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| MCY > SEC Filings for MCY > Form 10-K on 11-Feb-2013 | All Recent SEC Filings |
11-Feb-2013
Annual Report
Certain statements in this Annual Report on Form 10-K or in other materials the
Company has filed or will file with the SEC (as well as information included in
oral statements or other written statements made or to be made by the Company)
contain or may contain "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
may address, among other things, the Company's strategy for growth, business
development, regulatory approvals, market position, expenditures, financial
results, and reserves. Forward-looking statements are not guarantees of
performance and are subject to important factors and events that could cause the
Company's actual business, prospects, and results of operations to differ
materially from the historical information contained in this Annual Report on
Form 10-K and from those that may be expressed or implied by the forward-looking
statements contained in this Annual Report on Form 10-K and in other reports or
public statements made by the Company.
Factors that could cause or contribute to such differences include, among others: the competition currently existing in the automobile insurance markets in California and the other states in which the Company operates; the cyclical and generally competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserves or other estimates; the accuracy and adequacy of the Company's pricing methodologies; the Company's success in managing its business in states outside of California; the impact of potential third party "bad-faith" legislation, changes in laws, regulations or new interpretations of existing laws and regulations, tax position challenges by the California Franchise Tax Board ("FTB"), and decisions of courts, regulators and governmental bodies, particularly in California; the Company's ability to obtain and the timing of required regulatory approvals of premium rate changes for insurance policies issued in states where the Company operates; the Company's reliance on independent agents to market and distribute its policies; the investment yields the Company is able to obtain with its investments and the market risks associated with the Company's investment portfolio; the effect government policies may have on market interest rates; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters, including those which may be related to climate change, in the markets served by the Company; the stability of the Company's information technology systems and the ability of the Company to execute on its information technology initiatives; the Company's ability to realize current deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other uncertainties, all of which are difficult to predict and many of which are beyond the Company's control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods.
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. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report or statement. Investors should also understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company's forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements.
The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents in thirteen states. The Company also offers homeowners, commercial automobile and property, mechanical breakdown, fire, and umbrella insurance. Private passenger automobile lines of insurance accounted for 80.6% of the $2.7 billion of the Company's direct premiums written in 2012. 78.0% of the private passenger automobile premiums were written in California. The Company also operates in Arizona, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas, and Virginia.
The Company expects to continue its growth by expanding into new states in the future to achieve greater geographic diversification. There are challenges and risks involved in entering each new state, including establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems, and finding qualified agents to represent the Company. The Company does not expect to enter into any new states during 2013.
This section discusses some of the relevant factors that management considers in evaluating the Company's performance, prospects, and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of management's discussion and analysis, the Company's consolidated financial statements and notes thereto, and all other items contained within this Annual Report on Form 10-K.
2012 Financial Performance Summary
The Company's net income for the year ended December 31, 2012 decreased to
$116.9 million, or $2.13 per diluted share, from $191.2 million, or $3.49 per
diluted share, for the same period in 2011. Approximately $132 million in
pre-tax investment income was generated during 2012 on a portfolio of
approximately $3.2 billion at fair value at December 31, 2012, compared to $141
million pre-tax investment income during 2011 on a portfolio of approximately
$3.1 billion at fair value at December 31, 2011. Included in net income are net
realized investment gains of $66.4 million and $58.4 million in 2012 and 2011,
respectively. Net realized investment gains include gains of $45.5 million and
$31.3 million in 2012 and 2011, respectively, due to changes in the fair value
of total investments pursuant to application of the fair value accounting
option.
During 2012, 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 the Company very competitive in California and in other states.
The Company believes its thorough underwriting process gives it an advantage over competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower rates yet realize better margins than many competitors.
The Company's operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $148 million and $159 million in 2012 and 2011, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
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, 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 analysis shows that they are needed.
• Economic Conditions-Many businesses are experiencing a slow recovery from the severe economic recession, and economic uncertainty is expected to continue in 2013 due in large part to continuing political disagreements in Washington that may cause businesses and consumers to hold back spending. Further, the sovereign debt crisis in Europe continues to lead to weaker global economic growth, heightened financial vulnerabilities and some negative
rating actions. The Company is unable to predict the duration and severity of
current global economic conditions and their impact on the United States, and
California, where the majority of the Company's business is produced. If
economic conditions do not show improvement, there could be an adverse impact on
the Company's financial condition, results of operations, and liquidity.
• Inflation-The largest cost component for automobile insurers is losses,
which include medical costs, replacement automobile parts, and labor
costs. There can be significant variation in the overall increases in
medical cost inflation, and it is often a year or more after the
respective fiscal period ends before sufficient claims have closed for
the inflation rate to be known with a reasonable degree of
certainty. Therefore, it can be difficult to establish reserves and set
premium rates, particularly when actual inflation rates 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. There has been a long-term trend of declining loss frequency in the personal automobile insurance industry. However, in recent years, the trend has shown increasing loss frequency, and the Company may not be able to accurately predict the trend of loss frequency in the future.
• Underwriting Cycle and Competition-The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company has historically seen significant premium growth during hard markets. The Company believes that the market may be hardening as growth has begun to improve throughout 2012.
Technology
In 2012, the Company continued to enhance its internet agency portal, Mercury
First. Mercury First is a single entry point for agents providing a broad suite
of capabilities. One of its most powerful tools is a point of sale (POS) system
that allows agents to easily obtain and compare quotes and write new
business. Mercury First is designed as an easy-to-use agency portal that
provides a customized work queue for each agency user showing new business
leads, underwriting requests and other pertinent customer information in real
time. Agents can also assist customers with processing payments, reporting
claims or updating their records. The system enables quick access to documents
and forms and empowers the agents with several self-service capabilities.
The NextGen system is designed to be a multi-state, multi-line system. NextGen serves as the primary platform for all underwriting, billing, claims, and commission functions supporting the private passenger auto line in seven states (Virginia, New York, Florida, California, Georgia, Illinois, and Texas).
During 2010, the Company launched Guidewire, a commercially available software solution, to replace legacy platforms and implemented it for the Nevada homeowners line. In 2011, the Company expanded the Guidewire implementation to Texas, Georgia, Illinois, Pennsylvania, and Oklahoma for the homeowners line of business and for the Texas commercial auto line of business. In 2012, the Company continued to expand the Guidewire implementation to California, Oklahoma, Georgia, and Arizona for the commercial auto line and to Michigan and Nevada for the private passenger automobile line. The Company plans to expand Guidewire to other states and lines of business during 2013.
In 2012, as part of its continuing commitment to service excellence, the Company
enhanced the web capability for customers in California and Georgia to bind and
pay for new policies online. These policies are serviced by the Company's
agents. The Company plans to expand this capability to other states in the
future.
B. Regulatory and Legal Matters
The process for implementing rate changes varies by state, with California,
Georgia, New York, New Jersey, Pennsylvania, and Nevada requiring prior approval
from the respective DOI before a rate change may be implemented. Illinois,
Texas, Virginia, Arizona, and Michigan only require that rates be filed with the
DOI. Oklahoma and Florida have a modified version of prior approval laws. In all
states, the insurance code provides that rates must not be excessive,
inadequate, or unfairly discriminatory. For the Company's two largest lines of
business, private passenger automobile and homeowners, the Company filed rate
increases in thirteen states during 2012.
The California DOI uses rating factor regulations requiring automobile insurance
rates to be determined in decreasing order of importance by (1) driving safety
record, (2) miles driven per year, (3) years of driving experience, and
(4) other factors as determined by the California DOI to have a substantial
relationship to the risk of loss and adopted by regulation.
On October 26, 2012, the Company implemented the California DOI approved rate increase of approximately 4% on California private passenger automobile policies. The rate increase has not had a significant impact on the number of new and renewal policies written. In October 2012, the Company filed for a 6.9% rate increase in CAIC's private passenger automobile
line of business, and plans to file for a rate increase in MIC's private passenger automobile line of business. The Company must obtain approval from the California DOI before implementing these new rates.
In May 2009, the Company filed for a 3.9% rate increase for its California homeowners line of business. In May 2011, the matter was referred to an administrative law judge for review. After extensive evidentiary hearings, the administrative law judge delivered a proposed decision on the matter to the California Insurance Commissioner in September 2012 that recommended a rate reduction of approximately 5.5%. On October 29, 2012, the Company received notice from the California Insurance Commissioner rejecting the administrative law judge's proposed decision and referred the matter back to the administrative law judge to gather more evidence. However, the California Insurance Commissioner recently issued a ruling to disregard his order to gather more evidence. The Company expects a final ruling from the California Insurance Commissioner on this matter in the near future. The Company does not agree with the proposed rate decrease and believes that recent homeowners loss trends support an increase. Consequently, the Company recently filed for a rate increase of 6.9%.
In January 2013, the California DOI approved auto body repair regulation to strengthen consumer protection. This regulation builds on existing protection by requiring insurers to settle automobile insurance claims using repair standards described by the regulation and not by the insurers' own standards. The new ruling will become effective in March 2013. The full extent of the impact is currently unknown.
In April 2010, the California DOI issued a Notice of Non-Compliance ("2010 NNC") to Mercury Insurance Company ("MIC"), Mercury Casualty Company ("MCC"), and California Automobile Insurance Company ("CAIC") based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI in February 2010. The 2010 NNC includes allegations of 35 instances of noncompliance with applicable California insurance law and seeks to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and may also seek monetary penalties. In April 2010, the Company submitted a Statement of Compliance and Notice of Defense to the 2010 NNC, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each allegation. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense does not establish to the satisfaction of the California DOI that the alleged noncompliance does not exist, and the matters described in the 2010 NNC are not otherwise able to be resolved informally with the California DOI. However, no assurance can be given that efforts to resolve the 2010 NNC informally will be successful.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, "2004 NNC") alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer's insurance broker. The California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee and a penalty for each on which the Company allegedly used a misleading advertisement and to suspend certificates of authority for a period of one year. In January 2012, the administrative law judge bifurcated the 2004 NNC between (a) the California DOI's order to show cause, in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI's notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. In February 2012, the administrative law judge submitted a proposed decision dismissing the California DOI's 2004 NNC. In March 2012, the California Insurance Commissioner rejected the administrative law judge's proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, and the California Insurance Commissioner filed a demurrer to the Company's petition. Following a hearing, the trial court sustained the California Insurance Commissioner's demurrer without leave to amend because it found the Company must first exhaust its administrative remedies. The Company has appealed the trial court's decision and on January 3, 2013, filed a petition to stay the administrative proceeding pending a determination of its appeal. The Court of Appeal did not stay the adminstrative proceeding but has allowed the appeal to continue. The Company has filed its opening appellate brief, and the court granted the Company's request for an expedited appeal. On January 15, 2013, the administrative law judge heard various pending motions that had originally been filed by the Company in June 2011. The administrative law judge has not yet ruled on the motions.
The Company denies the allegations in the 2004 and 2010 NNC matters, and believes that no monetary penalties are warranted, and the Company intends to defend itself against the allegations vigorously. The Company has been subject to fines and penalties by the California DOI in the past due to alleged violations of the California Insurance Code. The largest and most recent of these was settled in 2008 for $300,000. However, prior settlement amounts are not necessarily indicative of the potential results in the current notice of non-compliance matters. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the 2004 and 2010 NNC matters will be material to the Company's financial position, results of operations, or cash flow. The Company has accrued a liability for the estimated cost to defend itself in the notice of non-compliance matters.
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 Estimates" and Note 1 of Notes to Consolidated Financial Statements.
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company's pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, 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 16
of Notes to Consolidated Financial Statements-Commitments and
Contingencies-Litigation.
C. Critical Accounting Estimates
Reserves
Preparation of the Company's consolidated financial statements requires judgment
and estimates. The most significant is the estimate of loss reserves. Estimating
loss reserves is a difficult process as many factors can ultimately affect the
final settlement of a claim and, therefore, the reserve that is
required. Changes in the regulatory and legal environment, results of
litigation, medical costs, the cost of repair materials, and labor rates, among
other factors, can impact ultimate claim costs. In addition, time can be a
critical part of reserving determinations since the longer the span between the
incidence of a loss and the payment or settlement of a claim, the more variable
the ultimate settlement amount could be. Accordingly, short-tail claims, such as
property damage claims, tend to be more reasonably predictable than long-tail
liability claims.
The Company calculates a point estimate rather than a range of loss reserve estimate. There is inherent uncertainty with estimates and this is particularly true with estimates for loss reserves. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, 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 reserve by looking at historical patterns and trends and projecting these out to current reserves. The underlying factors and assumptions that serve as the basis for preparing the 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 an independent actuarial consultant to review the
Company's reserves and to provide the annual actuarial opinions required under
state statutory accounting requirements. The Company does not rely on the
actuarial consultant for GAAP reporting or periodic report disclosure purposes.
The Company analyzes loss reserves quarterly primarily using the incurred loss,
claim count development, and average severity methods described below. The
Company also uses the paid loss development method to analyze loss adjustment
expense reserves as part of its reserve analysis. 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 business or coverage within a line of business. When establishing the
reserve, the Company will generally analyze the results from all of the methods
used rather than relying on a single method. While these methods are designed to
determine the ultimate losses on claims under the Company's policies, there is
inherent uncertainty in all actuarial models since they use historical data to
project outcomes. The Company believes that the techniques it uses provide a
reasonable basis in estimating loss reserves.
• The incurred loss development method analyzes historical incurred case
loss (case reserves plus paid losses) development to estimate ultimate
losses. The Company applies development factors against current case
incurred losses by accident period to calculate ultimate expected losses.
The Company believes that the incurred loss development method provides a
reasonable basis for evaluating ultimate losses, particularly in the
Company's larger, more established lines of business which have a long
operating history.
• The 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 . . .
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