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 states where the Company 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, cyber security, regulatory and litigation risks. From time to time, forward-looking statements are also included in the Company's quarterly reports on Form 10-Q and current reports on Form 8-K, in press releases, in presentations, on its web site, and in other materials released to the public. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of any document the Company incorporates by reference, any other report filed with theSEC or any other public statement made by the Company, the date of the document, report or statement. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. 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. The Company is headquartered inLos Angeles, California and writes primarily personal automobile lines of business selling policies through a network of independent agents, 100% owned insurance agents and direct channels, in 11 states:Arizona ,California ,Florida ,Georgia ,Illinois ,Nevada ,New Jersey ,New York ,Oklahoma ,Texas , andVirginia . The Company also offers homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. Private passenger automobile lines of insurance business accounted for approximately 70% of the$3.7 billion of the Company's direct premiums written in 2020, and approximately 88% of the private passenger automobile premiums were written inCalifornia . In 2021, the Company intends to cease accepting new business and renewing existing policies for the commercial automobile line of insurance business inArizona ,Georgia ,Illinois andNevada . The commercial automobile line of insurance business in those states has been volatile and challenged the Company's objective of growing the business profitably. The Company plans to focus resources on the states and lines of insurance business with better opportunities for sustainable growth. The combined net premiums written in 2020 for the commercial automobile line of insurance business in those states was approximately$20 million .
This section discusses some of the relevant factors that management considers in evaluating the Company's
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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 Annual Report on Form 10-K.
2020 Financial Performance Summary
The Company's net income for the year ended December 31, 2020 was $374.6
million , or $6.77 per diluted share, compared to $320.1 million , or $5.78 per
diluted share, for the same period in 2019. Included in net income was $134.9
million of pre-tax net investment income that was generated during 2020 on a
portfolio of $4.7 billion , at fair value, at December 31, 2020 , compared to
$141.3 million of pre-tax net investment income that was generated during 2019
on a portfolio of $4.3 billion , at fair value, at December 31, 2019 . Also
included in net income were pre-tax net realized investment gains of $85.7
million and $222.8 million in 2020 and 2019, respectively, and pre-tax
catastrophe losses, net of reinsurance benefits and related reinstatement
premiums earned, of approximately $60.9 million and $65.3 million in 2020 and
2019, respectively.
During 2020, the Company continued its marketing efforts to enhance name
recognition and lead generation. The Company believes that its marketing
efforts, combined with its ability to maintain relatively low prices and a
strong reputation, make its insurance products competitive in
The Company believes its thorough underwriting process gives it an advantage over its competitors. The Company's agent relationships and underwriting and claims processes are its most important competitive advantages.
The Company's operating results and growth have allowed it to consistently
generate positive cash flow from operations, which was approximately
Economic and Industry Wide Factors
•Regulatory Uncertainty-The insurance industry is subject to strict state
regulation and oversight and is governed by the laws of each state in which each
insurance company operates. State regulators generally have substantial power
and authority over insurance companies including, in some states, approving rate
changes and rating factors, restricting cancellation and non-renewal of
insurance policies, and establishing minimum capital and surplus
requirements. In many states, insurance commissioners may emphasize different
agendas or interpret existing regulations differently than previous
commissioners. There is no certainty that current or future regulations and the
interpretation of those regulations by insurance commissioners and the courts
will not have an adverse impact on the Company.
•Cost Uncertainty-Because insurance companies pay claims after premiums are
collected, the ultimate cost of an insurance policy is not known until well
after the policy revenues are earned. Consequently, significant assumptions are
made when establishing insurance rates and loss reserves. While insurance
companies use sophisticated models and experienced actuaries to assist in
setting rates and establishing loss reserves, there can be no assurance that
current rates or current reserve estimates will be adequate. Furthermore, there
can be no assurance that insurance regulators will approve rate increases when
the Company's actuarial analyses indicate that they are needed.
•Economic Conditions-The Company's financial condition, results of operations,
and liquidity may be negatively impacted by global, national and local economic
conditions, such as recessions, increased levels of unemployment, inflation, and
large fluctuations in interest rates. Further, volatility in global capital
markets could adversely affect the Company's investment portfolio. The Company
is not able to predict the timing and effect of these factors, or their duration
and severity.
•Inflation-The largest cost component for automobile insurers is losses, which
include medical, replacement automobile parts, and labor costs. There can be
significant variation in the overall increases in medical cost inflation, and it
is often years after the respective fiscal period ends before sufficient claims
have closed for the inflation rate to be known with a reasonable degree of
certainty. Therefore, it can be difficult to establish reserves and set premium
rates, particularly when actual inflation rates may be higher or lower than
anticipated.
•Loss Frequency-Another component of overall loss costs is loss frequency, which
is the number of claims per risk insured. Loss frequency trends are affected by
many factors such as fuel prices, the economy, the prevalence of distracted
driving, collision avoidance and other technology in vehicles, and stay-at-home
orders issued by state and local governments due to the pandemic.
•Underwriting Cycle and Competition-The property and casualty insurance industry
is highly cyclical, with alternating hard and soft market conditions. The
Company believes that the automobile insurance industry in 2020
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has generally experienced a significant softening of the market. Insurance
carriers lowered rates to reflect lower loss frequencies as stay-at-home orders
issued by the state and local governments following the COVID-19 pandemic led to
a decrease in the number of accidents, although this also depends on individual
state profitability and the carriers' growth appetite.
Technology
In 2020, the Company continued its insurance platform modernization initiative to migrate its lines of insurance business to Guidewire's InsuranceSuite, a widely adopted industry-leading software for property and casualty insurance. The Company has completed the migration to InsuranceSuite for all of its claims processing, and for many of the states and lines of insurance business in which the Company operates for its underwriting processing. The Company expects to complete the migration for the remaining states and lines of insurance business, including the policy and billing centers of theCalifornia private passenger automobile line of insurance business, over the next few years. In addition, the Company implemented a new product offering for Commercial Multi-Peril insurance, and improved paperless eDelivery as well as customer portal and billing self-service capabilities in 2020. Since March of 2020, the Company has been leveraging its information technology capabilities to enable all of its employees to work from home using mobile and collaborative technologies. The Company's other technology accomplishments in 2020 include: completion of major enhancements to its core network infrastructure and application systems, including a major Guidewire software upgrade which leverages new feature enhancements and adds capacity and performance; implementation of omni-channel customer service; development of a mobile application; and deployment of major technology enhancements to its customer portal, and several other technologies, such as computer vision and machine learning for photo-based estimation, mobile appraisal and business rules engine, Usage-Based Insurance, Robotic Process Automation, and enhancements to its cloud-based business analytics capabilities. In 2021, the Company intends to continue to invest in modernization of its technology platforms, and deploy advanced technologies for enhanced digital customer experience, cross selling and customer relationship management, which will improve its customer acquisition process based on direct-to-consumer and agent distribution models. 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 , the WHO 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. InSeptember 2020 , the Company extended its "work-from-home" policy for most of its employees toJune 2021 , and may further extend the policy, if necessary, based on the latest information on the pandemic's developments. The Company's automobile line of business began experiencing a significant decrease in loss frequency in mid to late March, and it remained lower than the historical levels through the end of 2020, although it began to increase in June and the second half of 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 resulting from 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 a higher percentage of high-speed serious accidents on less congested roads and freeways. The cost to repair vehicles may remain high 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 B. 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
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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 ended March 31, 2020 . Such
decline in the fair value of the Company's investment portfolio has recovered
during the subsequent quarters of 2020. In March 2020 , the Federal 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 the FOMC .
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.
On March 27, 2020 , the President of the 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. On December 27, 2020 ,
the President signed an additional round of COVID-19 relief legislation. To the
extent the Company's existing or potential policyholders, both individuals and
businesses, and its independent agents are aided by such relief programs, the
negative impact of the pandemic on its results of operations due to the reduced
premiums written or increased uncollectible premiums is mitigated.
The Company will continue to monitor the impact of the COVID-19 pandemic, and
the effects of the CARES Act and any future rounds of such relief legislation.
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 such
as broad vaccine rollout, 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.
B. Regulatory and Legal Matters
The process for implementing rate changes varies by state. For more detailed
information related to insurance rate approval, see "Item 1.
Business-Regulation."
During 2020, the Company implemented rate changes in ten states. In California ,
the following rate increases were approved by the California DOI for lines of
business that exceeded 5% of the Company's total net premiums earned in 2020:
?In each of February and July 2020 , the California DOI approved a 6.99% rate
increase on the California homeowners line of insurance business, which
represented approximately 14% of the Company's total net premiums earned in
2020. The Company implemented the February rate increase in April 2020 and the
July rate increase in October 2020 .
On April 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 impacted California policyholders for
the months of March and April 2020 . The Commissioner granted insurers
flexibility in determining how to quickly and fairly process the premium
refunds. On May 15, 2020 , the California Insurance Commissioner issued Bulletin
2020-4 extending the directives in Bulletin 2020-3 through May 31, 2020 . The
Bulletin 2020-8, originally issued on June 25, 2020 and amended on December 3,
2020 , extended the previous directives of Bulletin 2020-3 and Bulletin 2020-4
through June 30, 2020 , as well as any months subsequent to June 2020 because the
COVID-19 pandemic continued to result in projected loss exposures remaining
overstated or misclassified. The total amount of premiums returned to the
Company's policyholders through refunds
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or credits in 2020 was approximately $128 million . The Company's net premiums
earned was reduced by approximately $128 million for the twelve months ended
December 31, 2020 as a result of these premium refunds and credits.
In July 2019 , the governor of California signed a bill that created a $21
billion fund (the "California Wildfire Fund ") to help 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 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 past years. The Company received approximately $23 million , net of fees,
in 2020 from the Subrogation Trust Fund . 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 $3 million , representing a
reduction to reinstatement premiums previously recognized.
In November and December 2020 , the California Insurance Commissioner issued a
mandatory moratorium on cancellations and non-renewals of policies of
residential property insurance after the declaration of a state of emergency
through Bulletins 2020-11, 2020-12 and 2020-13. These Bulletins list
declarations of a state of emergency issued by the California Governor in
August, September and November 2020 , along with the ZIP Codes within and
adjacent to the fire perimeters in counties subject to each state of emergency.
The mandatory moratorium prohibits insurers from canceling or refusing to renew
a policy of residential property insurance for a property located in any ZIP
Code listed in these Bulletins for one year after the declaration of a state of
emergency and in effect at the time of the declared emergency, based solely on
the fact that the insured structure is located in an area in which a fire has
occurred. The Company will comply with these Bulletins and does not believe that
these Bulletins will have a material adverse impact on its financial condition
or cash flows.
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 "Critical
Accounting Policies and Estimates" below and Note 1. Summary of Significant
Accounting Policies of the Notes to Consolidated Financial Statements in "Item
8. Financial Statements and Supplementary Data."
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 material 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 Note 18.
Commitments and Contingencies-Litigation of the Notes to Consolidated Financial
Statements in "Item 8. Financial Statements and Supplementary Data."
C. 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 liability claims, such as property damage claims, tend to be more
reasonably predictable than long-tail liability claims.
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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
looking at 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.
The Company also engages independent actuarial consultants to review the
Company's loss reserves and to provide the annual actuarial opinions required
under state statutory accounting requirements. 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 generally analyzes 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 provides 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.
There are many factors that can cause variability between the ultimate expected
loss and the actual developed loss. While there are certainly other factors, the
Company believes that the following three items tend to create the most
variability between expected losses and actual losses.
(1) Inflation
For the Company's
•BI reserves-approximately 75% of total reserves
•Material damage ("MD") reserves, including collision and comprehensive property damage-approximately
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10% of total reserves
•Loss adjustment expense reserves-approximately 15% of total reserves.
Loss development on MD reserves is generally insignificant because MD claims are
generally settled in a shorter period than BI claims. The majority of the loss
adjustment expense reserves are estimated costs to defend BI claims, which tend
to require longer periods of time to settle as compared to MD claims.
BI loss reserves are generally the most difficult to estimate because they take
longer to close than other coverages. BI coverage in the Company's policies
includes injuries sustained by any person other than the insured, except in the
case of uninsured or underinsured motorist BI coverage, which covers damages to
the insured for BI caused by uninsured or underinsured motorists. BI payments
are primarily for medical costs and general damages.
The following table presents the typical closure patterns of BI claims in the
Company's
% of Total
Claims Closed Dollars Paid
BI claims closed in the accident year reported 40% 13%
BI claims closed one year after the accident year reported 77% 51%
BI claims closed two years after the accident year reported 92% 77%
BI claims closed three years after the accident year reported 97% 89%
BI claims closed in the accident year reported are generally the smaller and
less complex claims that settle for approximately $5,000 to $6,000 on average,
whereas the total average settlement, once all claims are closed in a particular
accident year, is approximately $15,000 to $20,000 . The Company creates incurred
and paid loss triangles to estimate ultimate losses utilizing historical payment
and reserving patterns and evaluates the results of this analysis against its
frequency and severity analysis to establish BI loss reserves. The Company
adjusts development factors to account for inflation trends it sees in loss
severity. As a larger proportion of claims from an accident year are settled,
there emerges a higher degree of certainty for the loss reserves established for
that accident year. At December 31, 2020 , the accident years that are most
likely to develop are the 2018 through 2020 accident years; however, it is
possible that older accident years could develop as well.
In general, the Company expects that historical claims trends will continue with
costs tending to increase, which is generally consistent with historical data,
and therefore the Company believes that it is reasonable to expect inflation to
continue. Many potential factors can affect the BI inflation rate, including
changes in claims handling process, changes in statutes and regulations, the
number of litigated files, increased use of medical procedures such as MRIs and
epidural injections, general economic factors, timeliness of claims
adjudication, vehicle safety, weather patterns, social inflation, and gasoline
prices, among other factors; however, the magnitude of the impact of such
factors on the inflation rate is unknown.
During 2020, the Company experienced a decrease in loss frequency primarily
resulting from the shelter-in-place orders issued by state and local governments
in response to the COVID-19 pandemic. In addition, the COVID-19 pandemic created
greater uncertainty in the reserve estimates: A greater number of large claims
may emerge from the 2020 accident year compared to the prior accident years as
claimants may be reluctant to go to a medical provider due to the pandemic but
subsequently seek monetary compensation to ease the economic hardship
attributable to the pandemic. A lower percentage of minor accidents with lower
average severity experienced during the pandemic are likely to push the total
average severity higher. There is reduced subrogation potential due to increased
single-vehicle accidents during 2020. Automobile parts and labor costs will be
higher if further supply shortages emerge due to the prolonged pandemic. Based
on these factors and uncertainty attributable to the pandemic, the reserve
estimates for the 2020 accident year are subject to a greater degree of
variability.
The Company believes that it is reasonably possible that the
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During the years 2016 through 2020, the changes in the loss severity amounts for the three preceding accident years from the prior year amounts (BI severity variance from prior year) have ranged as follows:
High Low
Immediate preceding accident year 1.4% (5.1)%
Second preceding accident year 7.5% (3.1)%
Third preceding accident year 5.2% (2.9)%
The following table presents the effects on the California automobile BI loss
reserves for the 2020, 2019, and 2018 accident years based on possible
variations in the severity recorded; however, the actual variations could be
more or less than these amounts:
California Automobile Bodily Injury Inflation Reserve Sensitivity Analysis
(A) Pro-forma (B) Pro-forma
severity if actual severity if actual Favorable loss Unfavorable loss
Actual severity is lower by severity is higher by development if development if
Recorded Implied 12% for 2020, 12% for 2020, actual severity is actual severity is
Accident Number of Claims Severity at Inflation Rate 8% for 2019, and 8% for 2019, and less than recorded more than recorded
Year Expected 12/31/2020 Recorded (1) 6% for 2018 6% for 2018 (Column A) (Column B)
2020 19,896 (2) $ 20,557 (2) 23.5 % (2) $ 18,090 $ 23,024 $ 49,083,000 $ (49,083,000)
2019 29,526 $ 16,649 9.7 % $ 15,317 $ 17,981 $ 39,329,000 $ (39,329,000)
2018 28,685 $ 15,171 11.0 % $ 14,261 $ 16,081 $ 26,103,000 $ (26,103,000)
2017 28,358 $ 13,670 - - - - -
Total Loss
Development-Favorable (Unfavorable)
(114,515,000)
___________
(1) Implied inflation rate is calculated by dividing the difference between the current and prior year actual recorded severity by the prior year actual recorded severity. The Company believes that severity increases are caused by litigation, medical costs, inflation, and increased utilization of medical procedures. (2) During 2020, the Company experienced a significant reduction in loss frequency resulting from the shelter-in-place orders issued by state and local governments in response to the COVID-19 pandemic, which led to the smaller number of claims expected for the 2020 accident year compared to the prior accident years. Conversely, a higher percentage of high-speed serious accidents on less congested roads combined with a lower percentage of minor accidents had the effect of increasing the actual recorded severity across the total claims population. Consequently, the implied inflation rate recorded for the 2020 accident year is skewed upward. (2)Claim Count Development The Company generally estimates ultimate claim counts for an accident period based on development of claim counts in prior accident periods. Typically, almost every claim is reported within one year following the end of an accident year and at that point the Company has a high degree of certainty as to the ultimate claim count. There are many factors that can affect the number of claims reported after an accident period ends. These factors include changes in weather patterns, a change in the number of litigated files, the number of automobiles insured, and whether the last day of the accident period falls on a weekday or a weekend. However, the Company is unable to determine which, if any, of the factors actually impact the number of claims reported and, if so, by what magnitude. The COVID-19 pandemic created greater uncertainty in the claims count development for the 2020 accident year. The Company believes that the reduced services for non-critical cases at medical facilities and fear of infection during the pandemic combined with the economic hardship caused by the pandemic are likely to increase the late reporting of claims seeking settlement for monetary compensation. AtDecember 31, 2020 , there were 17,829California automobile BI claims reported for the 2020 accident year, and while actual development in recent years has ranged approximately from 3% to 7%, the Company estimates that the BI claims for the 2020 accident year are expected to ultimately grow by approximately 11.6%, as it expects an increase in late reporting of claims given the high level of uncertainty in claims reporting patterns associated with the COVID-19 pandemic. The Company further believes that it is reasonable to expect that the range of the development for the 2020 accident year is subject to greater variability due to uncertainty related to the pandemic and could be as great as between 0% and 20%. However, actual development may be more or less than the expected range. 39 --------------------------------------------------------------------------------
The following table presents the effects on loss development of different claim
counts within the broader possible range at
California Automobile Bodily Injury Claim Count Reserve Sensitivity Analysis
Amount Recorded
at 12/31/2020 at Approximately Total Expected Total Expected
11.6% Amount If Claim Amount If Claim
Claim Count Count Development is Count Development is
2020 Accident Year Claims Reported Development 0% 20%
Claim count 17,829 19,896 17,829 21,395
Approximate average cost per claim Not meaningful $ 20,557 $ 20,557 $ 20,557
Total dollars Not meaningful $ 409,002,000 $ 366,511,000 $ 439,817,000
Total LossDevelopment-Favorable (Unfavorable) $ 42,491,000 $
(30,815,000)
(3) Unexpected Losses From Older Accident Periods
Unexpected losses are generally not provided for in the current loss reserve because they are not known or expected and tend to be unquantifiable. Once known, the Company establishes a provision for the losses, but it is not possible to provide any meaningful sensitivity analysis as to the potential size of any unexpected losses. These losses can be caused by many factors, including unexpected legal interpretations of coverage, ineffective claims handling, regulations extending claims reporting periods, assumption of unexpected or unknown risks, adverse court decisions as well as many unknown factors. During 2020, the Company did not incur any material unexpected losses related to claims from accident periods prior to 2017. Unexpected losses are fairly infrequent but can have a large impact on the Company's losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected losses in future periods. It is also possible that the Company has not identified and established a sufficient loss reserve for all material unexpected losses occurring in the older accident years, even though a comprehensive claims file review was undertaken. The Company may experience additional development on these loss reserves. Discussion of Losses and Loss Reserves and PriorPeriod Loss Development AtDecember 31, 2020 and 2019, the Company recorded its point estimate of approximately$1.99 billion and$1.92 billion ($1.94 billion and$1.85 billion , net of reinsurance), respectively, in loss and loss adjustment expense reserves, which included approximately$885 million and$847 million ($864 million and$829 million , net of reinsurance), respectively, of incurred-but-not-reported liabilities ("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 toDecember 31, 2020 and 2019, 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 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 2020, the Company reported unfavorable development of approximately$23 million on the 2019 and prior accident years' loss and loss adjustment expense reserves. The unfavorable development in 2020 was primarily attributable to higher than estimated losses and loss adjustment expenses in the homeowners and commercial automobile lines of insurance business, partially offset by favorable development in the private passenger automobile line of insurance business. The Company recorded catastrophe losses net of reinsurance of approximately$64 million in 2020. Catastrophe losses due to the catastrophe events that occurred during 2020 totaled approximately$69 million , with no reinsurance benefits used for these losses. The majority of the 2020 catastrophe losses resulted from wildfires and windstorms inCalifornia and extreme weather events outside ofCalifornia . These losses were partially offset by favorable development of approximately$5 million on prior years' catastrophe losses. 40 -------------------------------------------------------------------------------- Fair Value of Financial Instruments Financial instruments recorded in the consolidated balance sheets include investments, note receivable, other receivables, accounts payable, options sold, and 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 2. Financial Instruments, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data." The Company's financial instruments include securities issued by theU.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. 98.3% of the fair value of these financial instruments held atDecember 31, 2020 is based on observable market prices, observable pricing 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 pricing 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 financial 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. For a further discussion, see Note 4. Fair Value Measurements, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
Income Taxes
AtDecember 31, 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 and deferred acquisition costs. 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. 41 -------------------------------------------------------------------------------- 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 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, nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. Tax-exempt investment income of approximately$78 million coupled with pre-tax income of approximately$459 million resulted in an effective tax rate of 18.3%, below the statutory tax rate of 21%, in 2020, and tax-exempt investment income of approximately$82 million coupled with pre-tax income of approximately$378 million resulted in an effective tax rate of 15.3% 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, results of operations, or cash flows. See "Regulatory and Legal Matters" above and Note 18. Commitments and Contingencies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data." RESULTS OF OPERATIONS
Year Ended
Revenues
Net premiums earned and net premiums written in 2020 decreased 1.2% and 3.2%, respectively, from 2019. The Company's net premiums earned and written in 2020 were each reduced by approximately$128 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 to a 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$56.2 million and$56.7 million in 2020 and 2019, respectively. Net premiums written included ceded premiums written of$50.6 million and$43.8 million in 2020 and 2019, respectively. The increase in ceded premiums written resulted mostly from higher reinsurance coverage, higher 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 less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. 42
--------------------------------------------------------------------------------
The following is a reconciliation of total net premiums earned to net premiums
written:
Year Ended December 31,
2020 2019
(Amounts in thousands)
Net premiums earned $ 3,555,635 $ 3,599,418
Change in net unearned premiums 55,908 132,305
Net premiums written $ 3,611,543 $ 3,731,723
Expenses
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Company's consolidated loss, expense, and combined ratios determined in accordance with GAAP:
Year Ended December 31,
2020 2019
Loss ratio 67.4 % 75.2 %
Expense ratio 25.7 % 24.2 %
Combined ratio 93.1 % 99.4 %
Loss ratio is calculated by dividing losses and loss adjustment expenses by net
premiums earned. The Company's loss ratio was affected by unfavorable
development of approximately $23 million and $10 million on prior accident
years' loss and loss adjustment expense reserves for the years ended
December 31, 2020 and 2019, respectively. The unfavorable development in 2020
was primarily attributable to higher than estimated losses and loss adjustment
expenses in the homeowners and commercial automobile lines of insurance
business, partially offset by favorable development in the private passenger
automobile line of insurance business, while the unfavorable development in 2019
was primarily attributable to higher than estimated defense and cost containment
expenses in the California automobile line of insurance business, partially
offset by favorable development in certain of the Company's other lines of
insurance business.
The 2020 loss ratio was negatively impacted by a total of approximately $64
million of catastrophe losses, net of reinsurance benefits, primarily due to
wildfires and windstorms in California and extreme weather events outside of
California . The 2019 loss ratio was also negatively impacted by a total of
approximately $53 million of catastrophe losses, net of reinsurance benefits,
primarily due to wildfires and winter storms in California , a hurricane in
Texas , and tornadoes and wind and hail storms in the Midwest.
Excluding the effect of estimated prior periods' loss development and
catastrophe losses, the loss ratio was 64.8% and 73.3% for the years ended
December 31, 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,
partially offset by premium refunds and credits under the "Mercury Giveback"
program as described above, an increase in loss severity in the private
passenger automobile line of insurance business, and higher losses in the
homeowners line of insurance business.
Expense ratio is calculated by dividing the sum of policy acquisition costs and
other operating expenses by net premiums earned. The increase in the expense
ratio is largely due 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,
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.
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; a combined ratio over 100% generally reflects unprofitable
underwriting results.
Income tax expense was $83.9 million and $58.0 million for the years ended
December 31, 2020 and 2019, respectively. The $25.9 million increase in income
tax expense was mainly due to a significant increase in pre-tax income of $80.4
million .
43
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Tax-exempt investment income, a component of total pre-tax income, remained
relatively steady with the same period in 2019.
Investments
The following table presents the investment results of the Company:
Year Ended December 31,
2020 2019
(Amounts in thousands)
Average invested assets at cost (1)
Net investment income (2)
Before income taxes $ 134,858 $ 141,263
After income taxes $ 120,043 $ 125,637
Average annual yield on investments (2)
Before income taxes 3.1 % 3.5 %
After income taxes 2.8 % 3.1 %
Net realized investment gains (losses)
__________
(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)Net investment income before and after income taxes decreased primarily due to a lower average yield on investments, partially offset by higher average invested assets. Average annual yield on investments before and after income taxes decreased 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:
Year Ended
Gains (Losses) Recognized in Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses):
Fixed maturity securities (1)(2) $ (2,412) $ 41,394 $ 38,982
Equity securities (1)(3) (4,543) 32,232 27,689
Short-term investments (1) (2,292) (1,014) (3,306)
Note receivable (1) - 60 60
Options sold 22,322 (16) 22,306
Total $ 13,075 $ 72,656 $ 85,731
44--------------------------------------------------------------------------------
Year Ended December 31, 2019
Gains (Losses) Recognized in Income
Changes in
Sales fair value Total
(Amounts in thousands)
Net realized investment gains (losses):
Fixed maturity securities (1)(2) $ 1,347 $ 104,379 $ 105,726
Equity securities (1)(3) 19,322 90,920 110,242
Short-term investments (1) (1,956) 1,295 (661)
Note receivable (1) - 108 108
Total return swaps 1,039 - 1,039
Options sold 6,329 10 6,339
Total $ 26,081 $ 196,712 $ 222,793 __________
(1)The changes in fair value of the investment portfolio and note receivable
resulted from the application of the fair value option.
(2)The increases in fair value of fixed maturity securities in 2020 and 2019
were primarily due to decreases in market interest rates.
(3)The increases in fair value of equity securities in 2020 and 2019 were
primarily due to the overall improvement in equity markets.
Net Income
Year Ended December 31,
2020 2019
(Amounts in thousands, except per share data)
Net income $ 374,607 $ 320,087
Basic average shares outstanding 55,358 55,351
Diluted average shares outstanding 55,358 55,360
Basic Per Share Data:
Net income $ 6.77 $ 5.78
Net realized investment gains, net of tax $ 1.22 $ 3.18
Diluted Per Share Data:
Net income $ 6.77 $ 5.78
Net realized investment gains, net of tax $ 1.22 $ 3.18
Year Ended
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Form 10-K for the year endedDecember 31, 2019 for a discussion of changes in its results of operations from the year endedDecember 31, 2018 to the year endedDecember 31, 2019 . LIQUIDITY AND CAPITAL RESOURCES A. General The Company is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay ordinary dividends of approximately$222 million in 2021 toMercury General . The Insurance Companies paidMercury General ordinary dividends of$121 million during 2020. As ofDecember 31, 2020 ,Mercury General had approximately$140 million in investments and cash that could be utilized to satisfy its direct holding company obligations. 45 -------------------------------------------------------------------------------- The principal sources of funds for the Insurance Companies are premiums, sales and maturity of invested assets, and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends toMercury General , payment of debt and debt service costs, and the purchase of investments.
B. Cash Flows
The Company has generated positive cash flow from operations since the public offering of its common stock inNovember 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$724.1 million atDecember 31, 2020 as well as 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 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 year endedDecember 31, 2020 was$605.6 million , an increase of$85.9 million compared to the year endedDecember 31, 2019 . The increase was primarily due to a decrease in payments for losses and loss adjustment expenses, partially offset by a decrease in collections from reinsurers on reinsurance recoverables, an increase in payments for income taxes and a decrease in premium collections net of premium refunds. The Company utilized the cash provided by operating activities during the year endedDecember 31, 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 $ 246,708
Due after one year through two years 376,850
Due after two years through three years 213,301
Due after three years through four years 52,459
Due after four years through five years 50,457
$ 939,775
See "D. Debt" below for cash flow related to outstanding debt.
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.
46
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The following table presents the composition of the total investment portfolio
of the Company at
Cost(1) Fair Value
(Amounts in thousands)
Fixed maturity securities:
U.S. government bonds$ 13,756
Municipal securities 2,632,559
2,791,212
Mortgage-backed securities 91,527 93,264
Corporate securities 240,486 241,366
Collateralized loan obligations 256,558 256,891
Other asset-backed securities 153,532 153,261
3,388,418 3,549,810
Equity securities:
Common stock 563,394 691,782
Non-redeemable preferred stock 31,430
32,660
Private equity funds measured at net asset value (2) 100,326
79,409
695,150 803,851
Short-term investments 376,547 375,609
Total investments $ 4,460,115 $ 4,729,270
__________
(1)Fixed maturities and short-term bonds at amortized cost and equities and
other short-term investments at cost.
(2)The fair value is measured using the net asset value practical expedient. See
Note 4. Fair Value Measurements of the Notes to Consolidated Financial
Statements for additional information.
At December 31, 2020 , 55.1% of the Company's total investment portfolio at fair
value and 73.4% of its total fixed maturity investments 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 December 31, 2020 , 92.8% of
short-term investments consisted of highly rated short-duration securities
redeemable on a daily or weekly basis.
Fixed Maturity Securities and Short-Term Investments
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. Short-term investments 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.
47
--------------------------------------------------------------------------------The following table presents the maturities and durations of the Company's fixed maturity securities and short-term investments:
December 31, 2020 December 31, 2019
(in years)
Fixed Maturity Securities
Nominal average maturity:
excluding short-term investments 11.7 13.9
including short-term investments 10.6 12.0
Call-adjusted average maturities:
excluding short-term investments 4.1 4.6
including short-term investments 3.7 4.0
Modified duration reflecting anticipated early calls: excluding short-term investments
3.4 3.7
including short-term investments 3.0 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 December 31, 2020 , consistent with the average rating at
December 31, 2019 . The Company's municipal bond holdings, of which 93.4% were
tax exempt, represented 78.6% of its fixed maturity portfolio at December 31,
2020 , at fair value, and were broadly diversified geographically.
To calculate the weighted-average credit quality ratings as disclosed throughout
this Annual Report on Form 10-K, individual securities were weighted based on
fair value and a credit quality numeric score that was assigned to each
security's average of ratings assigned by nationally recognized securities
rating organizations.
Taxable holdings consist principally of investment grade issues. At December 31,
2020 , fixed maturity holdings rated below investment grade and non-rated bonds
totaled $25.5 million and $38.4 million , respectively, at fair value, and
represented 0.7% and 1.1%, 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 holdings rated
below investment grade and non-rated bonds totaled $19.2 million and $37.8
million , respectively, at fair value, and represented 0.6% and 1.2%,
respectively, of total fixed maturity securities.
Credit ratings for the Company's fixed maturity portfolio were stable in 2020,
with 91.4% of fixed maturity securities at fair value experiencing no change in
their overall rating. 2.6% and 6.0% of fixed maturity securities at fair value
experienced upgrades and downgrades, respectively, in 2020.
48
--------------------------------------------------------------------------------The following table presents the credit quality ratings of the Company's fixed maturity securities by security type at fair value:
December 31, 2020
Total Fair
Security Type AAA(1) AA(1) A(1) BBB(1) Non-Rated/Other (1) Value(1)
(Dollars in thousands)U.S. government bonds: Treasuries$ 13,816 $ - $ - $ - $ -$ 13,816 Total 13,816 - - - - 13,816 100.0 % - % - % - % - % 100.0 % Municipal securities: Insured 37,331 175,732 109,690 52,061 2,221 377,035 Uninsured 97,709 783,290 1,274,639 218,587 39,952 2,414,177 Total 135,040 959,022 1,384,329 270,648 42,173 2,791,212 4.8 % 34.4 % 49.6 % 9.7 % 1.5 % 100.0 % Mortgage-backed securities: Commercial 6,787 5,162 1,493 4,134 - 17,576 Agencies 1,094 - - - - 1,094 Non-agencies: Prime 24,841 40,396 6,726 57 621 72,641 Alt-A - 642 - 611 700 1,953 Total 32,722 46,200 8,219 4,802 1,321 93,264 35.2 % 49.5 % 8.8 % 5.1 % 1.4 % 100.0 % Corporate securities: Basic materials - - - 399 2,736 3,135 Communications - - 191 482 - 673 Consumer, cyclical - 2,575 7,477 5,593 4,975 20,620 Consumer, non-cyclical - 10,361 14,263 11,995 - 36,619 Energy - - 2,286 18,088 2,000 22,374 Financial - 12,514 87,152 30,061 3,270 132,997 Industrial - 450 2,055 15,753 - 18,258 Utilities - - 6,690 - - 6,690 Total - 25,900 120,114 82,371 12,981 241,366 - % 10.7 % 49.8 % 34.1 % 5.4 % 100.0 % Collateralized loan obligations: Corporate 79,860 24,260 151,771 - 1,000 256,891 Total 79,860 24,260 151,771 - 1,000 256,891 31.1 % 9.4 % 59.1 % - % 0.4 % 100.0 % Other asset-backed securities 58,000 77,000 11,884 - 6,377 153,261 37.8 % 50.2 % 7.8 % - % 4.2 % 100.0 % Total$ 319,438 $ 1,132,382 $ 1,676,317 $ 357,821 $ 63,852$ 3,549,810 9.0 % 31.9 % 47.2 % 10.1 % 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$13.8 million and$22.6 million , or 0.4% and 0.7% of its fixed maturity portfolio, at fair value, inU.S. government bonds atDecember 31, 2020 and 2019, respectively. AtDecember 31, 2020 , Moody's and Fitch ratings forU.S. government issued debt were Aaa andAAA , respectively, although a significant increase in government deficits and debt could lead to a downgrade. The Company understands that market participants continue to use rates of return onU.S. government 49 -------------------------------------------------------------------------------- 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 1.0 years atDecember 31, 2020 and 2019.Municipal Securities The Company had$2.79 billion and$2.55 billion , or 78.6% and 82.6% of its fixed maturity securities portfolio, at fair value, in municipal securities atDecember 31, 2020 and 2019, respectively, of which$377.0 million and$344.7 million , respectively, were insured by bond insurers. 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 bond ratings and the underlying credit ratings as ofDecember 31, 2020 and 2019. AtDecember 31, 2020 and 2019, respectively, 59.9% and 65.5% of the insured municipal securities, at fair value, most of which were investment grade, were insured by bond insurers that provide credit enhancement in addition to the ratings reflected by the financial strength of the underlying issuers. AtDecember 31, 2020 and 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 40.1% and 34.5% of insured municipal securities atDecember 31, 2020 and 2019, respectively, were insured by non-rated or below investment grade bond insurers that the Company believes did not provide credit enhancement. The modified duration of the municipal securities portfolio reflecting anticipated early calls was 3.4 years and 3.7 years atDecember 31, 2020 and 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 those municipal bonds.Mortgage-Backed Securities AtDecember 31, 2020 and 2019, respectively, the mortgage-backed securities portfolio of$93.3 million and$63.0 million , or 2.6% and 2.0% of the Company's fixed maturity securities portfolio, at fair value, was categorized as loans to "prime" borrowers, except for$2.0 million and$2.4 million , at fair value, 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$17.6 million and$18.9 million , at fair value, in commercial mortgage-backed securities atDecember 31, 2020 and 2019, respectively. The weighted-average rating of the Company's Alt-A mortgage-backed securities was BBB- atDecember 31, 2020 and 2019. The weighted-average rating of the entire mortgage backed securities portfolio was AA atDecember 31, 2020 and 2019. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 6.4 years and 3.1 years atDecember 31, 2020 and 2019, respectively.Corporate Securities AtDecember 31, 2020 and 2019, respectively, the company had corporate securities of$241.4 million and$235.6 million , or 6.8% and 7.6% of its fixed maturity securities portfolio, at fair value. The weighted-average rating was A- atDecember 31, 2020 and 2019. The modified duration reflecting anticipated early calls was 1.7 years and 2.0 years atDecember 31, 2020 and 2019, respectively. Collateralized Loan Obligations The Company had collateralized loan obligations of$256.9 million and$199.2 million , which represented 7.2% and 6.4% of its fixed maturity securities portfolio, at fair value, atDecember 31, 2020 and 2019, respectively. The weighted-average rating was AA- and A+ atDecember 31, 2020 and 2019, respectively. The modified duration reflecting anticipated early calls was 4.8 years and 5.2 years atDecember 31, 2020 and 2019, respectively. 50 --------------------------------------------------------------------------------
Other Asset-Backed Securities
The Company had other asset-backed securities of$153.3 million and$18.6 million , which represented 4.3% and 0.6% of its fixed maturity securities portfolio, at fair value, atDecember 31, 2020 and 2019, respectively. The weighted-average rating was AA+ and A atDecember 31, 2020 and 2019, respectively. The modified duration reflecting anticipated early calls was 1.6 years and 1.8 years atDecember 31, 2020 and 2019, respectively.Equity Securities Equity holdings of$803.9 million and$724.8 million , at fair value, as ofDecember 31, 2020 and 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 net gains due to changes in fair value of the Company's equity portfolio were$32.2 million and$90.9 million in 2020 and 2019, respectively. The primary cause for the increase in fair value of the Company's equity securities in 2020 and 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. AtDecember 31, 2020 , 17.0% of the total investment portfolio, at fair value, was held in equity securities, compared to 16.8% atDecember 31, 2019 .
The following table presents the equity security portfolio by industry sector at
December 31,
2020 2019
Cost Fair Value Cost Fair Value
(Amounts in thousands)
Equity securities:
Basic materials $ 7,520 $ 8,262 $ 9,528 $ 10,058
Communications 28,970 34,806 26,130 29,516
Consumer, cyclical 60,604 78,822 49,816 52,470
Consumer, non-cyclical 64,067 77,071 47,427 55,526
Energy 51,338 37,163 57,459 54,615
Financial 81,602 102,924 100,720 121,642
Funds 143,947 137,143 141,405 139,517
Industrial 59,084 76,348 45,132 55,135
Technology 97,190 145,023 65,280 89,681
Utilities 100,828 106,289 105,385 116,591
$ 695,150 $ 803,851 $ 648,282 $ 724,751
D. Debt
Notes payable consist of the following:
December 31,
Lender Interest Rate Expiration 2020 2019
(Amounts in thousands)
Senior unsecured notes(1) Publicly traded 4.40% March 15, 2027 $ 375,000 $ 375,000
Unsecured credit Bank of America and LIBOR plus 112.5-162.5
facility(2) Wells Fargo Bank basis points March 29, 2022 - -
Total principal amount 375,000 375,000
Less unamortized discount
and debt issuance costs(3) 2,468 2,867
Total $ 372,532 $ 372,133
__________
(1) 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 . These notes mature on March 15, 2027 . The
Company used the proceeds
51
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from the notes to pay off the total outstanding balance of $320 million under
the existing loan and credit facility agreements and terminated the agreements
on March 8, 2017 . The remainder of the proceeds from the notes was used 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%.
(2) 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 15.6% at December 31, 2020 , resulting in a 15 basis
point commitment fee on the $50 million undrawn portion of the credit facility.
As of February 16, 2021 , there have been no borrowings under this facility.
(3) The unamortized discount and debt issuance costs are associated with the
publicly traded $375 million senior unsecured notes. These are amortized to
interest expense over the life of the notes, and the unamortized balance is
presented in the Company's consolidated balance sheets as a direct deduction
from the carrying amount of the debt. The unamortized debt issuance cost of
approximately $0.1 million associated with the $50 million five-year unsecured
revolving credit facility maturing on March 29, 2022 is included in other assets
in the Company's consolidated balance sheets and amortized to interest expense
over the term of the credit facility.
The Company was in compliance with all of its financial covenants pertaining to
minimum statutory surplus, debt to total capital ratio, and RBC ratio under the
unsecured credit facility at December 31, 2020 .
For a further discussion, see Note 8. Notes Payable, of the Notes to
Consolidated Financial Statements in "Item 8. Financial Statements and
Supplementary Data."
E. Capital Expenditures
In 2020, the Company made capital expenditures, including capitalized software,
of approximately $40.0 million primarily related to information technology.
F. Regulatory Capital Requirements
The Insurance Companies must comply with minimum capital requirements under
applicable state laws and regulations. The RBC formula is used by insurance
regulators to monitor capital and surplus levels. It was designed to capture the
widely varying elements of risks undertaken by writers of different lines of
insurance business having differing risk characteristics, as well as writers of
similar lines where differences in risk may be related to corporate structure,
investment policies, reinsurance arrangements, and a number of other factors.
The Company periodically monitors the RBC level of each of the Insurance
Companies. As of December 31, 2020 , 2019 and 2018, each of the Insurance
Companies exceeded the minimum required RBC level, as determined by the NAIC and
adopted by the state insurance regulators. None of the Insurance Companies' RBC
ratios were less than 350% of the authorized control level RBC as of
December 31, 2020 , 2019 and 2018. Generally, an RBC ratio of 200% or less would
require some form of regulatory or company action.
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 $1.77 billion at December 31,
2020 and net premiums written in 2020 of $3.6 billion , the ratio of premiums
written to surplus was 2.04 to 1.
Insurance companies are required to file an Own Risk and Solvency Assessment
("ORSA") with the insurance regulators in their domiciliary states. The ORSA is
required to cover, among many items, a company's risk management policies, the
material risks to which the company is exposed, how the company measures,
monitors, manages and mitigates material risks, and how much economic and
regulatory capital is needed to continue to operate in a strong and healthy
manner. The ORSA is intended to be used by state insurance regulators to
evaluate the risk exposure and quality of the risk management processes within
insurance companies to assist in conducting risk-focused financial examinations
and for determining the overall financial condition of insurance companies. The
Company filed its most recent ORSA Summary Report with the California DOI in
November 2020 . Compliance with the ORSA requirements did not have a material
impact on the Company's consolidated financial statements.
52
--------------------------------------------------------------------------------The DOI in each state in which the Company operates is responsible for conducting periodic financial and market conduct 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.
The following table presents a summary of recent examinations:
State Exam Type Period Under Review Status
Desk audit was completed in the first
quarter of 2021 with no additional taxes
CA Premium Tax 2015 to 2018 due.
Desk audit was completed in the fourth
quarter of 2020 with no additional taxes
TX Premium and Maintenance Tax 2016 to 2019 due.
Final report of examination was adopted
CA Market Conduct 2014 by the DOI on November 6, 2019.
During the course of and at the conclusion of these examinations, the examining
DOI generally reports findings to the Company. On October 30, 2020 , the Company
received notice from the DOI that the market conduct examination report
mentioned above was being reviewed for potential further action in connection
with some of the findings in the report. Subsequently, the DOI gave the Company
notice of its intent to proceed with an enforcement action for the alleged
violations in the report. The Company will have the opportunity to resolve the
alleged violations before a Notice of Noncompliance is formally filed with the
DOI.
OFF-BALANCE SHEET ARRANGEMENTS
As of
CONTRACTUAL OBLIGATIONS
The Company's significant contractual obligations at December 31, 2020 are
summarized as follows:
Contractual Obligations
(4) Payments Due By Period
Total 2021 2022 2023 2024 2025 Thereafter
(Amounts in thousands)
Debt (including
interest)(1) $ 482,250 $ 16,500 $
16,500
49,295 15,992 13,361 8,717 5,010 3,230 2,985
Loss and loss adjustment expense reserves(3) 1,991,304 1,246,658 350,486 172,729 102,932 52,391
66,108
Total contractual obligations$ 2,522,849 $ 1,279,150 $ 380,347 $ 197,946 $ 124,442 $ 72,121 $ 468,843 __________ (1)The Company's debt contains various terms, conditions and covenants which, if violated by the Company, would result in a default and could result in the acceleration of the Company's payment obligations. Amounts differ from the balances presented on the consolidated balance sheets as ofDecember 31, 2020 because the debt amounts above include interest, calculated at the stated 4.4% coupon rate, and exclude the discount and issuance costs of the debt. (2)The Company is obligated under various non-cancellable lease agreements providing for office space, automobiles, office equipment, and electronic data processing equipment that expire at various dates through the year 2028. (3)Loss and loss adjustment expense reserves represents an estimate of amounts necessary to settle all outstanding claims, including IBNR as ofDecember 31, 2020 . The Company has estimated the timing of these payments based on its historical experience and expectation of future payment patterns. However, the timing of these payments may vary significantly from the amounts shown above. The ultimate cost of losses may vary materially from recorded amounts which are the Company's best estimates. The Company believes that cash flows from operations and existing cash and investments are sufficient to meet these obligations despite the uncertainty in payment patterns. For more detailed information on the Company's liquidity and cash flows, see "Liquidity and Capital Resources-B. Cash Flows" in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." (4)The table excludes liabilities of$6.2 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments. 53
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