Fitch Ratings has affirmed Mercury General Corporation's (MCY) property/casualty (P/C) operating subsidiaries' Insurer Financial Strength (IFS) ratings at 'A' (Strong).

Fitch has also affirmed MCY's Long-Term Issuer Default Rating (IDR) at 'BBB+' and its senior debt at 'BBB'. The Rating Outlooks have been revised to Negative from Stable.

The Outlook revision to Negative primarily reflects deterioration in 2022 underwriting results, operating environment challenges to returning to near-term underwriting profitability in 2023 and statutory capital declines.

Key Rating Drivers

Performance: Mercury reported a 9M22 GAAP combined ratio of 106.3%, compared to 95.8% in the prior year period. Underwriting result deterioration is driven by heightened severity for auto business over the past year, driven by inflationary pressures on the cost of auto parts and labor, as well as medical expenses for bodily injuries. The company has addressed loss trends with various non-rate actions across its portfolio and rate increases outside of California.

MCY's ability to return to favorable performance in 2023 will largely depend on the company's ability to get earned rate increases into its book, as well as the direction of loss trends.

Capitalization: Operating subsidiary capitalization declined in 9M22, with statutory surplus declining by approximately 13% to $1.59 billion, down from $1.83 billion at YE 2021. Fitch expects that MCY will maintain strong overall capital levels. However, Prism capital model results and traditional leverage metrics are expected to be pressured by the P/C statutory surplus decline in 2022. MCY maintains financial leverage consistent with the rating level of 19.6% at Sept. 30, 2022, an increase from 14.8% at YE 2021 as the company reported a 28% in GAAP equity through 9M22.

Coverage and Financial Flexibility: GAAP fixed-charge coverage declined to (4.6x) in 9M22, primarily driven by underwriting loss in the period, following strong coverage metrics reported in recent years. Average coverage in the three years prior (2019-2021) was 15x. Financial flexibility and liquidity remain strong with the company's holding company cash and short-term invested assets totaling approximately $74 million as of Dec. 31, 2021. MCY has no near-term debt maturity issues with its senior notes due in 2027. The company also has access to an unsecured credit agreement with a borrowing capacity of $75 million that was undrawn as of Sept. 30, 2022.

Reserve Development: The company's 9M22 results included $50 million of adverse prior-year reserve development (1.7% of 9M22 net earned premiums), primarily related to inflationary pressures in the personal auto business. Calendar-year results have generally included modest reserve charges in recent years (2017-2021), when prior-year adverse development averaged 0.9% of net earned premiums.

Company Profile: MCY is the sixth largest writer of personal automobile insurance in California (direct written premium at YE 2021). Roughly 81% of MCY's premiums were generated in California in 9M22, and 65% of premiums are derived from personal auto insurance in 9M22. Fitch believes that MCY's extensive history in California and strong relationship with its independent agent network is a key factor supporting its competitive position.

Risk Management: In its analysis of MCY, Fitch believes its assessment of reinsurance, risk mitigation and catastrophe risk has a higher influence on the company's ratings. MCY's has managed its exposure to wildfire risk with conservative underwriting guidelines, aggregation management and purchase of substantially higher catastrophe reinsurance limits in recent years including the program renewal in 2022. Fitch believes MCY's ability to purchase reinsurance in line with its targeted levels as critical to managing this risk factor, which is currently consistent with the company's ratings.

RATING SENSITIVITIES

Factors That Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade:

Deterioration in MCY's capitalization as measured by Fitch's Prism capital model score maintained below 'Strong';

An increase in statutory net leverage to over 5.3x;

Financial leverage above 25%;

Sustained combined ratio over 103% and operating ratio over 99%;

An outsized catastrophe loss experience that leads to a material reduction in capital.

Factors That Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:

Sustained combined ratios near 100% or better and operating returns on equity above 8% could lead to a return to a Stable Outlook;

Improvement in statutory capitalization, including a Prism score maintained at the 'Strong' category;

Further evolution of MCY's business profile that includes broader premium scale and geographic diversification, coupled with consistent profitability and book value growth.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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