisition for the same period in 2009.

The combined ratio 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; and a combined ratio over 100% generally reflects unprofitable underwriting results.

Income tax expense for the six months ended June 30, 2010 and 2009 was $17.7 million and $89.9 million, respectively. The decrease in income tax expense resulted primarily from changes in the fair value of the investment portfolio. For the six months ended June 30, 2010, the reduction in tax expense includes approximately $3 million in net benefit arising from a lower accrual for tax uncertainties.

Investments

The following table presents the investment results of the Company:

 

     Six Months Ended June 30,  
     2010     2009  
     (Amounts in thousands)  

Average invested assets at cost (1)

   $ 3,112,463      $ 3,229,138   

Net investment income:

    

Before income taxes

   $ 72,361      $ 74,126   

After income taxes

   $ 64,797      $ 65,970   

Average annual yield on investments:

    

Before income taxes

     4.7     4.6

After income taxes

     4.2     4.1

Net realized investment (losses) gains

   $ (5,669   $ 181,176   

 

(1)

Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

 

29


Table of Contents

Included in net income are net realized investment losses of $5.7 million and net realized investment gains of $181.2 million for the six months ended June 30, 2010 and 2009, respectively. Net realized investment (losses) gains include losses of $11.6 million and gains of $214.4 million for the six months ended June 30, 2010 and 2009, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The losses for the six months ended June 30, 2010 arose from a $38.5 million decline in the market value of the Company’s equity securities offset by a $27.6 million increase in the market value of the Company’s fixed maturity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for the six months ended June 30, 2010. The primary cause of the losses on the Company’s equity securities was the overall decline in the equity markets, especially in the oil sector as a result of the oil spill in the Gulf of Mexico.

Net Income

Net income was $79.0 million or $1.44 per diluted share and $211.1 million or $3.83 per diluted share in the six months ended June 30, 2010 and 2009, respectively. Diluted per share results were based on a weighted average of 54.8 million shares and 55.2 million shares in the six months ended June 30, 2010 and 2009, respectively. Basic per share results were $1.44 and $3.85 in the six months ended June 30, 2010 and 2009, respectively. Included in net income per share were net realized investment (losses) gains, net of income taxes, of $(0.07) and $2.15 per basic share, and $(0.07) and $2.14 per diluted share in the six months ended June 30, 2010 and 2009, respectively.

LIQUIDITY AND CAPITAL RESOURCES

A. Cash Flows

The Company has generated positive cash flow from operations for over twenty consecutive years. 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. With combined cash and short-term investments of $323.2 million at June 30, 2010, the Company believes its cash flow from operations is 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 by operating activities in the six months ended June 30, 2010 was $52.0 million, a decrease of $54.3 million compared to the corresponding period in 2009. This decrease was primarily due to the increased payment of accrued expenses, the increased tax payment, and the contributions related to Proposition 17 during the six months ended June 30, 2010 compared with the corresponding period in 2009. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders and the purchase and development of information technology. Funds derived from the sale, redemption or maturity of fixed maturity investments of $224.9 million were primarily reinvested by the Company in high grade fixed maturity securities.

The following table presents the estimated fair value of fixed maturity securities at June 30, 2010 by contractual maturity in the next five years:

 

     Fixed Maturities
     (Amounts in thousands)

Due in one year or less

   $ 15,570

Due after one year through two years

     34,180

Due after two years through three years

     88,141

Due after three years through four years

     135,551

Due after four years through five years

     85,997
      
   $ 359,439
      

 

30


Table of Contents

B. Invested Assets

Portfolio Composition

An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company continues to believe that this strategy maintains the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a recognized market risk and consistent asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.

 

31


Table of Contents

The following table presents the composition of the total investment portfolio of the Company at June 30, 2010:

 

     June 30, 2010
     Cost (1)    Fair Value
     (Amounts in thousands)

Fixed maturity securities:

     

U.S. government bonds and agencies

   $ 8,738    $ 8,904

Municipal securities

     2,432,608      2,478,394

Mortgage-backed securities

     73,890      76,770

Corporate securities

     85,129      87,058

Collateralized debt obligations

     39,247      47,585
             
     2,639,612      2,698,711
             

Equity securities:

     

Common stock:

     

Public utilities

     21,910      23,738

Banks, trusts and insurance companies

     15,236      13,890

Industrial and other

     288,093      227,109

Non-redeemable preferred stock

     14,739      13,916
             
     339,978      278,653
             

Short-term investments

     104,400      103,740
             

Total investments

   $ 3,083,990    $ 3,081,104
             

 

(1)

Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

At June 30, 2010, 80.2% of the Company’s total investment portfolio at fair value and 91.6% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. 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 received deduction. At June 30, 2010, 86.1% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any material direct equity investment in subprime lenders.

During the six months ended June 30, 2010, the Company recognized approximately $5.7 million in net realized investment losses, which mainly include gains of approximately $29.6 million related to fixed maturity securities and losses of approximately $37.9 million related to equity securities. Included in the gains and losses were approximately $27.6 million in gains and approximately $38.5 million in losses due to changes in the fair value of the Company’s fixed maturity portfolio and equity security portfolio, respectively.

Fixed maturity securities

Fixed maturity securities include debt securities, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As 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. The nominal average maturity of the overall bond portfolio, including short-term bonds, was 12.0 years at June 30, 2010, which reflects a portfolio heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturity of the overall bond portfolio, including short-term bonds, was approximately 5.5 years, related to holdings which 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 4.3 years at June 30, 2010, including collateralized mortgage obligations with modified durations of approximately 2.0 years and short-term bonds 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. As it measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in interest rates; modified duration is considered a better indicator of price volatility than simple maturity alone.

 

32


Table of Contents

Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-, at fair value, consistent with December 31, 2009. To calculate the weighted-average credit quality ratings as disclosed throughout this Quarterly Report on Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At June 30, 2010, fixed maturity holdings rated below investment grade and non-rated bonds totaled $93.9 million and $96.2 million, respectively, at fair value, and represented approximately 3.5% and 3.6%, respectively, of total fixed maturity securities. At December 31, 2009, fixed maturity holdings rated below investment grade and non-rated bonds totaled $92.0 million and $109.9 million, respectively, and represented approximately 3.4% and 4.1%, respectively, of total fixed maturity securities.

 

33


Table of Contents

The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at June 30, 2010 at fair value. The Company’s estimated credit quality ratings are based on the average of ratings assigned by nationally recognized securities rating organizations. Credit ratings for the Company’s fixed maturity portfolio were stable during the six months ended June 30, 2010, with 77.7% of fixed maturity securities at fair value experiencing no change in their overall rating. Approximately 20.5% experienced upgrades during the period, partially offset by approximately 1.8% in credit downgrades. The majority of the upgrades were due to the credit adjustments made by Moody’s based on its global credit evaluation scale on municipal bonds. The majority of the downgrades were due to continued downgrading of the monoline insurance carried on much of the municipal holdings and further downgrading of non-agency mortgage-backed securities. The majority of the downgrades was slight and still within the investment grade portfolio, except for approximately $3.3 million at fair value was downgraded to below investment grade during the quarter.

 

     June 30, 2010  
                 (Amounts in thousands)              
     AAA     AA (2)     A (2)     BBB (2)     Non-Rated/Other     Total  

U.S. government bonds and agencies:

            

Treasuries

   $ 6,830      $ —        $ —        $ —        $ —        $ 6,830   

Government agency

     2,074        —          —          —          —          2,074   
                                                

Total

     8,904        —          —          —          —          8,904   
                                                
     100.0             100.0

Municipal securities:

            

Insured (1)

     16,560        681,300        636,943        44,337        46,292        1,425,432   

Uninsured

     252,327        326,271        272,174        145,325        56,865        1,052,962   
                                                

Total

     268,887        1,007,571        909,117        189,662        103,157        2,478,394   
                                                
     10.8     40.7     36.7     7.6     4.2     100.0

Mortgage-backed securities:

            

Agencies

     47,404        —          —          —          —          47,404   

Non-agencies:

            

Prime

     6,862        820        449        695        6,612        15,438   

Alt-A

     2,138        3,065        4,355        981        3,389        13,928   
                                                

Total

     56,404        3,885        4,804        1,676        10,001        76,770   
                                                
     73.5     5.0     6.3     2.2     13.0     100.0

Corporate securities:

            

Communications

     —          —          —          6,769        —          6,769   

Consumer - cyclical

     —          —          —          —          135        135   

Energy

     —          —          —          1,686        7,704        9,390   

Basic materials

     —          —          —          4,168        —          4,168   

Financial

     5,237        23,416        5,248        7,660        20,385        61,946   

Utilities

     —          —          —          3,551        1,099        4,650   
                                                

Total

     5,237        23,416        5,248        23,834        29,323        87,058   
                                                
     6.0     26.9     6.0     27.4     33.7     100.0

Collateralized debt obligations:

            

Corporate - hybrid

     —          —          —          —          47,585        47,585   
                                                

Total

     —          —          —          —          47,585        47,585   
                                                
             100.0     100.0

Total

   $ 339,432      $ 1,034,872      $ 919,169      $ 215,172      $ 190,066      $ 2,698,711   
                                                
     12.6     38.3     34.1     8.0     7.0     100.0

 

(1)

Insured municipal bonds based on underlying ratings: AAA: $14,257, AA: $508,901, A: $647,257, BBB: $83,012, Non-Rated/Other: $172,005

(2)

Intermediate ratings are offered at each level (e.g., AA includes AA+, AA and AA-).

(1) Municipal Securities

The Company had approximately $2.5 billion at fair value ($2.4 billion at amortized cost) in municipal bonds at June 30, 2010, with a net unrealized gain of $45.8 million. Over half of the municipal bond positions are insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was AA- at June 30, 2010.

 

34


Table of Contents

The following table presents the Company’s insured municipal bond portfolio by bond insurer at June 30, 2010 and at December 31, 2009.

 

     June 30, 2010    December 31, 2009

Municipal bond insurer

   Rating  (1)    Fair Value    Rating  (1)    Fair Value
          (Amounts in thousands)     

NATL-RE (MBIA)

   BBB    $ 755,687    BBB    $ 736,741

AMBAC

   CCC      233,024    CC      223,262

FSA

   AA      215,512    AA      199,386

XLCA

   CC      49,608    CC      46,060

ASSURED GTY

   AA      43,420    AA      42,966

RADIAN

   BB      14,431    BB      14,074

CIFG

   NR      17,481    CC      17,262

ACA

   NR      12,838    NR      14,469

FGIC

   NR      8,925    NR      3,885

BHAC

   AA      1,360    —        —  

Other

   NR      73,146    NR      92,553
                   
      $ 1,425,432       $ 1,390,658
                   

 

(1)

Management’s estimate of average of ratings issued by Standard & Poor’s, Moody’s and Fitch.

The Company considers the strength of the underlying credit as a buffer against potential market value declines which may result from future rating downgrades of the bond insurers. In addition, the Company has a long-term time horizon for its municipal bond holdings which generally allows it to recover the full principal amounts upon maturity, avoiding forced sales prior to maturity of bonds that have declined in market value due to the bond insurers’ rating downgrades. Based on the uncertainty surrounding the financial condition of these insurers, it is possible that there will be additional downgrades to below investment grade ratings by the rating agencies in the future, and such downgrades could impact the estimated fair value of municipal bonds.

At June 30, 2010, municipal securities included ARS. The Company owned $1.4 million and $3.3 million at fair value of ARS at June 30, 2010 and December 31, 2009, respectively. ARS are valued based on a discounted cash flow model with certain inputs that are not observable in the market and are considered Level 3 inputs.

(2) Mortgage-Backed Securities

The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for approximately $13.9 million and $14.0 million ($12.7 million and $13.2 million at amortized cost) of Alt-A mortgages at June 30, 2010 and December 31, 2009, respectively. Alt-A mortgage backed securities are at fixed or variable rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles than sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. At June 30, 2010, the Company had no holdings in commercial mortgage-backed securities.

The weighted-average rating of the Company’s Alt-A mortgage holdings is BBB+. For mortgage backed securities that have ratings, the weighted-average rating is AA.

(3) Corporate Securities

Included in fixed maturity securities are $87.1 million of corporate securities which have an average duration of 4.2 years at June 30, 2010. For corporate securities that have ratings, the weighted-average rating is A-.

(4) Collateralized Debt Obligations

Included in fixed maturities securities are collateralized debt obligations of $47.6 million, which represent approximately 1.5% of the total investment portfolio and have an average duration of 2.4 years at June 30, 2010.

 

35


Table of Contents

Equity securities

Equity holdings consist of non-redeemable preferred stocks and common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction. The net losses due to changes in fair value of the Company’s equity portfolio during the six months ended June 30, 2010 were $38.5 million. The primary cause of the losses on the Company’s equity securities was the overall decline in the equity markets, especially in the oil sector as a result of the oil spill in the Gulf of Mexico.

The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At June 30, 2010, 9.0% of the total investment portfolio at fair value was held in equity securities, compared to 9.1% at December 31, 2009.

Short-term investments

At June 30, 2010, short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities and redeemable within one year.

C. Debt

The Company has $125 million of senior notes, which are unsecured, senior obligations 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 believes that it is able to obtain sufficient capital to repay the obligations at maturity.

The Company has a $120 million credit facility and an $18 million bank loan that contain certain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk based capital ratio. As of June 30, 2010, the Company was in compliance with these covenants.

D. Regulatory Capital Requirement

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 the Insurance Companies of $1.5 billion at June 30, 2010, and net premiums written for the twelve months ended on that date of $2.6 billion, the ratio of premium writings to surplus was 1.7 to 1.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risks

The Company is subject to various market risk exposures primarily due to its investing and borrowing activities. Primary market risk exposures are changes in interest rates, equity prices, and credit risk. Adverse changes to these rates and prices may occur due to changes in the liquidity of a market, or to changes in market perceptions of creditworthiness and risk tolerance. The following disclosure reflects estimates of future performance and economic conditions. Actual results may differ.

Overview

The Company’s investment policies define the overall framework for managing market and investment risks, including accountability and controls over risk management activities, and specify the investment limits and strategies that are appropriate given the liquidity, surplus, product profile, and regulatory requirements of the subsidiaries. Executive oversight of investment activities is conducted primarily through the Company’s investment committee. The Company’s investment committee focuses on strategies to enhance after-tax yields, mitigate market risks, and optimize capital to improve profitability and returns.

The Company manages exposures to market risk through the use of asset allocation, duration, and credit ratings. Asset allocation limits place restrictions on the total funds that may be invested within an asset class. Duration limits on the fixed maturities portfolio place restrictions on the amount of interest rate risk that may be taken. Comprehensive day-to-day management of market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon the acceptable boundaries established by investment policies.

 

36


Table of Contents

Credit risk

Credit risk is risk due to uncertainty in a counterparty’s ability to meet its obligations. Credit risk is managed by maintaining a high credit quality fixed maturities portfolio. As of June 30, 2010, the weighted-average credit quality rating of the fixed maturities portfolio was AA-, at fair value, consistent with December 31, 2009. Historically, the ten-year default rate per Moody’s for AA rated municipal bonds has been less than 1%. The Company’s municipal bond holdings, which represent 91.8% of its fixed maturity portfolio at June 30, 2010, at fair value, are broadly diversified geographically. Approximately 99.7% of municipal bond holdings are tax-exempt. The largest holdings are in populous states such as Texas (15.1%) and California (11.2%); however, such holdings are further diversified primarily among cities, counties, schools, public works, hospitals, and state general obligations. In California, the Company owns approximately $2.3 million at fair value of general obligations of the state at June 30, 2010. Credit risk is addressed by limiting exposure to any particular issuer to ensure diversification. Taxable fixed maturity securities represent 8.4% of the Company’s fixed maturity portfolio. Approximately 24.8% of the Company’s taxable fixed maturity securities were comprised of U.S. government bonds and agencies and mortgage-backed securities (agencies), which were rated AAA at June 30, 2010. Approximately 14.5% of the Company’s taxable fixed maturity securities were rated below investment grade. Below investment grade issues are considered “watch list” items by the Company, and their status is evaluated within the context of the Company’s overall portfolio and its investment policy on an aggregate risk management basis, as well as their ability to recover their investment on an individual issue basis.

Equity price risk

Equity price risk is the risk that the Company will incur losses due to adverse changes in the general levels of the equity markets.

At June 30, 2010, the Company’s primary objective for common equity investments is current income. The fair value of equity investments consists of $264.7 million in common stocks and $13.9 million in non-redeemable preferred stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market. The current market expectation is less optimistic than in the prior quarter following weaker economic data. The Company has retained more in the energy sector relative to the S&P 500 Index to hedge against potential inflationary pressures on the equity markets possible in a sudden economic recovery.

The common equity portfolio represents approximately 8.6% of total investments at fair value. 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 1.23 at June 30, 2010. Based on a hypothetical 25% or 50% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by approximately $81.4 million or $162.8 million, respectively.

Interest rate risk

Interest rate risk is the risk that the Company will incur a loss due to adverse changes in interest rates relative to the interest rate characteristics of interest bearing assets and liabilities. This risk arises from many of its primary activities, as the Company invests substantial funds in interest sensitive assets and issues interest sensitive liabilities. Interest rate risk includes risks related to changes in U.S. Treasury yields and other key benchmarks, as well as changes in interest rates resulting from the widening credit spreads and credit exposure to collateralized securities.

The value of the fixed maturity portfolio, which represents 87.6% of total investments at fair value, is subject to interest rate risk. As market interest rates decrease, the value of the portfolio increases and vice versa. 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 has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy resulted in a portfolio with a moderate duration. Bond investments made by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The decrease in municipal bond credit spreads in 2010 caused overall interest rates to decrease, which resulted in the decrease in the duration of the Company’s portfolio. Consequently, the modified duration of the bond portfolio reflecting anticipated early calls, including short-term bonds, was 4.3 years at June 30, 2010 compared to 5.1 years at December 31, 2009. Given a hypothetical parallel increase of 100 basis or 200 basis points in interest rates, the fair value of the bond portfolio at June 30, 2010 would decrease by approximately $120.5 million or $241.0 million, respectively.

 

37


Table of Contents

Interest rate swaps are used to manage interest rate risk associated with the Company’s loans with fixed or floating rates. On February 6, 2009, the Company entered into an interest swap of its floating LIBOR rate on the $120 million credit facility for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. On March 3, 2008, the Company entered into an interest rate swap of a floating LIBOR rate on an $18 million bank loan for a fixed rate of 3.75%, resulting in a total fixed rate of 4.25%. In addition, effective January 2, 2002, the Company entered into an interest rate swap of a 7.25% fixed rate obligation on its $125 million senior notes for a floating rate of LIBOR plus 107 basis points.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

As required by Securities and Exchange Commission Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this Quarterly Report on Form 10-Q. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company’s process for evaluating controls and procedures is continuous and encompasses constant improvement of the design and effectiveness of established controls and procedures and the remediation of any deficiencies which may be identified during this process.

PART II - OTHER INFORMATION

 

Item 1. 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 which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. Additionally, from time to time, regulators may take actions to challenge the Company’s business practices. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations in the period of such ruling; however, none is expected to be material to the Company’s financial position. For a discussion of the Company’s pending material litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

There are no environmental proceedings arising under federal, state, or local laws or regulations to be discussed.

 

Item 1A. Risk Factors

The Company’s business, results of operations, and financial condition are subject to various risks. These risks are described elsewhere in this Quarterly Report on Form 10-Q and in its other filings with the United States Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The risk factors identified in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 have not changed in any material respect.

 

38


Table of Contents
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

 

Item 3. Defaults Upon Senior Securities

None

 

Item 4. (Removed and Reserved)

 

Item 5. Other Information

On July 30, 2010, the Company’s Board of Directors approved an amendment to the Plan to remove non-employee directors from the eligible participants in the Plan. The amendment is filed as Exhibit 10.1 hereto, and is incorporated herein by reference.

 

Item 6. Exhibits

 

10.1

  

Amendment No. 1 to Mercury General Corporation 2005 Equity Incentive Award Plan.

15.1

  

Report of Independent Registered Public Accounting Firm

15.2

  

Awareness Letter of Independent Registered Public Accounting Firm

31.1

  

Certification of Registrant’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

  

Certification of Registrant’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

  

Certification of Registrant’s Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.

32.2

  

Certification of Registrant’s Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. This certification is being furnished solely to accompany this Quarterly Report on Form 10-Q and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company.

101

  

The following financial information from the Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2010, formatted in XBRL (Extensible Business Reporting Language) and furnished electronically herewith: (i) the Consolidated Balance Sheets; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Comprehensive Income; (iv) the Consolidated Statements of Cash Flows; and (v) the Condensed Notes to the Consolidated Financial Statements, tagged as blocks or text.

 

39


Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    MERCURY GENERAL CORPORATION

Date: August 4, 2010

   

By:

 

/s/ Gabriel Tirador

        Gabriel Tirador
        President and Chief Executive Officer

Date: August 4, 2010

   

By:

 

/s/ Theodore Stalick

        Theodore Stalick
        Vice President and Chief Financial Officer

 

40

EXHIBIT 10.1

AMENDMENT NO. 1

TO

MERCURY GENERAL CORPORATION

2005 EQUITY INCENTIVE AWARD PLAN

WHEREAS, Mercury General Corporation (the “Company”) maintains the Mercury General Corporation 2005 Equity Incentive Award Plan (the “Plan”); and

WHEREAS, the Company desires to amend the plan as set forth herein to eliminate any participation in the Plan by non-employee Directors of the Company;

NOW, THEREFORE, the Plan is amended as follows:

1. Amendment to Article 1 . Article 1 of the Plan is hereby amended in its entirety to read as follows:

“The purpose of the Mercury General Corporation 2005 Equity Incentive Award Plan (the “ Plan ”) is to promote the success and enhance the value of Mercury General Corporation (the “ Company ”) by linking the personal interests of Employees to those of Company stockholders and by providing such individuals with an incentive for outstanding performance to generate superior returns to Company stockholders. The Plan is further intended to provide flexibility to the Company in its ability to motivate, attract, and retain the services of Employees upon whose judgment, interest, and special effort the successful conduct of the Company’s operation is largely dependent.”

2. Amendment to Section 1.1 . Section 1.1 of the Plan is hereby amended in its entirety to read as follows:

“1.1 “ Eligible Individual ” means any person who is an Employee, as determined by the Committee.”

3. Amendment to Section 1.6 . Section 1.6 of the Plan is hereby amended in its entirety to read as follows:

“1.6 Intentionally Omitted.”

4. Amendment to Section 1.11 . Section 1.11 of the Plan is hereby amended in its entirety to read as follows:

“1.11 “ Participant ” means any Eligible Individual who has been granted an Award pursuant to the Plan.”


5. Amendment to Section 5.1(c) . Section 5.1(c) of the Plan is hereby amended in its entirety to read as follows:

“(c) Payment . The Committee shall determine the methods by which the exercise price of an Option may be paid, the form of payment, including, without limitation: (i) cash, (ii) promissory note bearing interest at no less than such rate as shall preclude the imputation of interest under the Code, (iii) shares of Stock held for such period of time as may be required by the Committee in order to avoid adverse accounting consequences and having a Fair Market Value on the date of delivery equal to the aggregate exercise price of the Option or exercised portion thereof, or (iv) other property acceptable to the Committee (including through the delivery of a notice that the Participant has placed a market sell order with a broker with respect to shares of Stock then issuable upon exercise of the Option, and that the broker has been directed to pay a sufficient portion of the net proceeds of the sale to the Company in satisfaction of the Option exercise price; provided that payment of such proceeds is then made to the Company upon settlement of such sale), and the methods by which shares of Stock shall be delivered or deemed to be delivered to Participants. Notwithstanding any other provision of the Plan to the contrary, no Participant who is an “executive officer” of the Company within the meaning of Section 13(k) of the Exchange Act shall be permitted to pay the exercise price of an Option in any method which would violate Section 13(k) of the Exchange Act.”

6. Deletion of Section 5.5 . Section 5.5 of the Plan is hereby deleted in its entirety.

7. Amendment to Section 8.10 . Section 8.10 of the Plan is hereby amended in its entirety to read as follows:

“8.10 Exercise Upon Termination of Employment or Service . An Award of Performance Shares, Performance Stock Units, Dividend Equivalents, Deferred Stock, Stock Payments, Restricted Stock Units and Other Stock-Based Award shall only be exercisable or payable while the Participant is an Employee; provided, however , that the Committee in its sole and absolute discretion may provide that an Award of Performance Shares, Performance Stock Units, Dividend Equivalents, Stock Payments, Deferred Stock, Restricted Stock Units or Other Stock-Based Award may be exercised or paid subsequent to a termination of employment or service, as applicable, or because of the Participant’s retirement, death or disability, or otherwise; provided, however , that any such provision with respect to Performance Shares or Performance Stock Units shall be subject to the requirements of Section 162(m) of the Code that apply to Qualified Performance-Based Compensation.”

8. Amendment to Section 12.1 . Section 12.1 of the Plan is hereby amended in its entirety to read as follows:

“12.1 Committee . Unless and until the Board delegates administration of the Plan to a Committee as set forth below, the Plan shall be administered by the full Board, and for such purposes the term “Committee” as used in this Plan shall be deemed to refer to the Board. The Board, at its discretion or as otherwise necessary to comply with the requirements of Section 162(m) of the Code, Rule 16b-3 promulgated under the Exchange Act or to the extent required by any other applicable rule or regulation, shall delegate administration of the Plan to a

 

2


Committee. The Committee shall consist solely of two or more members of the Board each of whom is both an “outside director,” within the meaning of Section 162(m) of the Code and any other applicable rules and regulations, and a Non- Employee Director. Notwithstanding the foregoing, the Committee may delegate its authority hereunder to the extent permitted by Section 12.5. Appointment of Committee members shall be effective upon acceptance of appointment. The Board may abolish the Committee at any time and revest in the Board the administration of the Plan. Committee members may resign at any time by delivering written notice to the Board. Vacancies in the Committee may only be filled by the Board.”

9. Amendment to Section 12.5 . Section 12.5 of the Plan is hereby amended in its entirety to read as follows:

“12.5 Delegation of Authority . To the extent permitted by applicable law, the Committee may from time to time delegate to a committee of one or more members of the Board or one or more officers of the Company the authority to grant or amend Awards to Participants other than (a) senior executives of the Company who are subject to Section 16 of the Exchange Act, (b) Covered Employees, or (c) officers of the Company to whom authority to grant or amend Awards has been delegated hereunder. Any delegation hereunder shall be subject to the restrictions and limits that the Committee specifies at the time of such delegation, and the Committee may at any time rescind the authority so delegated or appoint a new delegatee. At all times, the delegatee appointed under this Section 12.5 shall serve in such capacity at the pleasure of the Committee.”

*  *  *  *  *

I hereby certify that the foregoing Amendment No. 1 was duly adopted by the Board of Directors of Mercury General Corporation on July 30, 2010.

 

/s/ Judith A. Walters

Corporate Secretary

 

3

EXHIBIT 15.1

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Mercury General Corporation:

We have reviewed the consolidated balance sheet of Mercury General Corporation and subsidiaries as of June 30, 2010, the related consolidated statements of operations and comprehensive income for the three-month and six-month periods ended June 30, 2010 and 2009, and the related consolidated statements of cash flows for the six-month periods ended June 30, 2010 and 2009. These condensed consolidated financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Mercury General Corporation and subsidiaries as of December 31, 2009, and the related consolidated statements of operations, comprehensive income (loss), shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated February 18, 2010, we expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Los Angeles, California

August 4, 2010

EXHIBIT 15.2

Awareness Letter of Independent Registered Public Accounting Firm

August 4, 2010

Mercury General Corporation

Los Angeles, California

 

Re:

Registration Statement Nos. 333-62228, 333-01583 and 333-125460

With respect to the subject registration statements, we acknowledge our awareness of the use therein of our report dated August 4, 2010 related to our review of interim financial information.

Pursuant to Rule 436 under the Securities Act of 1933 (the Act), such report is not considered part of a registration statement prepared or certified by an independent registered public accounting firm, or a report prepared or certified by an independent registered public accounting firm within the meaning of Sections 7 and 11 of the Act.

/s/ KPMG LLP

Los Angeles, California

EXHIBIT 31.1

Certification of Chief Executive Officer

Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Gabriel Tirador, certify that:

 

1.

I have reviewed this Quarterly Report on Form 10-Q of Mercury General Corporation;

 

2.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

  a)

designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

  b)

designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;

 

  c)

evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

  d)

disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 

  a)

all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

  b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Date: August 4, 2010

   

/s/ GABRIEL TIRADOR

   

Gabriel Tirador, Chief Executive Officer

EXHIBIT 31.2

Certification of Chief Financial Officer

Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Theodore Stalick, certify that:

 

1.

I have reviewed this Quarterly Report on Form 10-Q of Mercury General Corporation;

 

2.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

 

3.

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

 

4.

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

  a)

designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

 

  b)

designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;

 

  c)

evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

 

  d)

disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

 

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

 

  a)

all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

 

  b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

 

Date: August 4, 2010

   

/s/ THEODORE STALICK

   

Theodore Stalick, Vice President and Chief Financial Officer

EXHIBIT 32.1

Certification of Chief Executive Officer

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant to 18 U.S.C. §1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002, the undersigned officer of Mercury General Corporation (the “ Company ”) hereby certifies, to such officer’s knowledge, that:

 

  (i)

the accompanying Quarterly Report on Form 10-Q of the Company for the period ended June 30, 2010 (the “ Report ”) fully complies with the requirements of Section 13(a) or Section 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and

 

  (ii)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

 

Date: August 4, 2010

   

/s/ GABRIEL TIRADOR

   

Gabriel Tirador, Chief Executive Officer

The foregoing certification is being furnished solely to accompany the Report pursuant to 18 U.S.C. §1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and are not to be incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

EXHIBIT 32.2

Certification of Chief Financial Officer

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Pursuant to 18 U.S.C. §1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002, the undersigned officer of Mercury General Corporation (the “ Company ”) hereby certifies, to such officer’s knowledge, that:

 

  (i)

the accompanying Quarterly Report on Form 10-Q of the Company for the period ended June 30, 2010 (the “ Report ”) fully complies with the requirements of Section 13(a) or Section 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and

 

  (ii)

the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

 

Date: August 4, 2010

   

/s/ THEODORE STALICK

   

Theodore Stalick, Vice President and Chief Financial Officer

The foregoing certification is being furnished solely to accompany the Report pursuant to 18 U.S.C. §1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and are not to be incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.