MERCURY GENERAL CORPORATION Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for certain forward-looking statements. Certain statements contained in this report are forward-looking statements based on the Company's current expectations and beliefs concerning future developments and their potential effects on the Company. There can be no assurance that future developments affecting the Company will be those anticipated by the Company. Actual results may differ from those projected in the forward-looking statements. These forward-looking statements involve significant risks and uncertainties (some of which are beyond the control of the Company) and are subject to change based upon various factors, including but not limited to the following risks and uncertainties: changes in the demand for the Company's insurance products, inflation and general economic conditions, including general market risks associated with the Company's investment portfolio; the accuracy and adequacy of the Company's pricing methodologies; catastrophes in the markets served by the Company; uncertainties related to estimates, assumptions and projections generally; the possibility that actual loss experience may vary adversely from the actuarial estimates made to determine the Company's loss reserves in general; the Company's ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in the states where it operates; legislation adverse to the automobile insurance industry or business generally that may be enacted in the states where the Company operates; the Company's success in managing its business in non-California states; the presence of competitors with greater financial resources and the impact of competitive pricing and marketing efforts; the ability of the Company to successfully manage its claims organization outside ofCalifornia ; the Company's ability to successfully allocate the resources used in the states with reduced or exited operations to its operations in other states; changes in driving patterns and loss trends; acts of war and terrorist activities; pandemics, epidemics, widespread health emergencies, or outbreaks of infectious diseases; court decisions and trends in litigation and health care and auto repair costs; and legal, cybersecurity, regulatory and litigation risks. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as the result of new information, future events or otherwise. For a more detailed discussion of some of the foregoing risks and uncertainties, see the Company's Annual Report on Form 10-K filed with theSecurities and Exchange Commission onFebruary 12, 2020 . 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, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty insurance 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 significant 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 consolidated financial statements and notes thereto, and all other items contained within this Quarterly Report on Form 10-Q.
Note on COVID-19
InMarch 2020 , the outbreak of COVID-19 was recognized as a pandemic by theWorld Health Organization (the "WHO"), and the outbreak has become increasingly widespread inthe United States , including in the markets in which the Company operates. The pandemic has had a notable impact on general economic conditions, including, but not limited to, the temporary closures of many businesses, "shelter in place" and other governmental orders, and reduced consumer spending. The Company is following guidelines established by theCenters for Disease Control , theWHO and orders issued by the state and local governments in which the Company operates. The Company has taken a number of precautionary steps to safeguard its business and employees from COVID-19, including activating its Business Continuity Plan. Most of the Company's employees have been working remotely, with only certain operationally critical employees working on site at various locations. The Company is monitoring and assessing the impact of the COVID-19 pandemic daily, including recommendations and orders issued by federal, state and local governments. InJuly 2020 , the Company extended its "work-from-home" policy for most of its employees to the end of 2020 based on the latest information on the pandemic's developments. 27 -------------------------------------------------------------------------------- Table of Contents The Company's automobile line of business began experiencing a significant decrease in loss frequency in mid to late March, and it remained low throughout the second quarter of 2020 compared to the historical levels, although it began to increase inJune 2020 as more drivers returned to the road following the gradual reopening of businesses inCalifornia and other states. The reduction in auto loss frequency was primarily due to reduced driving due to the shelter-in-place orders issued by state and local governments. Due to the uncertainty regarding COVID-19, it is unclear how long auto loss frequency will remain at these lower levels. Conversely, the severity of accidents, for both bodily injury and the cost to repair vehicles, has increased primarily due to high-speed serious accidents on less congested roads and freeways. The cost to repair vehicles may continue to increase due to supply chain and labor force issues. In addition, the Company's net premiums earned was negatively impacted as a result of premium refunds and credits voluntarily issued to policyholders by the Company, and also in compliance with the requests and directives from the California Insurance Commissioner (see C. Regulatory and Legal Matters below for additional details) and other insurance regulators in other states. COVID-19 is also impacting the ability of some of the Company's policyholders to pay their insurance premiums, and the Company has granted limited grace periods to those needing financial assistance. Many businesses have been required by state and local governments to cease or substantially reduce operations, and have suffered severe financial losses as a result. Many of these businesses have submitted claims to their insurers under the business interruption coverage of their commercial property policies, resulting in coverage disputes in many states. While the Company does insure a modest number of businesses with this business interruption coverage, these pandemic-related losses are not covered under the Company's policy terms and conditions. The Company's business interruption, or "business income" coverage, requires a "direct physical loss" to the property that results in suspension of operations, such as a fire or water loss. The coverage is not triggered under the present circumstances. Most of the Company's policies also contain an exclusion for losses caused directly or indirectly by "virus or bacteria." This exclusion was adopted by many insurers after the SARS outbreak of 2003-2004, upon recognition that such a pandemic could result in losses far exceeding the capacity of individual insurers and the private insurance market as a whole. The Company does not believe it has any material exposure to business interruption claims. Due to disruptions in the equity and fixed maturity securities markets following the outbreak of the COVID-19 pandemic, the Company's investment portfolio substantially declined in value during the quarter endedMarch 31, 2020 , which resulted in large net realized investment losses in its consolidated statements of operations due to the application of the fair value option for its investment portfolio (see Note 4. Fair Value Option of the Notes to its Consolidated Financial Statements). Such decline in the fair value of the Company's investment portfolio has substantially recovered during the second quarter of 2020. InMarch 2020 , theFederal Open Market Committee ("FOMC") unveiled a set of aggressive measures to cushion the economic impact of the global COVID-19 crisis, including, among others, cutting the federal funds rate by 100 basis points to a range of 0.00% to 0.25% and establishing a series of emergency credit facilities in an effort to support the flow of credit in the economy, easing liquidity pressure and calming market turmoil. While volatility in the financial markets remains elevated, overall market liquidity concerns have eased following the actions taken by theFOMC . The Company believes that it will continue to have sufficient liquidity to support its business operations during the COVID-19 crisis and beyond without the forced sale of investments, based on its existing cash and short-term investments, future cash flows from operations, and$50 million of undrawn credit in its revolving credit facility. OnMarch 27, 2020 , the President ofthe United States signed the Coronavirus Aid, Relief, and Economic Security ("CARES") Act, a substantial tax-and-spending package intended to provide additional economic stimulus to address the financial impact of the COVID-19 pandemic. The CARES Act includes, among other items, cash payments to individuals as well as emergency grants and forgivable loans to small businesses, if they meet certain criteria. To the extent the Company's existing or potential policyholders, both individuals and businesses, and its independent agents are aided by such CARES Act programs, the negative impact of the pandemic on its results of operations due to the reduced premiums written or increased uncollectible premiums may be mitigated. The Company continues to monitor the impact of the COVID-19 pandemic closely, as well as any effects that may result from the CARES Act. The extent of the impact of the pandemic on the Company's business and financial results will depend largely on future developments, including the duration of the pandemic, its impact on capital and financial markets and the related impact on consumer confidence and spending, the success of efforts to contain it, and the impact of actions taken in response, all of which are highly uncertain and cannot be predicted. As the impact of the COVID-19 pandemic continues to evolve, additional impacts may arise of which the Company is not currently aware.
B. Business
The Company is primarily engaged in writing personal automobile insurance
through 14 insurance subsidiaries ("Insurance Companies") in 11 states,
principally California . The Company also writes homeowners, commercial
automobile, commercial property, mechanical protection, and umbrella insurance.
The Company's insurance policies are mostly sold through independent agents who
receive a commission for selling policies. The Company believes that it has
thorough
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underwriting and claims handling processes that, together with its agent
relationships, provide the Company with competitive advantages.
The following tables present direct premiums written, by state and line of
insurance business, for the six months ended
Six Months Ended June 30, 2020
(Dollars in thousands)
Private Commercial
Passenger Automobile Homeowners Automobile Other Lines Total
California (1) $ 1,115,535 $ 283,606 $ 77,631 $ 68,206 $ 1,544,978 86.5 %
Other states (2) (3) 149,868 44,554 39,914 7,377 241,713 13.5 %
Total $ 1,265,403 $ 328,160 $ 117,545 $ 75,583 $ 1,786,691 100.0 %
70.8 % 18.4 % 6.6 % 4.2 % 100.0 %
Six Months Ended
(Dollars in thousands)
Private Commercial
Passenger Automobile Homeowners Automobile Other Lines Total
California $ 1,230,853 $ 252,608 $ 68,901 $ 58,894 $ 1,611,256 86.2 %
Other states (3) 172,065 37,318 41,278 6,254 256,915 13.8 %
Total $ 1,402,918 $ 289,926 $ 110,179 $ 65,148 $ 1,868,171 100.0 %
75.1 % 15.5 % 5.9 % 3.5 % 100.0 %
______________
(1) California private passenger automobile and commercial automobile direct
premiums written were reduced by approximately $92 million and $4 million ,
respectively, due to premium refunds and credits under the "Mercury Giveback"
program associated with reduced driving during the COVID-19 pandemic.
(2) Other states private passenger automobile and commercial automobile direct
premiums written were reduced by approximately $8 million and $1 million ,
respectively, due to premium refunds and credits, as described above.
(3) No individual state accounted for more than 4% of total direct premiums
written.
C. Regulatory and Legal Matters
The Department of Insurance ("DOI") in each state in which the Company operates is responsible for conducting periodic financial, market conduct, and rating and underwriting examinations of the Insurance Companies in their states. Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing, and other practices.
During the course of and at the conclusion of these examinations, the examining
DOI generally reports findings to the Company. There were no examinations
outstanding at
OnApril 13, 2020 , the California Insurance Commissioner issued Bulletin 2020-3 ordering insurers to make an initial premium adjustment within 120 days from the date of the Bulletin 2020-3 to adversely impactedCalifornia policyholders for the months of March andApril 2020 . The Commissioner granted insurers flexibility in determining how to quickly and fairly process the premium refunds. OnMay 15, 2020 , the California Insurance Commissioner issued Bulletin 2020-4 extending the directives in Bulletin 2020-3 throughMay 31, 2020 . OnJune 25, 2020 , the California Insurance Commissioner issued Bulletin 2020-8 extending the previous directives of Bulletin 2020-3 and Bulletin 2020-4 throughJune 30, 2020 , as well as any months subsequent toJune 2020 if the COVID-19 pandemic continues to result in projected loss exposures remaining overstated or misclassified. The total amount of premiums returned to the Company's policyholders through refunds or credits for March through June of 2020 is expected to be approximately$106 million . The Company's net premiums earned and written were reduced by approximately$106 million for the three and six months endedJune 30, 2020 as a result of these premium refunds and credits.
In each of February and
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of insurance business, which represented approximately 14% of the Company's
total net premiums earned for the six months ended June 30, 2020 . The Company
implemented the February rate increase in April 2020 and expects to implement
the July rate increase in October 2020 .
In July 2019 , the governor of California signed a bill that created a $21
billion fund (the "California Wildfire Fund ") to help then bankrupt PG&E and the
state's other investor-owned utility companies cover liabilities arising from
future wildfires caused by their equipment. The bill requires investor-owned
utility companies to put up half of the money in the California Wildfire Fund .
The other half comes from surcharges paid by ratepayers across the state. In
order to access the California Wildfire Fund , PG&E had to emerge from its
bankruptcy proceedings by June 30, 2020 . On July 1, 2020 , PG&E made an
announcement that it emerged out of bankruptcy and made an initial deposit of
approximately $5 billion to the California Wildfire Fund . It is expected that
the Company and other insurers will be reimbursed for some portion of the claims
paid for its policyholders if it is determined that a future wildfire is caused
by equipment failure. The announcement also confirmed that PG&E has funded the
Subrogation Trust Fund with $11 billion , which was set up to reimburse insurance
companies and other entities that paid claims by individuals and businesses
related to wildfires in recent years. The Company recognized approximately $16
million , net of fees, in the second quarter of 2020 in anticipation of the
initial distribution from this fund to the Company for certain claims paid to
its policyholders related to recent wildfires. However, the subrogation recovery
recognized was for losses and loss adjustment expenses previously ceded to the
Company's reinsurers, and therefore the recovery did not reduce losses and loss
adjustment expenses net of reinsurance. The benefit to the Company, net of
reinsurance and before taxes, was approximately $2 million , representing a
reduction to reinstatement premiums previously recognized.
The Company is, from time to time, named as a defendant in various lawsuits or
regulatory actions incidental to its insurance business. The majority of
lawsuits brought against the Company relate to insurance claims that arise in
the normal course of business and are reserved for through the reserving
process. For a discussion of the Company's reserving methods, see the Company's
Annual Report on Form 10-K for the year ended December 31, 2019 .
The Company establishes reserves for non-insurance claims related lawsuits,
regulatory actions, and other contingencies when the Company believes a loss is
probable and is able to estimate its potential exposure. For loss contingencies
believed to be reasonably possible, the Company also discloses the nature of the
loss contingency and an estimate of the possible loss, range of loss, or a
statement that such an estimate cannot be made. While actual losses may differ
from the amounts recorded and the ultimate outcome of the Company's pending
actions is generally not yet determinable, the Company does not believe that the
ultimate resolution of currently pending legal or regulatory proceedings, either
individually or in the aggregate, will have a material adverse effect on its
financial condition or cash flows.
In all cases, the Company vigorously defends itself unless a reasonable
settlement appears appropriate. For a discussion of legal matters, see the
Company's Annual Report on Form 10-K for the year ended December 31, 2019 , and
Note 12. Contingencies of the Notes to Consolidated Financial Statements of this
Quarterly Report.
D. Critical Accounting Policies and Estimates
Loss and Loss Adjustment Expense Reserves ("Loss Reserves")
Preparation of the Company's consolidated financial statements requires
management's 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 loss
reserve that is required. A key assumption in estimating loss reserves is the
degree to which the historical data used to analyze reserves will be predictive
of ultimate claim costs on incurred claims. Changes in the regulatory and legal
environments, results of litigation, medical costs, the cost of repair
materials, and labor rates, among other factors, can impact this assumption. In
addition, time can be a critical part of reserving determinations since the
longer the span between the incidence of a loss and the payment or settlement of
a claim, the more variable the ultimate settlement amount could be. Accordingly,
short-tail claims, such as property damage claims, tend to be more reasonably
predictable than long-tail liability claims.
The Company calculates a loss reserve point estimate rather than a range. There
is inherent uncertainty with estimates and this is particularly true with loss
reserve estimates. This uncertainty comes from many factors which may include
changes in claims reporting and settlement patterns, changes in the regulatory
and legal environments, uncertainty over inflation rates, and uncertainty for
unknown items. The Company does not make specific provisions for these
uncertainties, rather it considers them in establishing its loss reserve by
reviewing historical patterns and trends and projecting these out to current
loss reserves. The underlying factors and assumptions that serve as the basis
for preparing the loss reserve estimate include paid and incurred loss
development factors, expected average costs per claim, inflation trends,
expected loss ratios, industry data, and other relevant information.
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The Company also engages independent actuarial consultants to review the
Company's loss reserves and to provide the annual actuarial opinions under
statutory accounting principles as required by state regulation. The Company
analyzes loss reserves quarterly primarily using the incurred loss, paid loss,
average severity coupled with the claim count development methods, and the
generalized linear model ("GLM") described below. When deciding among methods to
use, 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 insurance business or coverage within a line of insurance business. The
Company may also evaluate qualitative factors such as known changes in laws or
legal rulings that could affect claims handling or other external environmental
factors or internal factors that could affect the settlement of claims. When
establishing the loss 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 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
method provides a reasonable basis for evaluating ultimate losses, particularly
in the Company's larger, more established lines of insurance business which have
a long operating history.
•The paid loss method analyzes historical payment patterns to estimate the
amount of losses yet to be paid.
•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 loss
reserves. 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 GLM determines an average severity for each percentile of claims that have
been closed as a percentage of estimated ultimate claims. The average severities
are applied to open claims to estimate the amount of losses yet to be paid. The
GLM utilizes operational time, determined as a percentile of claims closed
rather than a finite calendar period, which neutralizes the effect of changes in
the timing of claims handling.
The Company analyzes catastrophe losses separately from non-catastrophe losses.
For catastrophe losses, the Company generally determines claim counts based on
claims reported and development expectations from previous catastrophes and
applies an average expected loss per claim based on loss reserves established by
adjusters and average losses on previous similar catastrophes. For catastrophe
losses on individual properties that are expected to be total losses, the
Company typically establishes reserves at the policy limits.
At June 30, 2020 and December 31, 2019 , the Company recorded its point estimate
of approximately $1.87 billion and $1.92 billion ($1.82 billion and $1.85
billion , net of reinsurance), respectively, in loss reserves, which included
approximately $836.5 million and $846.7 million ($815.6 million and $829.2
million , net of reinsurance), respectively, of incurred but not reported loss
reserves ("IBNR"). IBNR includes estimates, based upon past experience, of
ultimate developed costs, which may differ from case estimates, unreported
claims that occurred on or prior to June 30, 2020 and December 31, 2019 , and
estimated future payments for reopened claims. Management believes that the
liability for loss reserves 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 provisions.
The Company evaluates its loss 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. 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 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, 2019 .
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Fair Value of Financial Instruments
Financial instruments recorded in the consolidated balance sheets include
investments, note receivable, other receivables, accounts payable, options sold,
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 other receivables and
accounts payable approximate their fair values. All investments are carried on
the consolidated balance sheets at fair value, as described in Note 3. Financial
Instruments of the 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
governments and agencies, certain corporate and other debt securities, equity
securities, and exchange traded funds. At June 30, 2020 , 98.5% of the fair value
of these financial instruments 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 by
financial instrument. Observable market prices and pricing parameters of a
financial instrument, or a related financial instrument, are used to derive a
price without requiring significant judgment. The Company's fixed maturity and
equity securities 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, are actively traded on national exchanges or
trading markets, and are valued at the last transaction price on the balance
sheet date.
The Company may hold or acquire financial instruments that lack observable
market prices or market parameters because they are less actively traded
currently or in future periods. 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 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 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
AtJune 30, 2020 , the Company's deferred income taxes were in a net liability position mainly due to deferred tax liabilities generated by unrealized gains on securities held. These deferred tax liabilities were substantially offset by deferred tax assets resulting from unearned premiums, loss reserve discounting, and expense accruals. 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 the Company's 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 that represent sources of future ordinary taxable income. Management's recoverability assessment with regard to its capital deferred tax assets is based on estimates of anticipated capital gains, tax-planning strategies available to generate future taxable capital gains, and the Company's capacity to absorb capital losses carried back to prior years, each of which would contribute to the realization of deferred tax benefits. The Company has significant unrealized gains in its investment portfolio that could be realized through asset dispositions, at management's discretion. In addition, the Company expects to hold certain debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a portion of the unrealized loss positions at period-end, are fully realizable at maturity. Management believes its long-term time horizon for holding these securities allows it to avoid any forced sales prior to maturity. Further, the Company has the capability to generate additional realized capital gains by entering into sale-leaseback transactions using one or more of its appreciated real estate holdings. Finally, the Company has the capacity to recoup capital deferred tax assets through tax capital loss carryback claims for taxes paid within permitted carryback periods. The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flows from operations and believes that its liquidity needs can be met in future periods without the forced sale of its investments. This capability assists management in controlling the timing and amount of realized losses generated during future 32 -------------------------------------------------------------------------------- Table of Contents periods. By prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability 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 Company's effective income tax rate can be affected by several factors. These generally include large changes in fully-taxable income including net realized investment gains or losses, tax-exempt investment income, non-deductible expenses, 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 endedJune 30, 2020 was 15.0%, compared to 18.5% for the same period in 2019. Tax-exempt investment income of approximately$39 million coupled with pre-tax income of approximately$105 million decreased the effective tax rate to a rate much lower than the statutory tax rate of 21% for the six months endedJune 30, 2020 , while tax-exempt investment income of approximately$42 million coupled with relatively high pre-tax income of approximately$269 million lowered the effective tax rate to a rate moderately lower than the statutory rate of 21% for the same period in 2019.
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 and/or discloses them in the notes to the
consolidated financial statements where required. The Company does not believe
that the ultimate resolution of currently pending legal or regulatory
proceedings, either individually or in the aggregate, will have a material
adverse effect on its financial condition or cash flows. See "Regulatory and
Legal Matters" above and Note 12. Contingencies of the Notes to Consolidated
Financial Statements.
RESULTS OF OPERATIONS
Three Months Ended
Revenues
Net premiums earned and net premiums written for the three months endedJune 30, 2020 decreased 8.6% and 12.5%, respectively, from the corresponding period in 2019. The Company's net premiums earned and written for the second quarter of 2020 were each reduced by approximately$106 million due to premium refunds and credits to its eligible policyholders associated with the "Mercury Giveback" program for reduced driving and business activities following the outbreak of the COVID-19 pandemic. The decrease in net premiums earned and net premiums written was primarily due to these premium refunds and credits and decline in the number of private passenger automobile policies written inCalifornia , partially offset by higher average premiums per policy arising from rate increases in theCalifornia homeowners line of insurance business and growth in the number of homeowners policies written inCalifornia . Net premiums earned included ceded premiums earned of$11.8 million and$16.2 million for the three months endedJune 30, 2020 and 2019, respectively. Net premiums written included ceded premiums written of$10.0 million and$10.3 million for the three months endedJune 30, 2020 and 2019, respectively. The decrease in ceded premiums earned for the three months endedJune 30, 2020 compared to the same period in 2019 resulted mostly from ceded reinstatement premiums earned during the three months endedJune 30, 2019 related to the Camp and Woolsey Fires in the fourth quarter of 2018, partially offset by an increase in ceded premiums earned resulting from higher reinsurance coverage and rates and growth in the covered book of business. Net premiums earned, a GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the periods presented and earned on a pro-rata basis over the term of the policies. Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period, net of any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. 33
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The following is a reconciliation of net premiums earned to net premiums
written:
Three Months Ended June 30,
2020 2019
(Amounts in thousands)
Net premiums earned $ 811,898 $ 888,776
Change in net unearned premiums 7,014
47,303
Net premiums written $ 818,912 $ 936,079
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, expense, and combined ratios determined in accordance
with GAAP:
Three Months Ended June 30,
2020 2019
Loss ratio 61.0 % 73.9 %
Expense ratio 27.2 % 24.4 %
Combined ratio 88.2 % 98.3 %
Loss ratio is calculated by dividing losses and loss adjustment expenses by net
premiums earned. The decrease in the loss ratio was primarily due to a
significant decrease in loss frequency in the private passenger automobile line
of insurance business stemming from the substantial decrease in overall driving
following the "stay-at-home" orders issued in response to the COVID-19 pandemic
in the states where the Company operates, as well as an increase in premium
rates in the California homeowners line of insurance business, partially offset
by a decrease in net premiums earned related to premium refunds and credits
under the "Mercury Giveback" program as described above and an increase in loss
severity in the California private passenger automobile line of insurance
business.
The Company's loss ratio was affected by unfavorable development of
approximately $12 million and $9 million on prior accident years' loss and loss
adjustment expense reserves for the second quarter of 2020 and 2019,
respectively. The unfavorable development for the second quarter of 2020 was
primarily attributable to higher than estimated losses and loss adjustment
expenses in the commercial automobile, homeowners and Florida private passenger
automobile lines of insurance business. The majority of the unfavorable
development in the second quarter of 2019 was attributable to higher than
estimated defense and cost containment expenses in the California private
passenger automobile line of insurance business.
In addition, the 2020 loss ratio was negatively impacted by approximately $14
million of catastrophe losses, excluding favorable development of approximately
$2 million on prior years' catastrophe losses, primarily due to extreme weather
events outside of California . The 2019 loss ratio was negatively impacted by
approximately $6 million of catastrophe losses, excluding unfavorable
development of approximately $3 million on prior years' catastrophe losses,
primarily due to tornadoes and wind and hail storms in the Midwest.
Expense ratio is calculated by dividing the sum of policy acquisition costs and
other operating expenses by net premiums earned. The expense ratio for the three
months ended June 30, 2020 increased compared to the same period in 2019,
largely due to a decrease in net premiums earned related to premium refunds and
credits as described above, without a corresponding decrease in policy
acquisition costs and other operating expenses. The Company did not recoup
commissions from its agents on the premiums returned to its eligible
policyholders under the "Mercury Giveback" program.
Combined ratio is equal to loss ratio plus expense ratio and 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 was $57.3 million and $18.3 million for the three months
ended June 30, 2020 and 2019, respectively. The increase in income tax expense
was primarily due to a $184 million increase in total pre-tax income. Tax-exempt
investment income, a component of total pre-tax income, remained relatively
unchanged compared to the same period in 2019.
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Investments
The following table presents the investment results of the Company:
Three Months Ended June 30,
2020 2019
(Dollars in thousands)
Average invested assets at cost (1)
Net investment income (2)
Before income taxes $ 34,166 $ 35,032
After income taxes $ 30,435 $ 31,404
Average annual yield on investments (2)
Before income taxes 3.2 % 3.5 %
After income taxes 2.9 % 3.1 %
Net realized investment gains $ 158,426 $ 53,329
__________
(1) Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each period. (2) Lower net investment income before and after income taxes for the three months endedJune 30, 2020 compared to the corresponding period in 2019 resulted largely from a lower average yield on investments, partially offset by higher average invested assets. Average annual yield on investments before and after income taxes for the three months endedJune 30, 2020 decreased compared to the corresponding period in 2019, primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher with lower yielding investments, as a result of decreasing market interest rates.
The following tables present the components of net realized investment gains (losses) included in net income:
Three
Months Ended
Gains (Losses) Recognized in Net Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses)
Fixed maturity securities (1)(2) $ (2,040) $ 50,251 $ 48,211
Equity securities (1)(3) (13,159) 111,940 98,781
Short-term investments (1) (2,148) 4,639 2,491
Note receivable (1) - (1) (1)
Options sold 8,189 755 8,944
Total $ (9,158) $ 167,584 $ 158,426
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Three Months Ended
Gains (Losses) Recognized in Net Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses)
Fixed maturity securities (1)(2) $ 102 $ 38,382 $ 38,484
Equity securities (1)(3) 689 11,361 12,050
Short-term investments (1) (730) 491 (239)
Note receivable (1) - 47 47
Total return swaps (75) 590 515
Options sold 2,503 (31) 2,472
Total $ 2,489 $ 50,840 $ 53,329
__________
(1)The changes in fair value of the investment portfolio and note receivable
resulted from application of the fair value option.
(2)The increase in fair value of fixed maturity securities for the second
quarter of 2020 primarily resulted from the overall improvement in fixed
maturity securities markets in the second quarter of 2020, following the overall
market disruptions and dislocations in the first quarter of 2020 attributable to
the outbreak of the COVID-19 pandemic. The increase in fair value of fixed
maturity securities for the second quarter of 2019 was primarily due to
decreases in market interest rates.
(3)The primary cause for the increase in fair value of equity securities for the
second quarter of 2020 was the overall improvement in equity markets in the
second quarter of 2020, following the overall market disruptions and
dislocations in the first quarter of 2020 attributable to the outbreak of the
COVID-19 pandemic. The primary cause for the increase in fair value of equity
securities for the second quarter of 2019 was the overall improvement in equity
markets.
Net Income (Loss)
Three Months Ended June 30,
2020 2019
(Amountsin thousands, except per share
data)
Net income$ 228,211 $ 83,250 Basic average shares outstanding 55,358 55,353 Diluted average shares outstanding 55,358 55,363 Basic Per Share Data: Net income $ 4.12$ 1.50 Net realized investment gains, net of tax $ 2.26$ 0.76 Diluted Per Share Data: Net income $ 4.12$ 1.50 Net realized investment gains, net of tax $ 2.26$ 0.76
Six Months Ended
Revenues
Net premiums earned and net premiums written for the six months endedJune 30, 2020 decreased 1.4% and 4.3%, respectively, from the corresponding period in 2019. The Company's net premiums earned and written for the first half of 2020 were each reduced by approximately$106 million due to premium refunds and credits to its eligible policyholders associated with the "Mercury Giveback" program for reduced driving and business activities following the outbreak of the COVID-19 pandemic. The decrease in net premiums earned and net premiums written was primarily due to these premium refunds and credits and decline in the number of private passenger automobile policies written inCalifornia , partially offset by higher average premiums per policy arising from rate increases in theCalifornia homeowners line of insurance business and growth in the number of homeowners policies written inCalifornia . 36 -------------------------------------------------------------------------------- Table of Contents Net premiums earned included ceded premiums earned of$25.6 million and$30.8 million for the six months endedJune 30, 2020 and 2019, respectively. Net premiums written included ceded premiums written of$21.4 million and$16.1 million for the six months endedJune 30, 2020 and 2019, respectively. The decrease in ceded premiums earned for the six months endedJune 30, 2020 compared to the same period in 2019 resulted mostly from ceded reinstatement premiums earned during the six months endedJune 30, 2019 related to the Camp and Woolsey Fires in the fourth quarter of 2018, partially offset by an increase in ceded premiums earned resulting from higher reinsurance coverage and rates and growth in the covered book of business. The increase in ceded premiums written for the six months endedJune 30, 2020 compared to the same period in 2019 resulted mostly from higher reinsurance coverage and rates and growth in the covered book of business, coupled with reductions in ceded reinstatement premiums in the first quarter of 2019 as a result of a decrease in estimated total losses and reinsurance benefits for the Camp and Woolsey Fires, as described further in Note 10. Loss and Loss Adjustment Expense Reserves of the Notes to Consolidated Financial Statements. The following is a reconciliation of net premiums earned to net premiums written: Six Months Ended June 30, 2020 2019 (Amounts in thousands) Net premiums earned$ 1,734,471 $ 1,759,021 Change in net unearned premiums 38,656 93,506 Net premiums written$ 1,773,127 $ 1,852,527 Expenses
The following table presents the Insurance Companies' loss, expense, and combined ratios determined in accordance with GAAP:
Six Months Ended June 30,
2020 2019
Loss ratio 66.1 % 73.2 %
Expense ratio 26.2 % 24.6 %
Combined ratio 92.3 % 97.8 %
The Company's loss ratio was affected by unfavorable development of
approximately $27 million and $11 million on prior accident years' loss and loss
adjustment expense reserves for the first half of 2020 and 2019, respectively.
The unfavorable development for the first half of 2020 was primarily
attributable to higher than estimated losses and loss adjustment expenses in the
commercial automobile, homeowners and Florida private passenger automobile lines
of insurance business. The majority of the unfavorable development for the first
half of 2019 was attributable to higher than estimated defense and cost
containment expenses in the California automobile line of insurance business,
partially offset by lower than estimated California homeowners losses largely
due to reductions in the Company's retained losses on the Camp and Woolsey Fires
under the Treaty after accounting for the assignment of subrogation rights that
occurred in the first quarter of 2019 and the re-estimation of reserves as part
of normal reserving procedures.
In addition, the 2020 loss ratio was negatively impacted by approximately $18
million of catastrophe losses, excluding favorable development of approximately
$4 million on prior years' catastrophe losses, primarily due to extreme weather
events outside of California and windstorms in California . The 2019 loss ratio
was also negatively impacted by approximately $17 million of catastrophe losses,
excluding favorable development of approximately $3 million on prior years'
catastrophe losses, primarily due to winter storms in California and tornadoes
and wind and hail storms in the Midwest.
Excluding the effect of estimated prior accident years' loss development and
catastrophe losses, the loss ratio was 63.5% and 71.6% for the first half of
2020 and 2019, respectively. The decrease in the loss ratio was primarily due to
a significant decrease in loss frequency in the private passenger automobile
line of insurance business stemming from the substantial decrease in overall
driving following the "stay-at-home" orders issued in response to the COVID-19
pandemic in the states where the Company operates, as well as an increase in
premium rates in the California homeowners line of insurance business, partially
offset by a decrease in net premiums earned related to premium refunds and
credits under the "Mercury Giveback" program as described above and an increase
in loss severity in the California private passenger automobile line of
insurance business.
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The expense ratio for the six months ended June 30, 2020 increased compared to
the same period in 2019, largely due to a decrease in net premiums earned
related to premium refunds and credits as described above, without a
corresponding decrease in policy acquisition costs and other operating expenses.
The Company did not recoup commissions from its agents on the premiums returned
to its eligible policyholders under the "Mercury Giveback" program. In addition,
an increase in allowance for credit losses on premiums receivable in the first
quarter of 2020, reflecting heightened credit risk for certain of the Company's
policyholders as a result of the economic downturn caused by the COVID-19
pandemic, contributed to an increase in the expense ratio.
Income tax expense was $15.8 million and $49.6 million for the six months ended
June 30, 2020 and 2019, respectively. The decrease in income tax expense was
primarily due to a $164 million decrease in total pre-tax income. Tax-exempt
investment income, a component of total pre-tax income, remained relatively
unchanged compared to the same period in 2019.
Investments
The following table presents the investment results of the Company:
Six Months Ended June 30,
2020 2019
(Dollars in thousands)
Average invested assets at cost (1)
Net investment income (2)
Before income taxes $ 68,661 $ 69,206
After income taxes $ 60,968 $ 61,658
Average annual yield on investments (2)
Before income taxes 3.3 % 3.5 %
After income taxes 2.9 % 3.1 %
Net realized investment (losses) gains
__________
(1) Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each period. (2) Lower net investment income before and after income taxes for the six months endedJune 30, 2020 compared to the corresponding period in 2019 resulted largely from a lower average yield on investments, partially offset by higher average invested assets. Average annual yield on investments before and after income taxes for the six months endedJune 30, 2020 decreased compared to the corresponding period in 2019, primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher with lower yielding investments, as a result of decreasing market interest rates.
The following tables present the components of net realized investment gains (losses) included in net income:
Six
Months Ended
Gains (Losses) Recognized in Net Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses)
Fixed maturity securities (1)(2) $ (2,667) $ 238 $ (2,429)
Equity securities (1)(3) (24,474) (74,433) (98,907)
Short-term investments (1) (2,248) 2 (2,246)
Note receivable (1) - 32 32
Options sold 10,175 481 10,656
Total $ (19,214) $ (73,680) $ (92,894)
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Six
Months Ended
Gains (Losses) Recognized in Net Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses)
Fixed maturity securities (1)(2) $ 1 $ 88,157 $ 88,158
Equity securities (1)(3) 5,940 65,048 70,988
Short-term investments (1) (1,671) 1,225 (446)
Note receivable (1) - 78 78
Total return swaps (848) 3,129 2,281
Options sold 3,357 (13) 3,344
Total $ 6,779 $ 157,624 $ 164,403
__________
(1)The changes in fair value of the investment portfolio and note receivable
resulted from application of the fair value option.
(2)The increase in fair value of fixed maturity securities for the first half of
2020 primarily resulted from the overall improvement in fixed maturity
securities markets in the second quarter of 2020, following the overall market
disruptions and dislocations in the first quarter of 2020 attributable to the
outbreak of the COVID-19 pandemic. The increase in fair value of fixed maturity
securities for the first half of 2019 was primarily due to decreases in market
interest rates.
(3)The primary cause for the decrease in fair value of equity securities for the
first half of 2020 was the overall market disruptions and dislocations in the
first quarter of 2020 following the outbreak of the COVID-19 pandemic. Such
decline in fair value of equity securities has significantly recovered in the
second quarter of 2020. The primary cause for the increase in fair value of
equity securities for the first half of 2019 was the overall improvement in
equity markets.
Net Income (Loss)
Six Months Ended June 30,
2020 2019
(Amounts in thousands, except per share data)
Net income $ 89,007 $ 219,117
Basic average shares outstanding 55,358 55,347
Diluted average shares outstanding 55,358 55,356
Basic Per Share Data:
Net income $ 1.61 $ 3.96
Net realized investment (losses) gains, net of tax $ (1.32) $ 2.35
Diluted Per Share Data:
Net income $ 1.61 $ 3.96
Net realized investment (losses) gains, net of tax $ (1.32) $ 2.35
LIQUIDITY AND CAPITAL RESOURCES
A. Cash Flows
The Company has generated positive cash flow from operations since the public
offering of its common stock in November 1985 . The Company does not attempt to
match the duration and timing of asset maturities with those of liabilities;
rather, it 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 $597.8 million at June 30, 2020 as well as $50 million of credit
available on a $50 million revolving credit facility, the Company believes its
cash flow from operations is adequate to satisfy its liquidity requirements
without the forced sale of investments. Investment maturities are also available
to meet the Company's liquidity needs. 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
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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 or for future business expansion, through the sale of equity or debt
securities or from credit facilities with lending institutions.
Net cash provided by operating activities for the six months ended June 30, 2020
was $259.6 million , a decrease of $6.0 million compared to the corresponding
period in 2019. The decrease was primarily due to a decrease in collections from
reinsurers on reinsurance recoverables, a decrease in premium collections, and
an increase in payments for income taxes and other operating expenses, mostly
offset by a decrease in payments for losses and loss adjustment expenses. The
Company utilized the cash provided by operating activities during the six months
ended June 30, 2020 primarily for the net purchases of investment securities and
payment of dividends to its shareholders.
The following table presents the estimated fair value of fixed maturity
securities at
Fixed Maturity Securities
(Amounts in thousands)
Due in one year or less $ 144,581
Due after one year through two years 268,092
Due after two years through three years 219,893
Due after three years through four years 85,441
Due after four years through five years 64,855
Total due within five years $ 782,862
B. Reinsurance
For California homeowners policies, the Company has reduced its catastrophe
exposure from earthquakes by placing earthquake risks directly with the
California Earthquake Authority ("CEA"). However, the Company continues to have
catastrophe exposure to fires following an earthquake.
The Company is party to a Catastrophe Reinsurance Treaty (the "Treaty") covering
a wide range of perils that is effective through June 30, 2021 . For the 12
months ending June 30, 2021 , the Treaty provides $717 million of coverage on a
per occurrence basis after covered catastrophe losses exceed the $40 million
Company retention limit. The Treaty specifically excludes coverage for any
Florida business and for California earthquake losses on fixed property policies
such as homeowners, but does cover losses from fires following an earthquake.
The Treaty includes additional territorial and coverage limits as noted in the
table below.
Coverage on individual catastrophes provided for the 12 months ending
Catastrophe Losses and LAE
Percentage of
In Excess of Up to Coverage
(Amounts in millions)
Retained $ - $ 40 - %
Layer of Coverage 40 100 70
Layer of Coverage (1) 100 400 100
Layer of Coverage (1) (2) (3) 400 775 100
__________
(1) Layer of Coverage represents multiple actual treaty layers that are grouped for presentation purposes. (2) 13.4% of this layer covers onlyCalifornia wildfires and fires following an earthquake inCalifornia , and is not subject to reinstatement. (3) 14% of this layer includes a territorial restriction coveringCalifornia ,Arizona andNevada only. For the 12 months endedJune 30, 2020 , the Treaty provided$600 million of coverage on a per occurrence basis after covered catastrophe losses exceeded the$40 million Company retention limit. The Treaty specifically excluded coverage for anyFlorida business and forCalifornia earthquake losses on fixed property policies such as homeowners, but did cover losses from fires following an earthquake. In addition, the Treaty excluded losses from wildfires on 89.5% of certain coverage layers 40 -------------------------------------------------------------------------------- Table of Contents of the Treaty as noted in the table below.
Coverage on individual catastrophes provided for the 12 months ended
Catastrophe Losses and LAE
Percentage of
In Excess of Up to Coverage
(Amounts in millions)
Retained $ - $ 40 - %
Layer of Coverage (1) 40 350 100
Layer of Coverage (wildfires not covered for 89.5% of this layer)
350 400 100
Layer of Coverage 400 456 100
Layer of Coverage (wildfires not covered for 89.5% of
this layer) 456 500 100
Layer of Coverage (1) 500 640 100
__________(1) Layer of Coverage represents multiple actual treaty layers that are grouped for presentation purposes.
The annual premium for the Treaty is approximately$50.3 million for the 12 months endingJune 30, 2021 , as compared to$38.0 million for the 12 months endedJune 30, 2020 . The increase in the annual premium is primarily due to an increase in reinsurance coverage and rates as well as growth in the covered book of business. The Treaty endingJune 30, 2021 provides for one full reinstatement of coverage limits and reinstatement premiums are based on the amount of reinsurance benefits used by the Company at 100% of the annual premium rate, with the exception of the reinstatement restriction noted in the table above, up to the maximum reinstatement premium of approximately$46 million if the full amount of benefit is used for the 12 months endingJune 30, 2021 . The Treaty endedJune 30, 2020 provided for one full reinstatement of coverage limits, and reinstatement premiums were based on the amount of reinsurance benefits used by the Company and at 100% of the annual premium rate with some minor exceptions, up to the maximum reinstatement premium of approximately$38 million if the full amount of benefit was used for the 12 months endedJune 30, 2020 . The total amount of reinstatement premiums is recorded as ceded reinstatement premiums written at the time of the catastrophe event based on the total amount of reinsurance benefits expected to be used for the event, and such reinstatement premiums are recognized ratably over the remaining term of the Treaty as ceded reinstatement premiums earned.
The table below presents the combined total reinsurance premiums under the
Treaty (annual premiums and reinstatement premiums) for the 12 months ending
Total Combined Premium
Treaty Annual Premium Reinstatement Premium (1) (1)
(Amounts in millions)
For the 12 months ending June 30, 2021 $ 50 $ - $ 50
For the 12 months ending June 30, 2020 $ 38 $ - $ 38
__________
(1) The reinstatement premium and the total combined premium for the treaty period endingJune 30, 2021 are projected amounts to be paid based on the assumption that there will be no reinstatements occurring during this treaty period. The reinstatement premium for the treaty period endedJune 30, 2020 is zero, as there were no actual reinstatement premiums paid. The catastrophe events that occurred in 2020 caused approximately$18 million in losses to the Company, with no reinsurance benefits used under the Treaty for these losses, as none of the 2020 catastrophe events resulted in losses in excess of the Company's per-occurrence retention limit under the Treaty of$40 million for the 12 months endedJune 30, 2020 . The catastrophe events that occurred in 2019 caused approximately$55 million in losses to the Company, including a series of wildfires inCalifornia during the fourth quarter of 2019. However, no reinsurance benefits were available to the Company under the Treaty for these catastrophe losses, as none of the 2019 catastrophe events resulted in losses in excess of the Company's per-occurrence retention limit under the Treaty of$10 million for the 12 months endedJune 30, 2019 and$40 million for the 12 months endedJune 30, 2020 . 41 -------------------------------------------------------------------------------- Table of Contents The Company carries a commercial umbrella reinsurance treaty and seeks facultative arrangements for large property risks. In addition, the Company has other reinsurance in force that is not material to the consolidated financial statements. If any reinsurers are unable to perform their obligations under a reinsurance treaty, the Company will be required, as primary insurer, to discharge all obligations to its policyholders in their entirety.
C. 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 believes that this strategy enables the optimal investment performance necessary to sustain investment income over time. The Company's portfolio management approach utilizes a 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. The following table presents the composition of the total investment portfolio of the Company atJune 30, 2020 : Cost (1) Fair Value (Amounts in thousands) Fixed maturity securities: U.S. government bonds$ 23,603 $ 23,852 Municipal securities 2,604,563 2,727,359 Mortgage-backed securities 77,521 78,492 Corporate securities 261,504 262,739 Collateralized loan obligations 204,288
199,945
Other asset-backed securities 35,646 34,975
3,207,125 3,327,362
Equity securities:
Common stock 605,372 645,362
Non-redeemable preferred stock 31,429 28,696
Private equity funds measured at net asset value (2) 100,326
65,105
737,127 739,163
Short-term investments 335,556 335,634
Total investments $ 4,279,808 $ 4,402,159
______________
(1) Fixed maturities and short-term bonds at amortized cost; equities and other
short-term investments at cost.
(2) The fair value is measured using the NAV practical expedient. See Note 5.
Fair Value Measurements of the Notes to Consolidated Financial Statements for
additional information.
At June 30, 2020 , 58.1% of the Company's total investment portfolio at fair
value and 76.9% of its total fixed maturity securities at fair value were
invested in tax-exempt state and municipal bonds. Equity holdings consist of
non-redeemable preferred stocks, dividend-bearing common stocks on which
dividend income is partially tax-sheltered by the 50% corporate dividend
received deduction, and private equity funds. At June 30, 2020 , 96.0% of
short-term investments consisted of highly rated short-duration securities
redeemable on a daily or weekly basis.
Fixed maturity securities include debt securities, which are mostly long-term
bonds and other debt with maturities of at least one year from purchase, and
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
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rates, anticipated prepayments, risk/reward characteristics, liquidity needs,
tax planning considerations, or other economic factors. Short-term instruments
include money market accounts, options, and short-term bonds that are highly
rated short duration securities and redeemable within one year.
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 has resulted in a
portfolio with a moderate duration. The Company's portfolio is heavily weighted
in investment grade tax-exempt municipal bonds. Fixed maturity securities
purchased by the Company typically have call options attached, which further
reduce the duration of the asset as interest rates decline. The holdings that
are heavily weighted with high coupon issues, are expected to be called prior to
maturity. 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.
The following table presents the maturities and durations of the Company's fixed
maturity securities and short-term investments:
June 30, 2020 December 31, 2019
(in years)
Fixed Maturity Securities
Nominal average maturity:
excluding short-term investments 12.7 13.9
including short-term investments 11.6 12.0
Call-adjusted average maturity:
excluding short-term investments 4.3 4.6
including short-term investments 3.9 4.0
Modified duration reflecting anticipated early calls: excluding short-term investments
2.9 3.7
including short-term investments 2.6 3.2
Short-Term Investments - -
Another exposure related to the fixed maturity securities is credit risk, which
is managed by maintaining a weighted-average portfolio credit quality rating of
A+, at fair value, at June 30, 2020 , consistent with the average rating at
December 31, 2019 . The Company's municipal bond holdings of which 93.8% were tax
exempt, represented 76.9% of its fixed maturity securities portfolio at June 30,
2020 , at fair value, and are broadly diversified geographically. See Part I-Item
3. Quantitative and Qualitative Disclosures About Market Risks for a breakdown
of municipal bond holdings by state.
To calculate the weighted-average credit quality ratings disclosed throughout
this Quarterly Report on Form 10-Q, individual securities were weighted based on
fair value and credit quality ratings assigned by nationally recognized
securities rating organizations.
Taxable holdings consist principally of investment grade issues. At June 30,
2020 , fixed maturity securities holdings rated below investment grade and
non-rated bonds totaled $18.9 million and $40.1 million , respectively, at fair
value, and represented 0.6% and 1.2%, respectively, of total fixed maturity
securities. The majority of non-rated issues are a result of municipalities
pre-funding and collateralizing those issues with U.S. government securities
with an implicit AAA equivalent credit risk. At December 31, 2019 , fixed
maturity securities holdings rated below investment grade and non-rated bonds
totaled $19.2 million and $37.8 million , respectively, at fair value, and
represented 0.6% and 1.2%, respectively, of total fixed maturity securities.
The overall credit ratings for the Company's fixed maturity securities portfolio
were relatively stable during the six months ended June 30, 2020 , with 96.8% of
fixed maturity securities at fair value experiencing no change in their overall
rating. 0.6% and 2.6% of fixed maturity securities at fair value experienced
upgrades and downgrades, respectively, during the six months ended June 30,
2020 .
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The following table presents the credit quality ratings of the Company's fixed
maturity securities by security type at fair value:
June 30, 2020
(Dollars in thousands)
Total Fair
Security Type AAA(1) AA(1) A(1) BBB(1) Non-Rated/Other(1) Value(1)
U.S. government bonds:
Treasuries $ 23,852 $ - $ - $ - $ - $ 23,852
Total 23,852 - - - - 23,852
100.0 % - % - % - % - % 100.0 %
Municipal securities:
Insured 37,632 172,969 110,742 55,652 4,156 381,151
Uninsured 121,374 697,930 1,274,681 214,854 37,369 2,346,208
Total 159,006 870,899 1,385,423 270,506 41,525 2,727,359
5.8 % 31.9 % 50.9 % 9.9 % 1.5 % 100.0 %
Mortgage-backed securities:
Commercial 7,077 - 1,462 4,129 - 12,668
Agencies 7,452 - - - - 7,452
Non-agencies:
Prime 19,542 29,388 6,496 63 670 56,159
Alt-A - 799 - 654 760 2,213
Total 34,071 30,187 7,958 4,846 1,430 78,492
43.4 % 38.5 % 10.1 % 6.2 % 1.8 % 100.0 %
Corporate securities:
Basic materials - - - 398 2,559 2,957
Communications - - 193 663 - 856
Consumer, cyclical - 2,627 7,212 5,502 4,725 20,066
Consumer, non-cyclical - 10,459 14,062 11,823 - 36,344
Energy - - 2,361 21,340 2,541 26,242
Financial - 26,280 105,889 21,446 - 153,615
Industrial - - - 15,810 - 15,810
Utilities - - 6,849 - - 6,849
Total - 39,366 136,566 76,982 9,825 262,739
- % 15.0 % 52.0 % 29.3 % 3.7 % 100.0 %
Collateralized loan obligations:
Corporate 32,331 32,240 135,374 - - 199,945
Total 32,331 32,240 135,374 - - 199,945
16.2 % 16.1 % 67.7 % - % - % 100.0 %
Other asset-backed securities - 20,000 6,336 2,395 6,244 34,975
- % 57.2 % 18.1 % 6.8 % 17.9 % 100.0 %
Total $ 249,260 $ 992,692 $ 1,671,657 $ 354,729 $ 59,024 $ 3,327,362
7.5 % 29.8 % 50.2 % 10.7 % 1.8 % 100.0 %
______________(1)Intermediate ratings are included at each level (e.g., AA includes AA+, AA and AA-).
U.S. Government Bonds The Company had$23.9 million and$22.6 million , or 0.7% and 0.7%, of its fixed maturity securities portfolio, at fair value, inU.S. government bonds atJune 30, 2020 andDecember 31, 2019 , respectively. AtJune 30, 2020 , Moody's and Fitch ratings forU.S. government-issued debt were Aaa andAAA , respectively, although a significant increase in government 44 -------------------------------------------------------------------------------- Table of Contents deficits and debt could lead to a downgrade. The Company understands that market participants continue to use rates of return onU.S. government debt as a risk-free rate and have continued to invest inU.S. Treasury securities. The modified duration of theU.S. government bonds portfolio reflecting anticipated early calls was 0.5 years and 1.0 years atJune 30, 2020 andDecember 31, 2019 , respectively.Municipal Securities The Company had$2.73 billion and$2.55 billion , or 82.0% and 82.6%, of its fixed maturity securities portfolio, at fair value, in municipal securities,$381.2 million and$344.7 million of which were insured, atJune 30, 2020 andDecember 31, 2019 , respectively. The underlying ratings for insured municipal bonds have been factored into the average rating of the securities by the rating agencies with no significant disparity between the absolute securities ratings and the underlying credit ratings as ofJune 30, 2020 andDecember 31, 2019 . AtJune 30, 2020 andDecember 31, 2019 , 59.7% and 65.5%, respectively, of the insured municipal securities, at fair value, most of which were investment grade, were insured by bond insurers that provide credit enhancement and ratings reflecting the credit of the underlying issuers. AtJune 30, 2020 andDecember 31, 2019 , the average rating of the Company's insured municipal securities was A+, which corresponded to the average rating of the investment grade bond insurers. The remaining 40.3% and 34.5% of insured municipal securities atJune 30, 2020 andDecember 31, 2019 , respectively, were non-rated or below investment grade, and were insured by bond insurers that the Company believes did not provide credit enhancement. The modified duration of the municipal securities portfolio reflecting anticipated early calls was 2.8 years and 3.7 years atJune 30, 2020 andDecember 31, 2019 , respectively. 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 and avoid 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.
AtJune 30, 2020 andDecember 31, 2019 , the mortgage-backed securities portfolio of$78.5 million and$63.0 million , or 2.4% and 2.0%, respectively, of the Company's fixed maturity securities portfolio, at fair value, was categorized as loans to "prime" residential and commercial real estate borrowers, except for$2.2 million and$2.4 million , respectively, at fair value ($2.2 million and$2.3 million at amortized cost) of Alt-A mortgages. 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 credit profiles stronger than those of sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. The Company had holdings of$12.7 million and$18.9 million at fair value ($12.4 million and$18.5 million at amortized cost) in commercial mortgage-backed securities atJune 30, 2020 andDecember 31, 2019 , respectively. The weighted-average rating of the Company's Alt-A mortgage-backed securities was BBB- atJune 30, 2020 andDecember 31, 2019 . The weighted-average rating of the entire mortgage-backed securities portfolio was AA atJune 30, 2020 andDecember 31, 2019 . The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 4.9 years and 3.1 years atJune 30, 2020 andDecember 31, 2019 , respectively.
Corporate securities included in fixed maturity securities were as follows:
June
30, 2020
(Amounts in thousands)
Corporate securities at fair value $ 262,739 $ 235,565
Percentage of total fixed maturity securities portfolio 7.9 % 7.6 %
Modified duration 1.8 years 2.0 years
Weighted-average rating A- A-
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Collateralized Loan Obligations
Collateralized loan obligations included in fixed maturity securities were as
follows:
June 30, 2020 December 31, 2019
(Amounts in thousands)
Collateralized loan obligations at fair value $ 199,945 $ 199,218
Percentage of total fixed maturity securities portfolio 6.0 % 6.4 %
Modified duration 5.1 years 5.2 years
Weighted-average rating A+ A+
Other Asset-Backed Securities
Other asset-backed securities included in fixed maturity securities were as
follows:
June 30, 2020 December 31, 2019
(Amounts in thousands)
Other asset-backed securities at fair value $ 34,975 $ 18,644
Percentage of total fixed maturity securities portfolio 1.1 % 0.6 %
Modified duration 1.9 years 1.8 years
Weighted-average rating A+ A
Equity Securities
Equity holdings of $739.2 million and $724.8 million at fair value, as of
June 30, 2020 and December 31, 2019 , respectively, consisted of non-redeemable
preferred stocks, common stocks on which dividend income is partially
tax-sheltered by the 50% corporate dividend received deduction, and private
equity funds. The Company had a net (loss) gain of $(74.4) million and $65.0
million due to changes in fair value of the Company's equity securities
portfolio for the six months ended June 30, 2020 and 2019, respectively. The
primary cause for the decrease in fair value of the Company's equity securities
portfolio for the six months ended June 30, 2020 was the overall market
disruptions and dislocations in the first quarter of 2020 resulting from the
outbreak of the COVID-19 pandemic. Such decline in fair value of the Company's
equity securities has significantly recovered in the second quarter of 2020. The
primary cause for the increase in fair value of the Company's equity securities
portfolio for the six months ended June 30, 2019 was the overall improvement in
equity markets.
The Company's common stock allocation is intended to enhance the return of and
provide diversification for the total portfolio. At June 30, 2020 and
December 31, 2019 , 16.8% of the total investment portfolio at fair value was
held in equity securities.
D. Debt
On March 8, 2017 , the Company completed a public debt offering issuing $375
million of senior notes. The notes are unsecured senior obligations of the
Company with a 4.4% annual coupon payable on March 15 and September 15 of each
year commencing September 15, 2017 . The notes mature on March 15, 2027 . The
Company used the proceeds from the notes to pay off amounts outstanding under
the existing loan and credit facilities and for general corporate purposes. The
Company incurred debt issuance costs of approximately $3.4 million , inclusive of
underwriters' fees. The notes were issued at a slight discount of 99.847% of
par, resulting in the effective annualized interest rate including debt issuance
costs of approximately 4.45%.
On March 29, 2017 , the Company entered into an unsecured credit agreement that
provides for revolving loans of up to $50 million and matures on March 29, 2022 .
The interest rates on borrowings under the credit facility are based on the
Company's debt to total capital ratio and range from LIBOR plus 112.5 basis
points when the ratio is under 15% to LIBOR plus 162.5 basis points when the
ratio is greater than or equal to 25%. Commitment fees for the undrawn portions
of the credit facility range from 12.5 basis points when the ratio is under 15%
to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to
total capital ratio is expressed as a percentage of (a) consolidated debt to (b)
consolidated shareholders' equity plus consolidated debt. The Company's debt to
total capital ratio was 17.1% at June 30, 2020 , resulting in a 15 basis point
commitment fee on the $50 million undrawn portion of the credit facility. As of
July 29, 2020 , there have been no borrowings under this facility.
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The Company was in compliance with all of the financial covenants pertaining to
minimum statutory surplus, debt to total capital ratio, and risk based capital
ratio under the unsecured credit facility at June 30, 2020 .
For additional information on debt, see Note 11. Notes Payable of the Notes to Consolidated Financial Statements.
E. Regulatory Capital Requirements
Among other considerations, 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$1.59 billion atJune 30, 2020 , and net premiums written of$3.7 billion for the twelve months ended on that date, the ratio of net premiums written to surplus was 2.29 to 1 atJune 30, 2020 .
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