-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HVTmKwr1B2RBE5Le0kjhXC7iYWxkWQ3RkwKhDadismLFtd5cwxF51ui9FVhgky0Q jbf1K1zATVCBqHZtlL964Q== 0000898430-02-001049.txt : 20020415 0000898430-02-001049.hdr.sgml : 20020415 ACCESSION NUMBER: 0000898430-02-001049 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20011231 FILED AS OF DATE: 20020327 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MERCURY GENERAL CORP CENTRAL INDEX KEY: 0000064996 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 952211612 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-12257 FILM NUMBER: 02588264 BUSINESS ADDRESS: STREET 1: 4484 WILSHIRE BOULEVARD CITY: LOS ANGELES STATE: CA ZIP: 90010 BUSINESS PHONE: 2139371060 MAIL ADDRESS: STREET 1: LOS ANGELES 10-K 1 d10k.txt FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2001 Commission File No. 0-3681 MERCURY GENERAL CORPORATION (Exact name of registrant as specified in its charter) California 95-221-1612 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 4484 Wilshire Boulevard, Los Angeles, California 90010 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (323) 937-1060 Securities registered pursuant to Section 12(b) of the Act Title of Class Name of Exchange on Which Registered -------------- ------------------------------------ Common Stock New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act NONE Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] - - Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the Registrant's voting stock held by non-affiliates of the Registrant at March 15, 2002, was approximately $1,124,694,160 (based upon the closing sales price on the New York Stock Exchange for such date, as reported by the Wall Street Journal). At March 15, 2002, the Registrant had issued and outstanding an aggregate of 54,294,548 shares of its Common Stock. Documents Incorporated by Reference Portions of the definitive proxy statement for the Annual Meeting of Shareholders of Registrant to be held on May 8, 2002 are incorporated herein by reference into Part III hereof. Item 1. Business -------- General Mercury General Corporation ("Mercury General") and its subsidiaries (collectively, the "Company") are engaged primarily in writing all risk classifications of automobile insurance in a number of states, principally California. During 2001, private passenger automobile insurance and commercial automobile insurance accounted for 88.8% and 3.9%, respectively, of the Company's total gross premiums written. The percentage of gross automobile insurance premiums written during 2001 by state was 88.4% in California, 4.1% in Texas, 4.0% in Florida, 1.4% in Oklahoma, 1.0% in Illinois, 1.0% in Georgia and 0.1% in all other states. The Company also writes homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance and commercial property insurance. The non-automobile lines of insurance accounted for 7.3% of gross written premiums in 2001, of which approximately 17% was in commercial lines. The Company offers automobile policyholders the following types of coverage: bodily injury liability, underinsured and uninsured motorist, personal injury protection, property damage liability, comprehensive, collision and other hazards. The Company's published maximum limits of liability for bodily injury are $250,000 per person, $500,000 per accident and, for property damage, $250,000 per accident. Subject to special underwriting approval, the combined policy limits may be as high as $1,000,000 for vehicles written under the Company's commercial automobile plan. However, under the majority of the Company's automobile policies, the limits of liability are equal to or less than $100,000 per person, $300,000 per accident and $50,000 for property damage. In 2001, A.M. Best & Co. ("A.M. Best") assigned a rating of A+ (Superior) to all of the Company's insurance subsidiaries actively writing business during that year except American Mercury Insurance Company ("AMI") and American Mercury Lloyds Insurance Company ("AML"). This is the second highest of the fifteen rating categories in the A.M. Best rating system, which range from A++ (Superior) to F (In Liquidation). AMI and AML, which accounted for approximately 5% of the Company's 2001 net written premiums, were rated A- (Excellent) in 2001 by A.M. Best. The principal executive offices of Mercury General are located in Los Angeles, California. The home office of its California insurance subsidiaries and the Company's computer and operations center is located in Brea, California. The Company maintains branch offices in a number of locations in California as well as branch offices in Richmond, Virginia, Latham, New York, Vernon Hills, Illinois, Atlanta, Georgia, Clearwater, Florida, Oklahoma City, Oklahoma, and Austin, Dallas, Fort Worth, Houston and San Antonio, Texas. The Company has approximately 2,800 employees. Organization Mercury General, an insurance holding company, is the parent of Mercury Casualty Company ("Mercury Casualty"), a California automobile insurer founded in 1961 by George Joseph, Mercury General's Chief Executive Officer. Its insurance operations in California are conducted through three California insurance company subsidiaries, Mercury Casualty, Mercury Insurance Company ("Mercury Insurance"), and California Automobile Insurance Company. Two subsidiaries, Mercury Insurance Company of Georgia and Mercury Insurance Company of Illinois, received authority in late 1989 to write automobile insurance in those two states. In 1992, Mercury Indemnity Company of Georgia and Mercury Indemnity Company of Illinois were formed to write preferred risk 2 automobile insurance in those two states. Through an acquisition in December 1996, three additional subsidiaries were added to the group: American Fidelity Insurance Company, domiciled in Oklahoma; Cimarron Insurance Company, domiciled in Kansas; and AFI Management Company, Inc. ("AFIMC"), a Texas corporation which serves as the attorney-in-fact for American Fidelity Lloyds Insurance Company, a Texas insurer. Their operations are included in the consolidated financial statements of the Company effective December 1, 1996. During 1997, the names of American Fidelity Insurance Company and American Fidelity Lloyds Insurance Company were changed to American Mercury Insurance Company and American Mercury Lloyds Insurance Company, respectively. In June 1998, Cimarron Insurance Company was sold for cash. In December 1999, the Company acquired control of Concord Insurance Services, Inc. ("Concord"), a Texas insurance agency headquartered in Houston, Texas. Concord's results of operations are included in the consolidated financial statements of the Company effective October 31, 1999. In September 2000, the Company acquired the authority and right to manage and control Elm County Mutual Insurance Company, a mutual insurance company organized under Chapter 17 of the Texas Insurance Code. The acquisition was made through the purchase of a management agreement from Employers Reinsurance Corporation. Effective January 2, 2001, Elm County Mutual Insurance Company's name was changed to Mercury County Mutual Insurance Company ("MCM"). MCM's results of operations are included in the consolidated results of the Company effective September 30, 2000. In December 2001, the Company received authority to write automobile insurance in the state of Florida through two newly established companies, Mercury Insurance Company of Florida ("MICFL") and Mercury Indemnity Company of Florida ("MIDFL"). In January 2002, MICFL commenced writing new business as well as renewing business that was previously written through Mercury Casualty Company in Florida. The financial results of the two companies which are included in the consolidated financial statements at December 31, 2001, are immaterial to the Company in 2001. Prior to January 1, 2001, Mercury General furnished management services to its California, Georgia, Illinois and Oklahoma subsidiaries. Since January 1, 2001, these management services have been provided by Mercury Insurance Services, LLC ("MISLLC"), a subsidiary of Mercury Casualty Company. Mercury General, its subsidiaries and AML and MCM, are referred to collectively as the "Company" unless the context indicates otherwise. Mercury General Corporation individually is referred to as "Mercury General." All of the subsidiaries as a group, including AML and MCM, but excluding AFIMC, MISLLC and Concord, are referred to as the "Insurance Companies." The term "California Companies" refers to Mercury Casualty, Mercury Insurance and California Automobile Insurance Company. Underwriting The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Insurance Commissioners of the applicable states. Automobile insurance rates on voluntary business in California have been subject to prior approval by the California Department of Insurance ("DOI") since November 1989. The Company uses its own extensive data base to establish rates and classifications. The California DOI has in effect rating factor regulations that influence the weight the Company ascribes to various classifications of data. At December 31, 2001, "good drivers" (as defined by the California Insurance Code) accounted for approximately 76% of all voluntary private passenger automobile policies in force in California, while the higher risk categories accounted for approximately 24%. The private passenger automobile renewal rate in California (the rate of acceptance of offers to renew) averages approximately 96%. 3 In October 1998, the Company began offering a monthly pay policy through its California Automobile Insurance Company subsidiary targeted at higher risk ("non-standard") drivers who do not fall into existing risk classifications. This voluntary business accounts for approximately 7% of the total voluntary private passenger automobile policies in-force in California. The Company's Oklahoma and Texas private passenger automobile business in force, underwritten through AMI, is primarily standard and preferred risks. AMI began offering a non- standard policy during 1998 in Texas. The amount of non-standard policies in force, written by AMI, was insignificant at December 31, 2001. The Company also offers non-standard private passenger automobile coverage in Texas through Concord. Non-standard policies in force, written through Concord, were not a significant portion of the Company's total premiums in force at December 31, 2001. The Company's Florida private passenger automobile business in force, underwritten by Mercury Casualty Company in 2001, is primarily standard and preferred risks and accounts for less than 4% of the Company's total policies in force at December 31, 2001. In December 1999, the Company began offering homeowners insurance to Florida residents. The amount of Florida homeowners policies in force at December 31, 2001 was not material. The Company's Illinois and Georgia private passenger automobile business in force is primarily standard and preferred risks and was not a significant portion of the Company's total premiums in force at December 31, 2001. Production and Servicing of Business The Company sells its policies through more than 2,300 independent agents and brokers, of which approximately 950 are located in California, approximately 600 are located in Florida and approximately 550 represent AMI in Oklahoma and Texas. The remainder are located in Georgia and Illinois. Approximately half of the agents and brokers in California have represented the Company for more than ten years. The agents and brokers, most of whom also represent one or more competing insurance companies, are independent contractors selected and appointed by the Company. Other than one broker that produced approximately 17%, 18% and 19% during 2001, 2000 and 1999, respectively, of the Company's total direct premiums written, no agent or broker accounted for more than 2% of direct premiums written. The Company believes that its agents' and brokers' compensation is higher than the industry average. During 2001, total commissions and bonuses incurred were 16.5% of net premiums written. The Company has had in place since the fourth quarter of 1995 a newspaper and direct mail advertising program. In April 1998, the advertising program was expanded to include radio and billboard advertising. While the majority of the advertising costs are borne by the Company, a portion of these costs are borne by the Company's agents and brokers based upon the number of account leads generated by the advertising. In 2000, the Company began television advertising and discontinued radio and outdoor advertising. The Company intends to continue the current level of advertising during the year 2002. The Company believes that its advertising program is important to create brand awareness and to remain competitive in the current insurance climate. See Competitive Conditions. 4 Claims Claims operations are conducted by the Company. The claims staff administers all claims and directs all legal and adjustment aspects of the claims process. The Company adjusts most claims without the assistance of outside adjusters. Loss and Loss Adjustment Expense Reserves The Company maintains reserves for the payment of losses and loss adjustment expenses for both reported and unreported claims. Loss reserves are estimated based upon a case-by-case evaluation of the type of claim involved and the expected development of such claim. The amount of loss reserves and loss adjustment expense reserves for unreported claims are determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results. The ultimate liability may be greater or lower than stated loss reserves. Reserves are closely monitored and are analyzed quarterly by the Company's actuarial consultants using new information on reported claims and a variety of statistical techniques. The Company does not discount to a present value that portion of its loss reserves expected to be paid in future periods. The Tax Reform Act of 1986 does, however, require the Company to discount loss reserves for Federal income tax purposes. The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expenses, net of reinsurance deductions, as shown on the Company's consolidated financial statements for the periods indicated:
Year ended December 31, ------------------------------------ 2001 2000 1999 ---- ---- ---- (Amounts in thousands) Net reserves for losses and loss adjustment expenses, beginning of year .................... $ 463,803 $418,800 $385,816 Incurred losses and loss adjustment expenses: Provision for insured events of the current year ............................ 993,510 878,144 781,316 Increase in provision for insured events of prior years ........... 16,929 23,637 7,787 ---------- -------- -------- Total incurred losses and loss adjustment expenses ................................ 1,010,439 901,781 789,103 ---------- -------- -------- Payments: Losses and loss adjustment expenses attribu- table to insured events of the current year ..................................... 636,007 562,163 492,314 Losses and loss adjustment expenses attribu- table to insured events of prior years ... 321,643 294,615 263,805 ---------- -------- -------- Total payments ........................... 957,650 856,778 756,119 ---------- -------- -------- Net reserves for losses and loss adjustment expenses at the end of the period ............... 516,592 463,803 418,800 Reinsurance recoverable .......................... 18,334 28,417 16,043 ---------- -------- -------- Gross liability at end of year ................... $ 534,926 $492,220 $434,843 ========== ======== ========
5 The increase in the provision for insured events of prior years in 2001, 2000 and 1999 largely relates to an increase in the ultimate liability for bodily injury and physical damage claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs. The AMI purchase agreement includes an indemnification by the seller on the loss and loss adjustment expense reserves of AMI at the acquisition date, excluding the mechanical breakdown line, to avoid any impact on the Company's financial statements from any future adverse development on the acquisition date loss reserves. With the exception of late claims reported between December 31, 2001 and December 31, 2004, the indemnification requires a final settlement on losses developed through December 31, 2001. Losses incurred through 2001 include approximately $2 million of adverse development related to acquisition date loss reserves of AMI. Approximately $1.3 million of this development is included in the $16.9 million increase in provision for insured events of prior years recorded in 2001. As per guidance provided by Financial Accounting Standards Board (FASB) release EITF D-54, the Company has recorded the effects of the reserve guarantee as other income rather than netting the effect directly against the loss reserve and loss expense accounts. The difference between the reserves reported in the Company's consolidated financial statements prepared in accordance with generally accepted accounting principles ("GAAP") and those reported in the statements filed with the Department of Insurance in accordance with statutory accounting principles ("SAP") is shown in the following table: December 31, ------------------------------------ 2001 2000 1999 -------- -------- -------- (Amounts in thousands) Reserves reported on a SAP basis ..... $516,592 $463,803 $418,800 Reinsurance recoverable .............. 18,334 28,417 16,043 -------- -------- -------- Reserves reported on a GAAP basis .... $534,926 $492,220 $434,843 ======== ======== ======== Under SAP, reserves are stated net of reinsurance recoverable in contrast to GAAP where reserves are stated gross of reinsurance recoverable. The following table represents the development of loss reserves for the period 1991 through 2001. The top line of the table shows the reserves at the balance sheet date net of reinsurance recoverable for each of the indicated years. This represents the estimated amount of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the cumulative amounts paid as of successive years with respect to that reserve liability. The middle portion of the table shows the re- estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The bottom line shows the redundancy (deficiency) that exists when the original reserve estimates are greater (less) than the re-estimated reserves at December 31, 2001. In evaluating the information in the table, it should be noted that each amount includes 6 the effects of all changes in amounts for prior periods. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
As of December 31, ----------------------------------------------------------------- 1991 1992 1993 1994 1995 1996 ---- ---- ---- ---- ---- ---- (Amounts in thousands) Net reserves for losses and loss adjustment expenses ............... $280,157 $239,203 $214,525 $223,392 $ 250,990 $ 311,754 Paid (cumulative) as of: One year later ................... 151,866 135,188 143,272 145,664 167,226 206,390 Two years later .................. 197,640 184,119 187,641 198,967 225,158 291,552 Three years later ................ 213,824 197,371 204,606 214,403 248,894 316,505 Four years later ................. 218,067 201,365 207,704 219,596 253,708 324,337 Five years later ................. 220,057 202,383 209,930 220,852 255,688 329,109 Six years later .................. 220,313 203,578 210,281 221,771 257,041 Seven years later ................ 221,098 203,461 210,767 222,912 Eight years later ................ 220,974 203,657 211,655 Nine years later ................. 220,975 203,673 Ten years later .................. 220,975 Net reserves re-estimated as of: One year later ................... 230,991 204,479 204,451 216,684 247,122 324,572 Two years later .................. 218,404 204,999 207,089 222,861 254,920 329,210 Three years later ................ 220,620 203,452 210,838 221,744 257,958 327,749 Four years later ................. 221,118 204,603 210,890 222,957 257,196 329,339 Five years later ................. 221,264 203,705 211,192 221,947 256,395 332,570 Six years later .................. 220,721 204,161 210,739 221,942 257,692 Seven years later ................ 220,974 203,775 210,719 223,215 Eight years later ................ 220,895 203,928 211,845 Nine years later ................. 221,070 203,853 Ten years later .................. 220,980 Net Cumulative Redundancy (deficiency) ..................... 59,177 35,350 2,680 177 (6,702) (20,816) As of December 31, ------------------------------------------------------- 1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- Net reserves for losses and loss adjustment expenses ............... $ 386,270 $ 385,816 $ 418,800 $463,803 $516,592 Paid (cumulative) as of: One year later ................... 247,310 263,805 294,615 321,643 Two years later .................. 338,016 366,908 403,378 Three years later ................ 369,173 395,574 Four years later ................. 379,233 Five years later ................. Six years later .................. Seven years later ................ Eight years later ................ Nine years later ................. Ten years later .................. Net reserves re-estimated as of: One year later ................... 376,861 393,603 442,437 $480,732 Two years later .................. 378,057 407,047 449,094 Three years later ................ 383,588 410,754 Four years later ................. 386,522 Five years later ................. Six years later .................. Seven years later ................ Eight years later ................ Nine years later ................. Ten years later .................. Net Cumulative Redundancy (deficiency) ..................... (252) (24,938) (30,294) (16,929)
As of December 31, -------------------------------------------------------------------- 1992 1993 1994 1995 1996 1997 ---- ---- ---- ---- ---- ---- (Amounts in thousands) Gross liability - end of year 240,183 215,301 227,499 253,546 336,685 409,061 Reinsurance recoverable (980) (776) (4,107) (2,556) (24,931) (22,791) ------- ------- ------- ------- ------- ------- Net liability - end of year 239,203 214,525 223,392 250,990 311,754 386,270 ======= ======= ======= ======= ======= ======= Gross re-estimated liability -latest 209,291 219,570 236,563 267,834 360,661 411,980 Re-estimated recoverable - latest (5,438) (7,725) (13,348) (10,142) (28,091) (25,458) ------- ------- ------- ------- ------- ------- Net re-estimated liability - latest 203,853 211,845 223,215 257,692 332,570 386,522 ======= ======= ======= ======= ======= ======= Gross cumulative redundancy(deficiency) 30,892 (4,269) (9,064) (14,288) (23,976) (2,919) ======= ======= ======= ======= ======= ======= As of December 31, --------------------------------------------- 1998 1999 2000 2001 ---- ---- ---- ---- Gross liability - end of year 405,976 434,843 492,220 $ 534,926 Reinsurance recoverable (20,160) (16,043) (28,417) (18,334) ------- ------- ------- --------- Net liability - end of year 385,816 418,800 463,803 516,592 ======= ======= ======= ========= Gross re-estimated liability -latest 429,385 466,470 509,674 Re-estimated recoverable - latest (18,631) (17,376) (28,942) ------- ------- ------- Net re-estimated liability - latest 410,754 449,094 480,732 ======= ======= ======= Gross cumulative redundancy(deficiency) (23,409) (31,627) (17,454) ======= ======= =======
For the calendar years 1998 through 2000, the Company's previously estimated loss reserves produced a deficiency which was reflected in the following years incurred losses. The Company attributes a large portion of the deficiency to an increase in the ultimate liability for bodily injury and physical damage claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs. For the calendar year 1997, the Company's previously estimated loss reserves produced 7 a minor deficiency. The previously estimated loss reserve would have produced a redundancy, however, the deficiency includes over $2 million of adverse loss development related to the acquisition date loss reserves of AMI. Without this amount there would be favorable development. The Company attributes the favorable loss development primarily to the effect of Proposition 213, a California initiative passed in November 1996 that prevents uninsured motorists, drunk drivers and fleeing felons from collecting awards for "pain and suffering." See Regulations - California Financial Responsibility Law. This law produced an overall reduction in bodily injury loss severity for calendar year 1997. In addition, a law, effective January 1, 1997 requiring proof of insurance before registration of a motor vehicle resulted in a much smaller pool of uninsured motorists, thereby decreasing the frequency of uninsured motorists claims. See Regulations-California Financial Responsibility Law. For the calendar years 1995 and 1996, the Company's previously estimated loss reserves produced deficiencies. These deficiencies relate to increases in the Company's ultimate estimates for loss adjustment expenses which are based principally on the Company's actual experience. The adverse development on such reserves reflects the increases in the legal expenses of defending the Company's insureds arising from the Company's policy of aggressively defending, including litigating, exaggerated bodily injury claims arising from minimal impact automobile accidents. For the calendar years 1991 through 1994, the Company's previously estimated loss reserves produced redundancies. The Company attributes this favorable loss development to several factors. First, the Company had completed its development of a full complement of claims personnel early in this period. Second, during 1988, the California Supreme Court reversed what was known as the "Royal Globe" doctrine, which, since 1978, had permitted third party plaintiffs to sue insurers for alleged "bad faith" in resolving claims, even when the plaintiff had voluntarily agreed to a settlement. This doctrine had placed undue pressures on claims representatives to settle legitimate disputes at unfairly high settlement amounts. After the reversal of Royal Globe, the Company believes that it has been able to achieve fairer settlements, because both parties are in a more equal bargaining position. See Regulations - Third Party "Bad Faith" Legislation. Third, during the years 1988 through 1990, the volume of business written in the Assigned Risk Program expanded substantially as rates were suppressed at grossly inadequate levels. Following the California Insurance Commissioner's approval of an 85% temporary rate increase in September 1990, the volume of assigned risk business had declined by nearly 80%. Many of the claims associated with the high volume of assigned risk business in the 1988-1990 period were later found to be fraudulent or grossly exaggerated and were settled in subsequent periods for substantially less than had been initially reserved. Operating Ratios Loss and Expense Ratios ----------------------- Loss and underwriting expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. Losses and loss adjustment expenses, on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses on a statutory basis are stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratios are less than 100%. The Company's loss ratio, expense ratio and combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in the following table. The Company's ratios include lines of insurance other than private passenger automobile. Since these other lines represent only a small percentage of premiums written, the 8 Company believes its ratios can be compared to the industry ratios included in the table. Year ended December 31, ------------------------------------------- 2001 2000 1999 1998 1997 ----- ----- ----- ----- ----- Loss Ratio...................... 73.2% 72.2% 66.5% 61.1% 63.5% Expense Ratio................... 26.0 26.4 26.5 26.3 24.7 ----- ----- ----- ---- ----- Combined Ratio.................. 99.2% 98.6% 93.0% 87.4% 88.2% ===== ===== ===== ==== ===== Industry combined ratio (all writers) (1).................. 107.0%(2)108.1% 102.6% 100.1% 99.5% Industry combined ratio (excluding direct writers) (1)........... N.A. 108.6% 102.3% 99.1% 100.1% - ---------- (1) Source: A.M. Best, Aggregates & Averages (1998 through 2001), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends). (2) Source: A.M. Best, "Best's Review, January 2002," "Review Preview." (N.A.) Not available. Under GAAP, the loss ratio is computed in the same manner as under statutory accounting, but the expense ratio is determined by matching underwriting expenses to the period that net premiums were earned, rather than by when net premiums were written. The following table sets forth the Company's loss ratio, expense ratio and combined ratio under GAAP for the last five years. Year ended December 31, -------------------------------- 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- Loss Ratio 73.2% 72.2% 66.4% 61.0% 63.5% Expense Ratio 26.4 26.3 26.8 26.6 25.1 ---- ---- ---- ---- ---- Combined Ratio 99.6% 98.5% 93.2% 87.6% 88.6% ==== ==== ==== ==== ==== Premiums to Surplus Ratio ------------------------- The following table shows, for the periods indicated, the Insurance Companies' statutory ratios of net premiums written to policyholders' surplus. While there is no statutory requirement applicable to the Company which establishes a permissible net premium writings to surplus ratio, widely recognized guidelines established by the National Association of Insurance Commissioners ("NAIC") indicate that this ratio should be no greater than 3 to 1.
Year ended December 31, -------------------------------------------------------------- 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- (Amounts in thousands, except ratios) Net premiums written..... $1,442,886 $1,272,447 $1,206,171 $1,144,051 $1,086,241 Policyholders' surplus... $1,045,104 $ 954,753 $ 853,794 $ 767,223 $ 679,359 Ratio.................... 1.4 to 1 1.3 to 1 1.4 to 1 1.5 to 1 1.6 to1
9 Risk Based Capital ------------------ In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which established recommended minimum capital requirements for casualty companies. The formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance 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. Based on the formula adopted by the NAIC, the Company has estimated the Risk-Based Capital Requirements of each of the Insurance Companies as of December 31, 2001. Each of the companies exceeded the highest level of minimum required capital. Statutory Accounting Principles ------------------------------- The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include primarily those published as Statements of Statutory Accounting Principles by the NAIC, as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2001, there were no material permitted statutory accounting practices utilized by the Insurance Companies. During 1998, the NAIC approved the codification of statutory accounting practices. Codification became effective January 1, 2001. Certain state laws may differ from codification. At December 31, 2001, the Company had surplus of approximately $41 million higher under codification as compared to what would have been reported under previous statutory accounting rules. This increase primarily relates to the establishment of a net deferred tax asset. Investments and Investment Results The investments of the Company are made by the Company's Chief Investment Officer under the supervision of the Company's Board of Directors. The Company follows an investment policy which is regularly reviewed and revised. The Company's policy emphasizes investment grade, fixed income securities and maximization of after-tax yields. The Company does not invest with a view to achieving realized gains. However, sales of securities are undertaken, with resulting gains or losses, in order to enhance after-tax yield and keep the portfolio in line with current market conditions. Tax considerations are important in portfolio management, and have been made more so since 1986 when the alternative minimum tax ("AMT") was imposed on casualty companies. Changes in loss experience, growth rates and profitability produce significant changes in the Company's exposure to AMT liability, requiring appropriate shifts in the investment asset mix between taxable bonds, tax-exempt bonds and equities in order to maximize after-tax yield. The optimum asset mix is subject to continuous review. At year-end, approximately 67% of the Company's portfolio, at market values, was invested in medium to long term, investment grade tax-exempt revenue and municipal bonds. The average Standard & Poor's rating of the Company's bond holdings was A at December 31, 2001. The nominal average maturity of the bond portfolio was 14.1 years at December 31, 2001, but the call-adjusted average maturity of the portfolio was shorter, approximately 8.8 years, because holdings are heavily weighted with high coupon issues which are expected to be called prior to maturity. The modified duration of the bond portfolio reflecting anticipated early 10 calls was 6.5 years at December 31, 2001. Duration is a measure of how long it takes, on average, to receive all the cash flows produced by a bond, including reinvestment of interest. Because of its sensitivity to interest rates, it is a proxy for a bond's price volatility. The longer the duration, the greater the price volatility in relation to changes in interest rates. Holdings of lower than investment grade bonds constitute approximately 1.7% of total assets. The Company continually evaluates the recoverability of its investment holdings. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the Consolidated Statement of Income. During 1999, the Company realized a loss of approximately $6.0 million on one equity security where the decline in market value was considered other than temporary. As the result of a liquidating dividend, the Company realized gains of $477,000 and $347,000 on the same equity security in 2001 and 2000, respectively. Equity holdings consist primarily of perpetual preferred stocks and dividend bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. The following table summarizes the investment results of the Company for the five years ended December 31, 2001:
Year ended December 31, ------------------------------------------------------------- 2001(1) 2000(1) 1999 1998 1997 ---- ---- ---- ---- ---- (Amounts in thousands) Averaged invested assets (includes short-term cash investments (2))........ $1,828,455 $1,710,176 $1,595,466 $1,473,843 $1,263,167 Net investment income: Before income taxes............... 114,511 106,466 99,374 96,169 86,812 After income taxes................ 98,909 95,154 89,598 87,199 77,917 Average annual yield on investments: Before income taxes............... 6.3% 6.2% 6.2% 6.5% 6.9% After income taxes................ 5.4% 5.6% 5.6% 5.9% 6.2% Net realized investment gains (losses) after income taxes............. 4,233 2,564 (7,754) (2,552) 3,232 Net increase (decrease) in un- realized gains/losses on all investments after income taxes...................... $ (13,896) $ 70,342 $ (90,667) $ 5,065 $ 27,175
(1) Includes MCM for the last three months of 2000 and the full year 2001. (2) Fixed maturities and equities at cost. 11 The following table sets forth the composition of the investment portfolio of the Company at the dates indicated:
December 31, --------------------------------------------------------------------------- 2001 2000 1999 ----------------------- ----------------------- ----------------------- Amortized Market Amortized Market Amortized Market Cost Value Cost Value Cost Value ---- ----- ---- ----- ---- ----- (Amounts in thousands) Taxable bonds .......... $ 283,991 $ 271,925 $ 151,281 $ 152,704 $ 21,461 $ 20,779 Tax-exempt state and municipal bonds ....... 1,260,485 1,298,637 1,292,711 1,336,555 1,300,896 1,269,604 Sinking fund preferred stocks ................ 15,704 15,871 19,905 20,215 31,408 31,671 ---------- ---------- ---------- ---------- ---------- ---------- Total fixed maturity investments ........ 1,560,180 1,586,433 1,463,897 1,509,474 1,353,765 1,322,054 Equity investments incl perpetual preferred stocks ................ 277,925 277,787 250,593 252,510 238,856 209,843 Short-term cash investments ........... 71,951 71,951 32,977 32,977 43,568 43,568 ---------- ---------- ---------- ---------- ---------- ---------- Total investments ...... $1,910,056 $1,936,171 $1,747,467 $1,794,961 $1,636,189 $1,575,465 ========== ========== ========== ========== ========== ==========
At December 31, 2001, the Company had a net unrealized gain on all investments of $26,115,000 before income taxes. Competitive Conditions The property and casualty insurance industry is highly competitive. The insurance industry consists of a large number of companies, many of which operate in more than one state, offering automobile, homeowners and commercial property insurance, as well as insurance coverage in other lines. Many of the Company's competitors have larger volumes of business and greater financial resources than the Company. Based on regularly published statistical compilations, the Company in 2001 was the sixth largest writer of private passenger automobile insurance in California. All of the Company's competitors having greater shares of the California market sell insurance either directly and/or through exclusive agents, rather than through independent agents. The property and casualty insurance industry is highly cyclical, characterized by periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. In the Company's view, the overall profitability of the California marketplace during the 1996 through 1998 time period created a favorable environment for automobile insurance writers. Many major automobile insurers attempted to capitalize on the favorable climate by increasing their marketing efforts and reducing rates in attempts to capture more business. These industry wide rate reductions and increased severity trends on bodily injury, collision and physical damage coverages contributed to the deterioration of industry loss ratios in the years 1999 through 2001 (See Operating 12 Ratios - Loss and Expense). Most competitors have filed for and implemented rate increases. Consequently, the industry has now entered a period of rising premium rates and reduced underwriting capacity. In 2001, the Company received approval from the California Department of Insurance for a 6.9% rate increase in its non-standard line and in its non good driver private passenger automobile line written by Mercury Casualty Company. The Company recently received approval for a 4.1% rate increase for Mercury Insurance Company, which represents approximately 55% of Company-wide premiums written, and a 6.9% combined rate increase for Mercury Casualty Company and California Automobile Insurance Company, which represents approximately 24% of Company-wide premiums written. These increases went into effect for all new and renewal California business as of March 1, 2002. The Company plans to make additional filings for rate increases in California as well as other states. Despite the increases, the Company believes that its rates will remain competitive in the marketplace. Price and reputation for service are the principal means by which the Company competes with other automobile insurers. The Company believes that it has a good reputation for service, and it has, historically, been among the lowest-priced insurers doing business in California according to surveys conducted by the California DOI. In addition to good service and competitive pricing, for those insurers dealing through independent agents, as the Company does, the marketing efforts of agents and brokers is a means of competition. According to a study released by the California DOI, the combined results for the Company's California subsidiaries included in the study, tied the Company for best among the largest seven automobile insurers in California when measured by consumer complaints. The Company's California subsidiaries included in the study had 1.3 million earned cars, as defined by the California Department of Insurance, in 1999 and only 24 justified complaints, a ratio of 1.8 for every 100,000 cars. The Company had no justified complaints on its homeowners business. All rates charged by private passenger automobile insurers are subject to the prior approval of the California DOI. See Regulation - Automobile Insurance Rating Factor Regulations. The Company encounters similar competition in each state and each line of business in which it operates outside California. Reinsurance With the exception of personal umbrella policies, the Company no longer maintains reinsurance for its liability coverage in California. Effective January 1, 1994, the Company terminated its liability reinsurance coverage with Employers Reinsurance Corporation ("ERC") because of rising premiums and under utilization of such coverage. The Company regularly evaluates the need for liability reinsurance. The Company maintained property reinsurance under a treaty which was effective April 1, 1995 through December 31, 1998, with National Reinsurance Corporation, which is rated A+ by A.M. Best. The treaty provided $900,000 coverage in excess of $100,000 for each risk subject to a maximum of $2,700,000 for any one occurrence. A second layer of coverage provided an additional $1,000,000 in excess of the first $1,000,000 per risk subject to a maximum of $2,000,000 for any one occurrence. This treaty was replaced with a treaty with Swiss Re, which is rated A++ by A.M. Best, effective January 1, 1999. The new treaty provides $750,000 coverage in excess of $250,000 for each risk subject to a maximum of $2,250,000 for any one occurrence. 13 A second layer of coverage provides an additional $1,000,000 in excess of the first $1,000,000 per risk. Effective January 1, 2000, the Company maintains property and liability excess per risk coverage through Swiss Re for its Florida homeowners line of business. The treaty provides $200,000 coverage in excess of $100,000 for each risk subject to a maximum of $600,000 for any one occurrence. A second layer of coverage provides an additional $1,200,000 in excess of the first $300,000 per risk subject to a maximum of $1,200,000 for any one occurrence. The Company had in place a treaty reinsurance agreement with Swiss Re, effective October 1, 1998, where risks written under personal umbrella policies were ceded to Swiss Re on a 100% quota share basis. The maximum coverage was $5 million per risk. This treaty was revised effective October 1, 2000. The revised treaty provides $4 million coverage in excess of $1 million for each risk. Prior to 1998, the Company maintained catastrophe reinsurance for property and automobile physical damage business. Effective October 1, 1998, the Company did not renew this catastrophe reinsurance. The reinsurance program was not renewed because the Company believes it has adequate capitalization to absorb catastrophe losses in these lines. The Company periodically reviews its requirements for catastrophic reinsurance particularly in areas that are prone to catastrophes such as Florida and California. For California, the Company has reduced its catastrophe exposure from earthquakes due to the placement, beginning in the second quarter of 1998, of earthquake risks written in conjunction with California homeowners policies, with the California Earthquake Authority (CEA). See Regulation - California Earthquake Authority. Although the Company's catastrophe exposure to earthquakes has been reduced, the Company continues to have catastrophe exposure for fire following an earthquake. ERC reinsured AMI through working layer treaties for property and casualty losses in excess of $200,000. For the years 1990 through 1996 the mechanical breakdown line of business was reinsured with Constitution Reinsurance Corporation through a quota-share treaty covering 50% to 85% of the business written depending on the year the policy incepted. For policies effective on or after January 1, 1997, AMI is retaining the full exposure. AMI has other reinsurance treaties and facultative arrangements in place for various smaller lines of business. MCM has reinsurance treaties with several different reinsurers. 100% of all risks written by MCM are ceded to reinsurers. The Company also holds a formal guarantee from ERC which reimburses MCM if any of the reinsurers fail to satisfy their obligations under their respective reinsurance agreements. Effective January 1, 2001 all new business written by MCM is ceded to either Mercury Casualty Company or AMI. If the reinsurers were unable to perform their obligations under the reinsurance treaty, the Company would be required, as primary insurer, to discharge all obligations to its insureds in their entirety. Regulation The Company's business in California is subject to regulation and supervision by the California DOI, which has broad regulatory, supervisory and administrative powers. 14 The powers of the California DOI primarily include the prior approval of insurance rates and rating factors and the establishment of standards of solvency which must be met and maintained. The regulation and supervision by the California DOI are designed principally for the benefit of policyholders and not for insurance company shareholders. The California DOI conducts periodic examinations of the Company's insurance subsidiaries. The last examination conducted of the California Companies was as of December 31, 2000. The reports on the results of that examination are not yet available, however, the Company does not expect any adjustments to the statutory financial statements. The insurance subsidiaries outside California are subject to the regulatory powers of the insurance departments of those states. Those powers are similar to the regulatory powers in California enumerated above. Generally, the regulations relate primarily to standards of solvency and are designed for the benefit of policyholders and not for insurance company shareholders. In California, insurance rates have required prior approval since November 1989. Georgia also requires prior approval, while Illinois only requires that rates be filed with the Department of Insurance prior to their use. Texas, 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." The Georgia DOI conducted an examination of Mercury Insurance Company of Georgia and Mercury Indemnity Company of Georgia as of December 31, 2000. The reports on the results of that examination are not yet available. The Illinois DOI conducted an examination of Mercury Insurance Company of Illinois and Mercury Indemnity Company of Illinois as of December 31, 2000. The reports on that examination are not yet available. The Oklahoma DOI conducted an examination of AMI as of December 31, 1998. The exam resulted in no material findings or recommendations. The State of Texas will conduct periodic examinations of AMI and MCM and the State of Florida will conduct periodic examinations of MICFL and MIDFL. The operations of the Company are dependent on the laws of the state in which it does business and changes in those laws can materially affect the revenue and expenses of the Company. The Company retains its own legislative advocates in California. The Company also makes financial contributions to officeholders and candidates. In 2001 and 2000, those contributions amounted to $490,815 and $579,800, respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines to be appropriate. Insurance Guarantee Association ------------------------------- In 1969, the California Insurance Guarantee Association (the "Association") was created pursuant to California law to provide for payment of claims for which insolvent insurers of most casualty lines are liable but which cannot be paid out of such insurers' assets. The Company is subject to assessment by the Association for its pro-rata share of such claims based on premiums written in the particular line in the year preceding the assessment by insurers writing that line of insurance in California. Such assessments are based upon estimates of losses to be incurred in liquidating an insolvent insurer. In a particular year, the Company cannot be assessed an amount greater than 1% of its premiums written in the preceding year. There have been no assessments imposed during the past five years. Assessments are recouped through a mandated surcharge to policyholders the year after the assessment. Insurance subsidiaries in the other states are subject to the provisions of similar insurance guaranty associations. No 15 material assessments were imposed in the last five years in those states either. Holding Company Act ------------------- The California Companies are subject to regulation by the California DOI pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the "Holding Company Act"). Pursuant to the Holding Company Act, the California DOI may examine the affairs of each company at any time. The Holding Company Act requires disclosure of any material transactions among the companies. Certain transactions and dividends defined to be of an "extraordinary" type may not be effected if the California DOI disapproves the transaction within 30 days after notice. Such transactions include, but are not limited to, certain reinsurance transactions and sales, purchases, exchanges, loans and extensions of credit, and investments, in the net aggregate, involving more than the lesser of 3% of the Company's admitted assets or 25% of surplus as to policyholders, as of the preceding December 31. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the preceding 12 months, exceeds the greater of 10% of the insurance company's policyholders' surplus as of the preceding December 31 or the insurance company's net income for the preceding calendar year. An insurance company is also required to notify the California DOI of any dividend after declaration, but prior to payment. The Holding Company Act also provides that the acquisition or change of "control" of a California domiciled insurance company or of any person who controls such an insurance company cannot be consummated without the prior approval of the Insurance Commissioner. In general, a presumption of "control" arises from the ownership of voting securities and securities that are convertible into voting securities, which in the aggregate constitute 10% or more of the voting securities of a California insurance company or of a person that controls a California insurance company, such as Mercury General. A person seeking to acquire "control," directly or indirectly, of the Company must generally file with the Insurance Commissioner an application for change of control containing certain information required by statute and published regulations and provide a copy of the application to the Company. The Holding Company Act also effectively restricts the Company from consummating certain reorganizations or mergers without prior regulatory approval. The insurance subsidiaries in Florida, Georgia, Illinois, Oklahoma and Texas are subject to holding company acts in those states, the provisions of which are substantially similar to those of the Holding Company Act. Regulatory approval was obtained from California, Oklahoma and Texas before the acquisition of AMI was completed. Approval was granted by Texas for the transaction in which the Company acquired control of MCM. Assigned Risks -------------- Automobile liability insurers in California are required to sell bodily injury liability, property damage liability, medical expense and uninsured motorist coverage to a proportionate number (based on the insurer's share of the California automobile casualty insurance market) of those drivers applying for placement as "assigned risks." Drivers seek placement as assigned risks because their driving records or other relevant characteristics, as defined by Proposition 103, make them difficult to insure in the voluntary market. During the last five years, approximately 0.5% of the direct automobile insurance premium written by the Company was for assigned risk business. In 2001, assigned risks represented 0.2% of total automobile direct premiums written and 0.2% of total automobile direct premium earned. Premium rates for assigned risk business are set by the California DOI. In October 1990, more stringent rules for gaining 16 entry into the plan were approved, resulting in a substantial reduction in the number of assigned risks insured by the Company since 1991. Since January 1, 1994, the California Insurance Code has required that rates established for the plan be adequate to support the plan's losses and expenses. The last rate increase approved by the Commissioner approximated 4.8% and became effective June 1, 1995. The Commissioner approved a rate decrease of 28.3% effective February 1, 1999. The number of assignments decreased in 2000 and increased slightly in 2001. The Company attributes the low level of assignments to the competitive voluntary market. California Automobile Insurance Low Cost Program ------------------------------------------------ In 1999, California enacted a pilot low cost automobile program ("LCP") for low income good drivers in San Francisco City and County and Los Angeles County which became effective July 1, 2000. The program provides a low limit policy (bodily injury liability coverage of $10,000 per person and $20,000 per occurrence and property damage liability coverage of $3,000) that satisfies financial responsibility requirements, to good drivers with income that does not exceed 150% of the federal poverty level. The LCP is administered by the California Automobile Assigned Risk Plan which is the same entity that administers the assigned risk program for California. LCP policies are assigned to insurance companies in proportion to each insurer's share of the California private passenger automobile insurance market. The volume and profitability of the program, including the annual assessment, are insignificant to the consolidated financial results of the Company. The LCP will expire on January 1, 2004, unless reenacted by the California legislature. Automobile Insurance Rating Factor Regulations ---------------------------------------------- Since 1989, California Proposition 103 has required that property and casualty insurance rates be approved by the Insurance Commissioner prior to their use, and that no rate be approved which is excessive, inadequate, unfairly discriminatory or otherwise in violation of the provisions of the initiative. The proposition specified four statutory factors required to be applied in "decreasing order of importance" in determining rates for private passenger automobile insurance: (1) the insured's driving safety record, (2) the number of miles the insured drives annually, (3) the number of years of driving experience of the insured and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to risk of loss and adopted by regulation. The statute further provided that insurers are required to give at least a 20% discount to "good drivers," as defined, from rates that would otherwise be charged to such drivers and that no insurer may refuse to insure a "good driver." The Company, and most other insurers, historically charged different rates for residents of different geographical areas within California. The rates for urban areas, particularly in Los Angeles, have been generally substantially higher than for suburban and rural areas. The Company's geographical rate differentials have been derived by actuarial analysis of the claims costs in a given area. In September 1996, the California Insurance Commissioner issued permanent rating factor regulations which were designed to implement the Proposition 103 guidelines and replaced emergency regulations which had been in use since 1989. They required all automobile insurers in California to submit new rating plans complying with the regulations in early 1997. The 17 Company submitted its new proposed rating plan on March 11, 1997. The Company's plan, and the plans of most other California automobile insurers, were approved by the Department in October 1997. The Company's plan became effective October 1, 1997. The rate changes resulting from implementation of that plan have not materially affected the Company's competitive position or its profitability. California Financial Responsibility Law --------------------------------------- Effective January 1, 1997 California enacted a new law which requires proof of insurance for the registration (new or renewal) of a motor vehicle. It also provides for substantial penalties for failure to supply proof of insurance if a driver is stopped for a traffic violation. Media attention to the new law resulted in a surge of new business applications during the first half of 1997. The renewal experience of this new business has been similar to that of the Company's existing business. In November 1996 an initiative sponsored by the California Insurance Commissioner was overwhelmingly approved by the California voters. It provides that uninsured drivers who are injured in an automobile accident are able to recover only actual, out-of-pocket medical expenses and lost wages and are not entitled to receive awards for general damages, i.e., "pain and suffering." This restriction also applies to drunk drivers and fleeing felons. The law has helped in controlling loss costs. Third Party "Bad Faith" Legislation ----------------------------------- Recent initiatives to reinstate third party "bad faith" lawsuits have been unsuccessful. If such legislation is enacted, it could have a significant detrimental effect on the Company's operating results. This would particularly be the case if the Company had difficulty in implementing rate increases to compensate for increased loss costs. California Earthquake Authority ------------------------------- The California Earthquake Authority (CEA) is a Quasi-Governmental organization that was established to provide a market for earthquake coverage to California homeowners. During 1998, the Company began placing all new and renewal earthquake coverage offered with its homeowners policy through the California Earthquake Authority. The Company receives a small fee for placing business with the CEA. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company's participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company's maximum total exposure to CEA assessments at April 19, 2001, is approximately $20.5 million. Item 2. Properties ---------- The home office of the California Companies and the Company's computer facilities are located in Brea, California in an 80,000 square foot office building owned by the Company. Since December 1986, Mercury General's executive offices have been located in a 36,000 18 square foot office building in Los Angeles, California, owned by Mercury Casualty. The Company occupies approximately 95% of the building and leases the remaining office space to others. In October 1992, the Company purchased a 158,000 square foot office building in Brea, California. The Company occupies the entire facility. In November 2001, the Company purchased twelve acres of land in Rancho Cucamonga, California. Construction of a 100,000 square foot office building to house Company personnel is planned to begin in 2002 with completion anticipated in early 2003. Any space in the building that is not occupied by the Company will be leased to outside parties. The Company leases all of its other office space. Office location is not material to the Company's operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space. Item 3. Legal Proceedings ----------------- The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. The Company believes that adverse results, if any, in the actions currently pending should not have a material effect on the Company's operations or financial position. Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- No matters were submitted to a vote of security holders by the Company during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information concerning the executive officers of the Company as of March 16, 2002: Name Age Position - ---- --- -------- George Joseph 80 Chairman of the Board and Chief Executive Officer Gabriel Tirador 37 President and Chief Operating Officer Cooper Blanton, Jr. 75 Executive Vice President Bruce E. Norman 53 Senior Vice President - Marketing Joanna Y. Moore 46 Vice President and Chief Claims Officer Kenneth G. Kitzmiller 55 Vice President - Underwriting Theodore R. Stalick 38 Vice President and Chief Financial Officer Judy A. Walters 55 Vice President - Corporate Affairs and Secretary Peter R. Simon 42 Vice President - Information Systems Christopher Graves 36 Vice President and Chief Investment Officer Charles Toney 40 Vice President - Chief Actuary Mr. Joseph, Chief Executive Officer of the Company and Chairman of its Board of Directors, has served in those capacities since 1961. Mr. Joseph has more than 45 years 19 experience in the property and casualty insurance business. Mr. Tirador, President and Chief Operating Officer, served as the Company's assistant controller from March 1994 to December 1996. During January 1997 to February 1998 he served as the Vice President and Controller of the Automobile Club of Southern California. He rejoined the Company in February 1998 as Vice President and Chief Financial Officer. He was appointed President and Chief Operating Officer in October 2001. Mr. Tirador has over fifteen years experience in the property and casualty insurance industry and is a Certified Public Accountant. Mr. Blanton, Executive Vice President, joined the Company in 1966 and supervised its underwriting activities from 1967 until September 1995. He was appointed Executive Vice President of Mercury Casualty and Mercury Insurance in 1983 and was named Executive Vice President of Mercury General in 1985. In May 1995 he was named President of the Georgia and Illinois insurance company subsidiaries and in February 1996 he was elected to the Board of Directors of those companies. In January 1999 he was named Chairman of the Board of AMIC and President in April 2000. Mr. Blanton has over 40 years of experience in underwriting and other aspects of the property and casualty insurance business. Mr. Norman, Senior Vice President in charge of Marketing, has been employed by the Company since 1971. Mr. Norman was named to this position in February 1999, and has been a Vice President since October 1985 and a Vice President of Mercury Casualty since 1983. Mr. Norman has supervised the selection and training of agents and managed relations between agents and the Company since 1977. In February 1996 he was elected to the Board of Directors of the California Companies. Ms. Moore, Vice President & Chief Claims Officer, joined the Company in the claims department in March 1981. She was named Vice President of Claims of Mercury General in August 1991 and has held her present position since July 1995. Mr. Kitzmiller, Vice President in charge of Underwriting, has been employed by the Company in the underwriting department since 1972. In August 1991 he was appointed Vice President of Underwriting of Mercury General and has supervised the underwriting activities of the Company since early 1996. Mr. Stalick, Vice President and Chief Financial Officer, joined the Company as Corporate Controller in June 1997. In October 2000 he was named Chief Accounting Officer, a role he held until appointed to his current position in October 2001. Mr. Stalick is a Certified Public Accountant. Ms. Walters has been employed by the Company since 1967, and has served as its Secretary since 1982. Ms. Walters was named Vice President - Corporate Affairs in June 1998. Mr. Simon has been employed by the Company since 1980. He was named Vice President of Information Systems in December 1999. Mr. Graves, Vice President and Chief Investment Officer, has been employed by the Company in the investment department since 1986. Mr. Graves was appointed Chief Investment Officer in June 1998 and named Vice President in April 2001. Mr. Toney, Vice President and Chief Actuary, joined the Company in May 1984 as a 20 programmer/analyst. In 1994 he earned his Fellowship in the Casualty Actuarial Society and was appointed to his current position. PART II Item 5. Market for the Registrant's Common Equity and Related Security Holder --------------------------------------------------------------------- Matters ------- Price Range of Common Stock The common stock is traded on the New York Stock Exchange (symbol: MCY). The following table shows the high and low sales prices per share in each quarter during the past two years as reported in the consolidated transaction reporting system. High Low ---- --- 2000 1st Quarter.............................. $29.688 $21.063 2nd Quarter.............................. $30.250 $23.563 3rd Quarter.............................. $28.375 $23.375 4th Quarter.............................. $44.875 $26.125 High Low ---- --- 2001 1st Quarter.............................. $43.813 $32.210 2nd Quarter.............................. $36.950 $32.000 3rd Quarter.............................. $41.200 $33.180 4th Quarter.............................. $44.500 $38.810 High Low ---- --- 2002 1st Quarter (January 1 - March 15)....... $43.900 $39.210 Dividends Following the public offering of its common stock in November 1985, the Company has paid regular quarterly dividends on its common stock. During 2001 and 2000, the Company paid dividends on its common stock of $1.06 per share and $0.96 per share, respectively. On January 25, 2002, the Board of Directors declared a $0.30 quarterly dividend payable on March 28, 2002 to stockholders of record on March 15, 2002. The common stock dividend rate has been increased eighteen times since dividends were initiated in January, 1986, at an annual rate of $0.05, adjusted for the two-for-one stock splits in September 1992 and September 1997. For financial statement purposes, the Company records dividends on the declaration date. The Company expects to continue the payment of quarterly dividends. The continued payment and amount of cash dividends will depend upon, among other factors, the Company's operating results, overall financial condition, capital requirements and general business conditions. As a holding company, Mercury General is largely dependent upon dividends from its subsidiaries to pay dividends to its shareholders. These subsidiaries are subject to state laws 21 that restrict their ability to distribute dividends. The state laws permit a casualty insurance company to pay dividends and advances within any 12-month period, without any prior regulatory approval, in an amount up to the greater of 10% of statutory earned surplus at the preceding December 31, or statutory net income for the calendar year preceding the date the dividend is paid. Under this test, the direct insurance subsidiaries of the Company are entitled to pay dividends to Mercury General during 2002 of up to approximately $102 million. See Note 10 of Notes to Consolidated Financial Statements and Business - Regulation - Holding Company Act. Shareholders of Record The approximate number of holders of record of the Company's common stock as of March 15, 2002 was 241. The approximate number of beneficial holders as of March 15, 2002 was 7,700 according to the Bank of New York, the Company's transfer agent. 22 Item 6. Selected Consolidated Financial Data ------------------------------------
Year ended December 31, ------------------------------------------------------------------- 2001 2000 1999 1998 1997 ----------- ----------- ----------- ----------- ----------- (Amounts in thousands, except per share data) Income Data: Premiums earned ................. $ 1,380,561 $ 1,249,259 $ 1,188,307 $ 1,121,584 $ 1,031,280 Net investment income ........... 114,511 106,466 99,374 96,169 86,812 Realized investment gains(losses) 6,512 3,944 (11,929) (3,926) 4,973 Realized gain from sale of subsidiary .................... -- -- -- 2,586 -- Other ........................... 5,396 6,349 4,924 5,710 4,881 ----------- ----------- ----------- ----------- ----------- Total Revenues ......... 1,506,980 1,366,018 1,280,676 1,222,123 1,127,946 ----------- ----------- ----------- ----------- ----------- Losses and loss adjustment expenses ...................... 1,010,439 901,781 789,103 684,468 654,729 Policy acquisition costs ........ 301,670 268,657 267,399 252,592 224,883 Other operating expenses ........ 62,335 59,733 50,675 44,941 33,579 Interest ........................ 7,727 7,292 4,960 4,842 4,976 ----------- ----------- ----------- ----------- ----------- Total Expenses ......... 1,382,171 1,237,463 1,112,137 986,843 918,167 ----------- ----------- ----------- ----------- ----------- Income before income taxes ...... 124,809 128,555 168,539 235,280 209,779 Income taxes ........... 19,470 19,189 34,830 57,754 53,473 ----------- ----------- ----------- ----------- ----------- Net Income ...................... $ 105,339 $ 109,366 $ 133,709 $ 177,526 $ 156,306 =========== =========== =========== =========== =========== Per Share Data: Basic earnings per share ........ $ 1.94 $ 2.02 $ 2.45 $ 3.23 $ 2.84 =========== =========== =========== =========== =========== Diluted earnings per share ...... $ 1.94 $ 2.02 $ 2.44 $ 3.21 $ 2.82 =========== =========== =========== =========== =========== Dividends paid .................. $ 1.06 $ .96 $ .84 $ .70 $ .58 =========== =========== =========== =========== ===========
December 31, -------------------------------------------------------------- 2001 2000 1999 1998 1997 ---------- ---------- ---------- ---------- ---------- (Amounts in thousands, except per share data) Balance Sheet Data: Total investments........... $1,936,171 $1,794,961 $1,575,465 $1,590,645 $1,448,248 Premiums receivable......... 143,612 123,070 115,654 107,950 104,216 Total assets................ 2,316,540 2,142,263 1,906,367 1,877,025 1,725,532 Unpaid losses and loss adjustment expenses........ 534,926 492,220 434,843 405,976 409,061 Unearned premiums........... 421,342 365,579 340,846 327,129 309,376 Notes payable............... 129,513 107,889 92,000 78,000 75,000 Deferred income tax liability (asset).......... (1,252) 8,336 (28,541) 22,639 19,722 Shareholders' equity........ 1,069,711 1,032,905 909,591 917,375 799,592 Book value per share........ 19.72 19.08 16.73 16.80 14.51
- ---------- 23 Item 7. Management's Discussion and Analysis of Financial Condition and Results ----------------------------------------------------------------------- of Operations ------------- Overview The operating results of property and casualty insurance companies are subject to significant fluctuations from quarter-to-quarter and from year-to-year due to the effect of competition on pricing, the frequency and severity of losses, including the effect of natural disasters on losses, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates and other factors such as changes in tax laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the ability of the Company to grow and retain business. The Company operates primarily in the state of California, which was the only state it produced business in prior to 1990. The Company expanded its operations into Georgia and Illinois in 1990. With the acquisition of American Fidelity Insurance Group ("AFI") in December 1996, now American Mercury Insurance Group ("AMI"), the Company expanded into the states of Oklahoma and Texas. The Company further expanded its operations into the state of Florida during 1998. Further expansion into Texas occurred with the Concord Insurance Services, Inc. transaction in December 1999 and the Mercury County Mutual Insurance Company ("MCM") transaction in September 2000. In 2001, the Company expanded into Virginia and New York. During 2001, approximately 87.5% of the Company's net premiums written were derived from California. In California, as in various other states, all property and casualty rates must be approved by the Insurance Commissioner before they can be used. In February 1994, the California Insurance Commissioner approved new rates which were designed to improve the Company's competitive position for new insureds. These rate changes, which became effective on May 1, 1994, provided for decreases in premium rates for new insureds. Several rate modifications were approved and made effective subsequent to May 1, 1994. A rate change made April 1, 1998, reduced rates by approximately 7% and was primarily made to improve Mercury's competitive position in the marketplace. On August 23, 2001, the Company increased premium rates by 6.9% on its non-standard line and on its non-good driver private passenger automobile line written by Mercury Casualty Company. The Company recently received approval for a 4.1% rate increase for private passenger automobile insurance in Mercury Insurance Company, which represents approximately 55% of Company-wide premiums written, and a 6.9% combined rate increase for private passenger automobile insurance in Mercury Casualty Company and California Automobile Insurance Company, which represent approximately 24% of Company-wide premiums written. These increases went into effect for all new and renewal California business as of March 1, 2002. Since March 31, 1994, Private Passenger Automobile policies in force in California have increased from approximately 300,000 to 828,000 at December 31, 2001, an annual rate of increase of approximately 14%. Policy count growth for the year 2001 was at a 7% rate, an improvement over 2000 when the rate was down negligibly from the prior year. In September 1996, the California Insurance Commissioner issued permanent rating factor regulations designed to implement the requirements that automobile insurance rates be determined by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further 24 requires that each of the four factors be applied in decreasing order of importance. The Company submitted a proposed rating plan in response to these regulations in March 1997. The Company's plan was approved by the California DOI and became effective October 1, 1997. Although the rate changes produced some minor dislocations, implementation of the plan has not materially changed the Company's overall competitive position or its profitability. The preparation of the Company's financial statements requires judgments and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60 (SFAS No. 60), "Accounting and Reporting by Insurance Enterprises" and Statement of Financial Accounting Standards No. 5 (SFAS No. 5), "Accounting for Contingencies". Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates can all 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 the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. 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. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision. The Company complies with the SFAS No. 60 definition of how insurance enterprises should recognize revenue on insurance policies written. The Company's insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums. To the extent that any of the Company's lines of business become substantially unprofitable then a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business. The Company carries its fixed maturity and equity investments at market value as required for securities classified as "Available for Sale" by Statement of Financial Accounting Standards No. 115 (SFAS No. 115), "Accounting for Certain Investments in Debt and Equity Securities." In most cases, market valuations were drawn from trade data sources. In no case were any valuations made by the Company's management. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date. The Company constantly evaluates its investments for other than temporary declines and writes them off as realized losses through the Statement of Income, as required by SFAS No. 115, if the circumstances warrant. Temporary unrealized investment gains and losses are credited or charged directly to shareholders' equity as accumulated other comprehensive income, net of applicable taxes. It is possible that future information will become available about the Company's current investments that would require accounting for them as realized losses due to other than temporary declines in value. The financial statement effect would be to move the unrealized loss from accumulated other comprehensive income on the Balance Sheet to realized investment losses on the Statements of Income. 25 The Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits incidental to our business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the financial statement footnotes if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the ultimate outcome of contingent liabilities, management does not expect them to have a material effect on the consolidated operations or financial position. Statement of Financial Accounting Standards No. 133 (SFAS NO. 133), "Accounting for Derivative Instruments and Hedging Activities" became effective for fiscal years beginning after June 15, 1999. Statement of Financial Accounting Standards No. 137 (SFAS No. 137), "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" defers the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. This standard, adopted by the Company on January 1, 2001 had no impact on the Consolidated Financial Statements. Statement of Financial Accounting Standards SFAS No. 141 (SFAS No. 141), "Business Combinations" and Statement of Financial Accounting Standards SFAS No. 142 (SFAS No. 142), "Goodwill and Other Intangible Assets" became effective January 1, 2002. SFAS No. 141 requires companies to apply the purchase method of accounting for all business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interest method. SFAS No. 142 changes the method by which companies may recognize intangible assets in purchase business combinations and generally requires identifiable intangible assets to be recognized separately from goodwill. In addition, it eliminates the amortization of all existing and newly acquired goodwill on a prospective basis and requires companies to assess goodwill for impairment, at least annually, based on the fair value of the reporting unit. At December 31, 2001, the Company had on its books approximately $7.3 million in Goodwill related to the 1999 acquisition of Concord and approximately $9.3 million of intangible assets with indefinite useful lives related to the Elm acquisition. As required by SFAS 142, the Company has assessed these assets and determined that they are not impaired. Furthermore, as required by SFAS 142, the Company will no longer amortize these assets after 2001. Total amortization expense in 2001 related to these assets was $1.9 million. Results of Operations Year Ended December 31, 2001 Compared to Year Ended December 31, 2000 --------------------------------------------------------------------- Premiums earned in 2001 of $1,380.6 million increased 10.5% and net premiums written in 2001 of $1,442.9 million increased 13.4% over amounts recorded in 2000. These premium increases were principally attributable to increased policy sales in the California automobile insurance lines as well as increased production in California homeowners insurance, Florida automobile insurance and Texas automobile insurance. The California private passenger automobile insurance marketplace has entered a period of rising premium rates. Virtually all of the Company's competitors have recently filed for rate increases which helped spur the Company's premium growth during 2001. In August 2001 the Company received approval from the California Department of Insurance for a 6.9% rate increase in its non-standard line and in its non-good driver private passenger automobile line written 26 by Mercury Casualty Company. The Company recently received approval for a 4.1% rate increase for private passenger automobile insurance in Mercury Insurance Company, which represents approximately 55% of Company-wide premiums written, and a 6.9% combined rate increase for private passenger automobile insurance in Mercury Casualty Company and California Automobile Insurance Company, which represent approximately 24% of Company-wide premiums written. These increases go into effect for all new and renewal California business as of March 1, 2002. The Company plans to make additional filings for rate increases in California as well as other states. Despite the increases, the Company believes that its rates will remain competitive in the marketplace. During 2001, the Company continued its marketing efforts for name recognition and lead generation. The Company feels that its marketing effort combined with price and reputation make the Company very competitive in California. The GAAP loss ratio in 2001 (loss and loss adjustment expenses related to premiums earned) was 73.2% compared with 72.2% in 2000. The less favorable loss ratio is primarily driven by higher loss ratios in the California automobile and homeowners lines of business which are partially offset by lower loss ratios in the Florida, Georgia and Illinois automobile lines of business. The GAAP expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 26.4% in 2001 and 26.3% in 2000. The expense ratio was relatively unchanged as total expenses increased at essentially the same rate as premium volume. The majority of expenses vary directly with premiums. Total losses and expenses in 2001, excluding interest expense of $7.7 million, were $1,374.4 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $6.1 million, compared with an underwriting gain of $19.1 million in 2000. Investment income in 2001 was $114.5 million, compared with $106.5 million in 2000. The after-tax yield on average investments of $1,828.5 million (cost basis) was 5.41%, compared with 5.56% on average investments of $1,710.2 million in 2000. The effective tax rate on investment income was 13.6% in 2001, compared to 10.6% in 2000. The higher tax rate and decrease in investment yields in 2001 reflect a shift in the mix of the Company's portfolio from non-taxable to taxable issues. Bonds matured and called in 2001 totaled $67.6 million, compared to $45.6 million in 2000. Approximately $120.4 million of bonds are expected to mature or be called in 2002. Realized investment gains in 2001 were $6.5 million, compared with realized gains of $3.9 million in 2000. The income tax provision of $19.5 million in 2001 represented an effective tax rate of 15.6%, compared with an effective rate of 14.9% in 2000. The higher rate in 2001 reflects a shift in a portion of the Company's investments from tax-exempt issues to taxable issues. Net income in 2001 was $105.3 million or $1.94 per share (diluted), compared with $109.4 million or $2.02 per share (diluted), in 2000. Diluted per share results are based on 54.4 million average shares in 2001 and 54.3 million shares in 2000. Basic per share results were $1.94 in 2001 and $2.02 in 2000. 27 Year Ended December 31, 2000 Compared to Year Ended December 31, 1999 --------------------------------------------------------------------- Premiums earned in 2000 of $1,249.3 million increased 5.1% and net premiums written in 2000 of $1,272.4 million increased 5.5% over amounts recorded in 1999. Contributing to the overall premium written growth were initial automobile premiums in Texas from the recent Concord agency transaction, and increases in California homeowner premiums, California non-standard automobile premiums and Florida automobile premiums. The Company's core California private passenger automobile premiums were relatively flat and AMI experienced a decline in premium volume. The GAAP loss ratio (loss and loss adjustment expenses related to premiums earned) was 72.2% in 2000 and 66.4% in 1999. The major reason for the less favorable result is an increase in severity for California automobile claims which is the result of inflationary trends in health care costs, auto parts and body shop labor costs. The GAAP expense ratio in 2000 (policy acquisition costs and other operating expenses related to premiums earned) was 26.3% compared with 26.8% in 1999. The decrease was due mainly to a reduction in base and contingent commissions, which are tied to loss performance, partially offset by an increase in advertising spending. Total losses and expenses in 2000, excluding interest expense of $7.3 million, were $1,230.2 million, resulting in an underwriting gain (premiums earned less total losses and expenses excluding interest) for the period of $19.1 million compared with an underwriting gain of $81.1 million in 1999. Investment income in 2000 was $106.5 million compared with $99.4 million in 1999. The after-tax yield on average investments of $1,710.2 million (cost basis) was 5.56%, compared with 5.62% on average investments of $1,595.5 million in 1999. The effective tax rate on investment income in 2000 was 10.6%, compared with 9.8% in 1999. The higher tax rate in 2000 reflects a modest shift in the Company's portfolio mix from non-taxable to taxable issues. Bonds matured and called in 2000 totaled $45.6 million compared with $49.2 million in 1999. Realized investment gains in 2000 were $3.9 million compared with realized losses of $11.9 million in 1999. The gains realized in 2000 were designed to utilize capital loss tax benefits. Included in 1999 losses was a $6.0 million write-down of a preferred stock investment that became other than temporarily impaired during the third quarter. The income tax provision of $19.2 million in 2000 represented an effective rate of 14.9%, compared with an effective rate of 20.7% in 1999. The lower rate in 2000 is primarily attributable to the increased proportion of investment income which consists primarily of tax-exempt interest and tax sheltered dividend income in contrast to underwriting income which is taxed at the full corporate rate of 35%. Net income in 2000 was $109.4 million or $2.02 per share (diluted), compared with $133.7 million or $2.44 per share (diluted), in 1999. Diluted per share results are based on 54.3 million average shares in 2000 and 54.8 million shares in 1999. Basic per share results were $2.02 in 2000 and $2.45 in 1999. 28 Liquidity and Capital Resources Net cash provided from operating activities in 2001, was $199.5 million, while funds derived from the sale, redemption or maturity of investments was $323.2 million, of which approximately 58% was represented by the sale of fixed maturities. The amortized cost of fixed-maturity investments increased by $96.3 million during the year. Equity investments, including perpetual preferred stocks, increased by $27.3 million at cost, while short-term cash investments increased by $39.0 million. The amortized cost of fixed-maturities available for sale that were sold, called or matured during the year was $254.2 million. The market value of all investments held at market as "Available for Sale" exceeded the amortized cost of $1,910.1 million at December 31, 2001 by $26.1 million. That unrealized gain, reflected in shareholders' equity, as Accumulated Other Comprehensive Income, net of applicable tax effects, was $17.0 million at December 31, 2001 compared with a gain of $30.9 million at December 31, 2000. The decrease in market values since December 31, 2000 were largely caused by widening spreads on many of the Company's corporate bonds. The widening spreads reflect the perceived increased credit risk by the market and by the major rating agencies in the wake of both the September 11 events and the industry-wide accounting concerns raised after the collapse of Enron. The Company's unrestricted cash and short term investments totaled $72.8 million at December 31, 2001. Together with funds generated internally, such liquid assets are adequate to pay claims without the sale of long term investments. As of December 31, 2001, the average Standard & Poor's rating of the $1,544.5 million bond portfolio (at amortized cost) was A, while the average effective maturity, giving effect to anticipated early call provisions, approximates 8.8 years. The modified duration of the bond portfolio at year-end was 6.5 years. Duration measures the length of time it takes to receive all cash flows produced by a bond, including reinvestment of interest income. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a much better indicator of price volatility than simple maturity alone. Bond holdings are broadly diversified geographically and by obligor. Traditionally, it has been the Company's policy not to invest in high yield or "junk" bonds. At December 31, 2001 bond holdings rated below investment grade totaled $39.1 million at market (cost $40.2 million), or less than 2% of total assets. A decrease in the portfolio's average rating from AA- at December 31, 2000 to A at December 31, 2001 reflects some downgrades in the Company's existing holdings as well as the fact that a larger percentage of the portfolio is invested in corporate bonds which generally have lower ratings than municipal issues. Fixed maturity investments of $1,560.2 million (amortized cost), include $15.7 million (amortized cost) of sinking fund preferred stocks, principally utility issues. The market value of all fixed maturities exceeded cost by $26.3 million at December 31, 2001. Except for Company-occupied buildings and land to be utilized for Company office space, the Company has no direct investments in real estate and no holdings of mortgages secured by commercial real estate. Equity holdings of $277.8 million at market (cost $277.9 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 26% of total shareholders' equity. 29 On August 7, 2001, the Company completed a public debt offering issuing $125 million of senior notes payable under a $300 million shelf registration filed with the SEC in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year commencing February 15, 2002. These notes mature on August 15, 2011. The Company incurred debt issuance costs of approximately $1.3 million, inclusive of underwriter's fees. These costs are deferred and then amortized as a component of interest expense over the term of the notes. The notes were issued at a slight discount at 99.723%, making the effective annualized interest rate including debt issuance costs approximately 7.44%. As part of the Elm County Mutual transaction the Company agreed to make annual $1 million payments to Employers Reinsurance Corporation over 7 years beginning September 30, 2001. At December 31, 2001, the Company is carrying a note payable for $4.8 million, which represents the discounted value of the six remaining payments using a 7% rate. The Company had outstanding debt at December 31, 2001 of $129.5 million. Prior to the $125 million senior note issuance, the Company had $75 million payable under a revolving credit facility due November 21, 2001 and $27 million payable under a $30 million revolving credit facility due October 26, 2001. The interest rate on these two loans was variable and through August 7, 2001 was priced off of the Eurodollar London Interbank Rate (LIBOR) making the effective interest rate 5.77% and 5.78%, respectively. On August 7, 2001, the Company repaid the entire balance of both the $75 million and $27 million borrowings with proceeds received from the $125 million senior note issuance. The Company also terminated the $75 million revolving credit facility. The $30 million facility that expired on October 26, 2001 was not renewed. Prior to the issuance of the senior notes, the Company used short-term floating rate bank debt as part of its capital structure. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate of LIBOR plus 107 basis points. The Company believes that the swap will significantly reduce interest expense in 2002, but does expose it to higher interest expense in future periods, should LIBOR rates increase. The swap will be accounted for as a fair value hedge under SFAS No. 133. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Under the stock repurchase program, the Company may purchase over a one-year period up to $200 million of Mercury General's common stock. The purchases may be made from time to time in the open market at the discretion of management. The program will be funded by the sale of lower yielding tax-exempt bonds, the proceeds of the senior note issuance and internal cash generation. During 2000, the Company purchased 314,900 shares of the common stock in the open market at an average price of $22.16. Since the inception of the program in 1998 through December 31, 2000, the Company has purchased 1,266,100 shares of common stock at an average price of $31.36. The shares purchased were retired. No stock was purchased in 2001. In March 1994, the Company's Employee Stock Ownership Plan (the "Plan") purchased 322,000 shares of Mercury General's common stock in the open market at a price of $14.875 per share, adjusted for the two-for-one stock split effective September 16, 1997. The purchases were funded by a five year term bank loan of $5.0 million to the Plan which is guaranteed by the Company. The shares have been allocated to employees over the amortization period of the loan, with the initial allocation made in December 1994. The remaining balance of the loan of $2.0 30 million was retired in March 1998 with the proceeds of contributions to the Plan by the Company for the year 1997, and the remaining unallocated shares were credited to employees' ESOP balances at December 31, 1997. In August 1998, the Plan purchased 115,000 shares of Mercury General's common stock in the open market at a price of $43.05 per share. The purchases were funded by a five year term bank loan of $5 million to the Plan which is guaranteed by the Company. At December 31, 2001 the loan balance was $2 million, recorded in the balance sheet as other liabilities. The shares are being allocated to the employees over a five-year period, with the initial allocation made in December 1998. Since dividends on unallocated shares held by the Plan are tax deductible if they are used for debt service, as are Company contributions to the Plan, the net, after-tax interest cost to the Company for the borrowed funds used for the Plan stock purchase is less than the effective rate of interest on the loan, which, in 2001, was 5.06%. In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance 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 has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 2001. Each of the Insurance Companies' policyholders' surplus exceeded the highest level of minimum required capital. As of December 31, 2001, the Company had no material commitments for capital expenditures. The Company anticipates spending approximately $10 million of internally generated funds in 2002 for the construction of a new office building in Rancho Cucamonga, California. The California Earthquake Authority ("CEA") is a Quasi-Governmental organization that was established in 1996 to provide a market for earthquake coverage to California homeowners. During the second quarter of 1998, the Company began placing all new and renewal earthquake coverage offered with its homeowners policy through the California Earthquake Authority. The Company receives a small fee for placing business with the CEA. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company's participation percentage multiplied by the amount of the total assessment. Based upon the most current information provided by the CEA, the Company's maximum total exposure to CEA assessments at April 19, 2001, is approximately $20.5 million. 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 of the Insurance Companies of $1,045.1 million at December 31, 2001, and net written premiums for the twelve months ended on that date of $1,442.9 million, the ratio of writings to surplus was approximately 1.4 to 1. Item 7A. Quantitative and Qualitative Disclosures about Market Risks ----------------------------------------------------------- The Company is subject to various market risk exposures including interest rate risk 31 and equity price risk. The following disclosure reflects estimates of future performance and economic conditions. Actual results may differ. The Company invests its assets primarily in fixed maturity investments, which at December 31, 2001 comprised 82% of total investments at market value. Tax-exempt bonds represent 82% of the fixed maturity investments with the remaining amount consisting of sinking fund preferred stocks and taxable bonds. Equity securities, consisting primarily of preferred stocks, account for 14% of total investments at market. The remaining 4% of the investment portfolio consists of highly liquid short-term investments which are primarily short-term money market funds. The value of the fixed maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio goes up with the opposite holding true in rising interest rate environments. A common measure of the interest sensitivity of fixed maturity assets is modified duration, a calculation that takes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. The Company has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company's investment philosophy has resulted in a portfolio with a moderate duration. During 2001, lower market interest reduced the duration of the Company's bond portfolio. Bond investments made by the Company typically have call options attached, which reduce the duration of the asset as interest rates decline. Consequently, the average modified duration of the portfolio declined from 6.8 years at December 31, 2000 to 6.5 years at December 31, 2001. Given a hypothetical parallel increase of 100 basis points in interest rates, the fair value of the bond portfolio would decrease by approximately $102 million. At December 31, 2001, the Company's strategy for equity investments was a buy and hold strategy which focuses primarily on current income with a secondary focus on capital appreciation. The value of the equity investments consists of $125.1 million in common stocks and $152.7 million in non-sinking fund preferred stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market. The non-sinking fund preferred stocks are typically valued using credit spreads to U. S. Treasury benchmarks. This causes them to be comparable to fixed income securities in terms of interest rate risk. During most of the year 2001, non-sinking fund preferred stocks were not actively traded by the market, though lower interest rates intrinsically benefit their market values. At December 31, 2001, the duration on the Company's non-sinking fund preferred stock portfolio was 8.9 years. This implies that an upward parallel shift in the yield curve by 100 basis points would reduce the asset value at December 31, 2001 by approximately $14 million, everything else remaining the same. The remainder of the equity portfolio, representing 6% of total investments at market value, consists primarily of public utility common stocks. These assets are defensive in nature and therefore have low volatility to changes in market price as measured by their Beta. Beta is a measure of a security's systematic (non-diversifiable) risk, which is the percentage change in an individual security's return for a 1% change in the return of the market. The average Beta for the Company's common stock holdings was 0.52. Based on a 32 hypothetical 20% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by approximately $13 million. As discussed in the Liquidity and Capital Resources section, in August 2001 the Company repaid total short-term floating rate bank debt of $102 million with the proceeds from the issuance of the $125 million fixed-rate senior notes maturing on August 15, 2011. To the extent market interest rates fluctuate, the fair value of the fixed rate debt will fluctuate in the opposite direction. At December 31, 2001 the fair value of the debt was $125.4 million. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes, thus eliminating the market risk on the liability. Forward-looking statements Certain statements in this report on Form 10-K that are not historical fact and constitute "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, our 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 our actual business, prospects and results of operations to differ materially from the historical information contained in this Form 10-K and from those that may be expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, among others: the intense competition currently existing in the California automobile insurance markets, our success in expanding our business in states outside of California, the impact of potential third party "bad-faith" legislation, changes in laws or regulations, third party relations and approvals, and decisions of courts, regulators and governmental bodies, particularly in California, our ability to obtain the approval of the California Insurance Commissioner for premium rate changes for private passenger automobile policies issued in California and similar rate approvals in other states where we do business, our success in integrating and profitably operating the businesses we have acquired, the level of investment yields we are able to obtain with our investments in comparison to recent yields, the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve estimates, and other uncertainties, all of which are difficult to predict and many of which are beyond our control. We assume no obligation to update any forward-looking statements as a result of new information or future events or developments. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Form 10-K or, in the case of any document we incorporate by reference, the date of that document. Investors also should 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 our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. 33 Quarterly Data Summarized quarterly financial data for 2001 and 2000 is as follows (in thousands except per share data): Quarter Ended ----------------------------------------- March 31 June 30 Sept. 30 Dec. 31 -------- -------- -------- -------- 2001 - ---- Earned premiums..................... $323,772 $338,171 $351,896 $366,722 Income before income taxes.......... $ 28,597 $ 31,798 $ 39,967 $ 24,447 Net income.......................... $ 24,708 $ 26,465 $ 32,055 $ 22,111 Basic earnings per share............ $ .46 $ .49 $ .59 $ .41 Diluted earnings per share.......... $ .45 $ .49 $ .59 $ .41 Dividends declared per share........ $ .265 $ .265 $ .265 $ .265 2000 - ---- Earned premiums..................... $304,655 $312,187 $315,108 $317,309 Income before income taxes ......... $ 36,038 $ 30,232 $ 32,045 $ 30,240 Net income.......................... $ 29,938 $ 26,002 $ 27,421 $ 26,005 Basic earnings per share............ $ .55 $ .48 $ .51 $ .48 Diluted earnings per share.......... $ .55 $ .48 $ .51 $ .48 Dividends declared per share........ $ .24 $ .24 $ .24 $ .24 34 Item 8. Financial Statements -------------------- INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Independent Auditors' Report ............................................ 36 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 2001 and 2000 ..... 37 Consolidated Statements of Income for Each of the Years in the Three-Year Period Ended December 31, 2001 ....................... 38 Consolidated Statements of Comprehensive Income for each of the Years in the Three-Year Period Ended December 31, 2001 .......... 39 Consolidated Statements of Shareholders' Equity for Each of the Years in the Three-Year Period Ended December 31, 2001 .......... 40 Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2001 ................... 41 Notes to Consolidated Financial Statements ....................... 43 35 INDEPENDENT AUDITORS' REPORT The Board of Directors Mercury General Corporation: We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. KPMG LLP Los Angeles, California February 1, 2002 36 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2001 AND 2000 AMOUNTS EXPRESSED IN THOUSANDS, except share amounts
ASSETS 2001 2000 ---------- ---------- Investments: Fixed maturities available for sale (amortized cost $1,560,180 in 2001 and $1,463,897 in 2000) ........... $1,586,433 $1,509,474 Equity securities available for sale (cost $277,925 in 2001 and $250,593 in 2000) ........................ 277,787 252,510 Short-term cash investments, at cost, which approximates market .................................. 71,951 32,977 ---------- ---------- Total investments .......................... 1,936,171 1,794,961 Cash ..................................................... 3,851 5,935 Receivables: Premiums receivable ................................... 143,612 123,070 Premium notes ......................................... 17,256 14,205 Accrued investment income ............................. 27,979 25,707 Other ................................................. 29,529 36,410 ---------- ---------- 218,376 199,392 Deferred policy acquisition costs ........................ 83,440 71,126 Fixed assets, net ........................................ 44,448 35,208 Deferred income taxes .................................... 1,252 -- Other assets ............................................. 29,002 35,641 ---------- ---------- $2,316,540 $2,142,263 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Losses and loss adjustment expenses ...................... $ 534,926 $ 492,220 Unearned premiums ........................................ 421,342 365,579 Notes payable ............................................ 129,513 107,889 Loss drafts payable ...................................... 53,629 49,954 Accounts payable and accrued expenses .................... 46,638 39,715 Current income tax ....................................... 4,367 3,471 Deferred income taxes .................................... -- 8,336 Other liabilities ........................................ 56,414 42,194 ---------- ---------- Total liabilities .......................... 1,246,829 1,109,358 ---------- ---------- Shareholders' equity: Common stock without par value or stated value: Authorized 70,000,000 shares; issued and outstanding 54,276,798 shares in 2001 and 54,193,423 in 2000 ..... 53,955 52,162 Accumulated other comprehensive income ................ 16,975 30,871 Unearned ESOP compensation ............................ (1,000) (2,000) Retained earnings .................................... 999,781 951,872 ---------- ---------- Total shareholders' equity ................. 1,069,711 1,032,905 ---------- ---------- Commitments and contingencies ......................... $2,316,540 $2,142,263 ========== ==========
See accompanying notes to consolidated financial statements. 37 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Three years ended December 31, 2001 Amounts expressed in thousands, except per share data 2001 2000 1999 ---------- ---------- ---------- Revenues: Earned premiums ...................... $1,380,561 $1,249,259 $1,188,307 Net investment income ................ 114,511 106,466 99,374 Net realized investment gains (losses) 6,512 3,944 (11,929) Other ................................ 5,396 6,349 4,924 ---------- ---------- ---------- Total revenues .................. 1,506,980 1,366,018 1,280,676 ---------- ---------- ---------- Expenses: Losses and loss adjustment expenses .. 1,010,439 901,781 789,103 Policy acquisition costs ............. 301,670 268,657 267,399 Other operating expenses ............. 62,335 59,733 50,675 Interest ............................. 7,727 7,292 4,960 ---------- ---------- ---------- Total expenses .................. 1,382,171 1,237,463 1,112,137 ---------- ---------- ---------- Income before income taxes ........... 124,809 128,555 168,539 Income taxes ........................... 19,470 19,189 34,830 ---------- ---------- ---------- Net income ........................... $ 105,339 $ 109,366 $ 133,709 ========== ========== ========== Basic earnings per share ............... $ 1.94 $ 2.02 $ 2.45 ========== ========== ========== Diluted earnings per share ............. $ 1.94 $ 2.02 2.44 ========== ========== ========== See accompanying notes to consolidated financial statements. 38 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Three Years ended December 31, 2001 Amounts expressed in thousands
2001 2000 1999 -------- -------- --------- Net income ....................................... $105,339 $109,366 $ 133,709 Other comprehensive income (loss), before tax: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period ............................. (16,854) 109,432 (146,637) Less: reclassification adjustment for net losses (gains) included in net income ..... (4,524) (1,214) 7,149 -------- -------- --------- Other comprehensive income (loss), before tax ................................ (21,378) 108,218 (139,488) Income tax expense (benefit) related to unrealized holding gains (losses) arising during period .... (5,899) 38,301 (51,323) Income tax expense (benefit) related to reclassification adjustment for (gains) losses included in net income .......................... (1,583) (425) 2,502 -------- -------- --------- Comprehensive income, net of tax ................. $ 91,443 $179,708 $ 43,042 ======== ======== =========
See accompanying notes to consolidated financial statements 39 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Three years ended December 31, 2001 Amounts expressed in thousands
2001 2000 1999 ---------- ---------- -------- Common stock, beginning of year .............. $ 52,162 $ 50,963 $ 48,830 Proceeds of stock options exercised .......... 1,344 1,304 565 Tax benefit on sales of incentive stock options ..................................... 587 549 152 Release of common stock by the ESOP .......... (138) (358) (254) Purchase and retirement of common stock ...... -- (296) (330) Issuance of restricted common stock .......... -- -- 2,000 ---------- ---------- -------- Common stock, end of year .................... 53,955 52,162 50,963 ---------- ---------- -------- Accumulated other comprehensive income (loss), beginning of year ........................... 30,871 (39,471) 51,196 Net increase (decrease) in other comprehensive income, net of tax .......................... (13,896) 70,342 (90,667) ---------- ---------- -------- Accumulated other comprehensive income (loss), end of year ................................. 16,975 30,871 (39,471) ---------- ---------- -------- Unearned ESOP compensation, beginning of year (2,000) (3,000) (4,000) Amortization of unearned ESOP compensation ... 1,000 1,000 1,000 ---------- ---------- -------- Unearned ESOP compensation, end of year ...... (1,000) (2,000) (3,000) ---------- ---------- -------- Retained earnings, beginning of year ......... 951,872 901,099 821,349 Purchase and retirement of common stock ...... -- (6,683) (8,105) Net income ................................... 105,339 109,366 133,709 Dividends paid to shareholders ............... (57,430) (51,910) (45,854) ---------- ---------- -------- Retained earnings, end of year ............... 999,781 951,872 901,099 ---------- ---------- -------- Total shareholders' equity ............ $1,069,711 $1,032,905 $909,591 ========== ========== ========
See accompanying notes to consolidated financial statements. 40 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 2001 Amounts expressed in thousands
2001 2000 1999 ---- ---- ---- Cash flows from operating activities: Net income .......................................... $ 105,339 $ 109,366 $ 133,709 Adjustments to reconcile net income to net cash provided from operating activities: Increase in unpaid losses and loss adjustment expenses ........................................... 42,706 41,719 28,867 Increase in unearned premiums ....................... 55,763 15,389 13,717 (Increase) decrease in premium notes receivable ..... (3,051) (831) 364 Increase in premiums receivable ..................... (20,542) (7,417) (7,704) Increase (decrease) in reinsurance recoveries ....... 19,335 (1,509) (4,288) Increase in deferred policy acquisition costs ....... (12,314) (7,151) (2,028) Increase in premiums collected in advance ........... 6,922 2,284 554 Increase in loss drafts payable ..................... 3,675 9,891 1,630 Decrease (increase) in accrued income taxes, excluding deferred tax on change in unrealized gain (1,209) 2,153 1,577 (Decrease) increase in accounts payable and accrued expenses .......................................... 6,923 (13,407) (1,223) Depreciation ........................................ 8,477 6,926 6,896 Net realized investment (gains) losses .............. (6,512) (3,944) 11,929 Bond accretion, net ................................. (9,229) (7,337) (5,450) Other, net .......................................... 3,169 6,938 10,527 --------- --------- --------- Net cash provided from operating activities . 199,452 153,070 189,077 Cash flows from investing activities: Fixed maturities available for sale: Purchases .......................................... (341,471) (294,827) (215,960) Sales .............................................. 186,949 137,448 54,537 Calls or maturities ................................ 71,758 54,914 58,411 Equity securities available for sale: Purchases .......................................... (90,067) (83,372) (475,525) Sales .............................................. 64,450 81,294 445,330 Mercury County Mutual Insurance Company (ELM) transaction less cash acquired (See Note 9) ........ -- (5,138) -- Concord transaction (See Note 8) .................... -- -- (3,665) (Increase) decrease in receivable from securities ... 167 (200) 613 (Increase) decrease in short-term cash investments, net ................................................ (38,974) 10,591 2,424 Purchase of fixed assets ............................ (18,095) (8,342) (9,268) Sale of fixed assets ................................ 563 1,031 916 --------- --------- --------- Net cash used in investing activities ...... $(164,720) $(106,601) $(142,187)
(Continued) 41 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 2001 Amounts expressed in thousands (Continued)
2001 2000 1999 --------- -------- -------- Cash flows from financing activities: Net proceeds from issuance of senior notes ... $ 123,309 $ -- $ -- Increases in notes payable ................... -- 37,000 17,000 Net payments under credit arrangements ....... (103,039) (27,000) (3,000) Dividends paid to shareholders ............... (57,430) (51,910) (45,854) Proceeds from stock options exercised ........ 1,344 1,303 565 Purchase and retirement of common stock ...... -- (6,979) (8,436) Payments on ESOP loan ........................ (1,000) (1,000) (1,000) --------- -------- -------- Net cash used in financing activities (36,816) (48,586) (40,725) --------- -------- -------- Net (decrease) increase in cash .............. (2,084) (2,117) 6,165 Cash: Beginning of the year ...................... 5,935 8,052 1,887 --------- -------- -------- End of the year ............................ $ 3,851 $ 5,935 $ 8,052 ========= ======== ========
See accompanying notes to consolidated financial statements. 42 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001 and 2000 (1) Significant Accounting Policies Principles of Consolidation and Presentation The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. In 2001 and 2000 over 87% of the net written premiums were from California. The consolidated financial statements include the accounts of Mercury General Corporation (the Company or MGC) and its wholly-owned subsidiaries, Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Inc., Mercury Insurance Company of Georgia, Mercury Insurance Company of Illinois, Mercury Insurance Company of Florida, Mercury Indemnity Company of Georgia, Mercury Indemnity Company of Illinois, Mercury Indemnity Company of Florida, Mercury Insurance Services, LLC (MISLLC), American Mercury Insurance Company (AMIC), AFI Management Company, Inc. (AFIMC), American Mercury Lloyds Insurance Company (AML) and Mercury County Mutual Insurance Company (MCM). AML is not owned by MGC, but is controlled by MGC through its attorney-in-fact, AFIMC. MCM is not owned by the Company but is controlled through a management contract. American Mercury MGA, Inc. (AMMGA), is a wholly owned subsidiary of AMIC. Effective October 31, 1999 the financial statements also include Concord Insurance Services, Inc., (Concord) a Texas insurance agency owned by MGC. Concord is discussed further in Note 8. The results of MCM are included in the financial statements effective September 30, 2000. MCM is discussed further in Note 9. All of the subsidiaries as a group, including AML and MCM, but excluding AFIMC, AMMGA, MISLLC and Concord, are referred to as the Insurance Companies. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant assumptions in the preparation of these consolidated financial statements relate to loss and loss adjustment expenses. Actual results could differ from those estimates. 43 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (1) Significant Accounting Policies (Continued) Investments Fixed maturities available for sale include those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. Fixed maturities available for sale, which include bonds and sinking fund preferred stocks, are carried at market. Short-term investments are carried at cost, which approximates market. Investments in equity securities, which include common stocks and non-redeemable preferred stocks, are carried at market. In most cases, the market valuations were drawn from standard trade data sources. In no case were any valuations made by the Company's management. Equity holdings, including non- sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price on the balance sheet date. Temporary unrealized investment gains and losses on securities available for sale are credited or charged directly to shareholders' equity as accumulated other comprehensive income, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statements of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method. Included in realized losses for 1999 is a $6.0 million write-down of a preferred stock investment that became other than temporarily impaired during the third quarter of 1999. As the result of a liquidating dividend, the Company realized gains of $477,000 and $347,000 on the same equity security in 2001 and 2000, respectively. Fair Value of Financial Instruments Under Statement of Financial Accounting Standards No. 115 (SFAS No. 115), "Accounting for Certain Investments in Debt and Equity Securities", the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 and were drawn from standard trade data sources such as market and broker quotes. The carrying value of receivables, accounts payable and other liabilities is equivalent to the estimated fair value of those items. The notes payable are carried at their book value which is calculated as the principal less unamortized discount on the senior debt and the discounted value of future payments on the Employers Re note. The terms of the notes are discussed in Note 5. 44 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (1) Significant Accounting Policies (Continued) Premium Income Recognition Insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are computed on the monthly pro rata basis. Unearned premiums are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets. Net premiums written during 2001, 2000 and 1999 were $1,442,886,000, $1,272,447,000 and $1,206,171,000, respectively. One broker produced direct premiums written of approximately 17%, 18% and 19% of the Company's total direct premiums written during 2001, 2000 and 1999, respectively. No other agent or broker accounted for more than 2% of direct premiums written. Premium Notes Premium notes receivable represent the balance due to the Company from policyholders who elect to finance their premiums over the policy term. The Company requires both a downpayment and monthly payments as part of its financing program. Premium finance fees are charged to policyholders who elect to finance premiums. The fees are charged at rates that vary with the amount of premium financed. Premium finance fees are recognized over the term of the premium note based upon the effective yield. Deferred Policy Acquisition Costs Acquisition costs related to unearned premiums, which consist of commissions, premium taxes and certain other underwriting costs, which vary directly with and are directly related to the production of business, are deferred and amortized to income ratably over the terms of the policies. Deferred acquisition costs are limited to the amount which will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses and the servicing costs that will be incurred as the premiums are earned. The Company does not defer advertising expenses. 45 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (1) Significant Accounting Policies (Continued) Losses and Loss Adjustment Expenses The liability for losses and loss adjustment expenses is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period, plus estimates, based upon past experience, of ultimate developed costs which may differ from case estimates and of unreported claims. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of reinsurance recoverable is included in other receivables. Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates can all 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 the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. 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. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions. Depreciation Buildings and furniture and equipment are depreciated over 30-year and 3-year to 10-year periods, respectively, on a combination of straight-line and accelerated methods. Automobiles are depreciated over 5 years, using an accelerated method. Earnings per Share During 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share", which requires presentation of basic and diluted earnings per share for all publicly traded companies effective for fiscal years ending after December 15, 1997. Note 15 contains the required disclosures which make up the calculation of basic and diluted earnings per share. Segment Reporting Statement of Financial Accounting Standards No. 131 (SFAS No. 131), "Disclosures about Segments of an Enterprise and Related Information," became effective for fiscal years beginning after December 15, 1997. SFAS 131 establishes standards for the way information about operating segments is reported in financial statements. The Company does not have any operations that require separate disclosure as operating segments. 46 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (1) Significant Accounting Policies (Continued) Recently Issued Accounting Standards Statement of Financial Accounting Standards No. 133, (SFAS No. 133) "Accounting for Derivative Instruments and Hedging Activities" became effective for fiscal years beginning after June 15, 1999. Statement of Financial Accounting Standards No. 137 (SFAS No. 137), "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133" defers the effective date of SFAS 133 to fiscal years beginning after June 15, 2000. The Company adopted this new Standard on January 1, 2001 and it had no impact on the Consolidated Financial Statements. Statement of Financial Accounting Standards No. 141, (SFAS No. 141) "Business Combinations" and Statement of Financial Accounting Standards No. 142,(SFAS No. 142) "Goodwill and Other Intangible Assets" became effective January 1, 2002. SFAS No. 141 requires companies to apply the purchase method of accounting for all business combinations initiated after June 30, 2001 and prohibits the use of the pooling-of-interest method. SFAS No. 142 changes the method by which companies may recognize intangible assets in purchase business combinations and generally requires identifiable intangible assets to be recognized separately from goodwill. In addition, it eliminates the amortization of all existing and newly acquired goodwill on a prospective basis and requires companies to assess goodwill for impairment, at least annually, based on the fair value of the reporting unit. See Notes 8 and 9. Income Taxes The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities and expected benefits of utilizing net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled and reflected in the financial statements in the period enacted. Reinsurance Liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The ceded amounts are immaterial and are carried in other assets and other receivables. Earned premiums are stated net of deductions for ceded reinsurance. 47 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (1) Significant Accounting Policies (Continued) The Insurance Companies, as primary insurers, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements. Statements of Cash Flows At December 31, 2001, the cash balance includes $3,000,000 of restricted cash related to the Concord transaction (See Note 8). Interest paid during 2001, 2000, and 1999 was $4,610,000, $7,357,000 and $4,758,000, respectively. Income taxes paid were $20,089,000 in 2001, $14,609,000 in 2000 and $33,102,000 in 1999. The tax benefit realized on stock options exercised and included in cash provided from operations in 2001, 2000 and 1999 was $588,000, $550,000 and $152,000, respectively. In 2001, debt issuance costs of $1,345,000 were paid in connection with the public debt offering of $125 million of senior notes payable. In 2000, notes payable with a discounted value of $5,889,000 were issued as part of the consideration for the right to manage and control Elm County Mutual Insurance Company (ELM) (See Note 9). Stock-Based Compensation The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by Statement of Financial Accounting Standards No. 123,(SFAS No. 123) "Accounting for Stock-Based Compensation". Disclosure of stock-based compensation determined in accordance with SFAS No. 123 is presented in Note 14. Reclassifications Certain reclassifications have been made to the prior year balances to conform to the current year presentation. 48 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (2) Investments and Investment Income A summary of net investment income is shown in the following table: Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 -------- -------- -------- Interest and dividends on fixed maturities ... $ 95,187 $ 86,644 $ 78,559 Dividends on equity securities ............... 17,080 17,136 18,885 Interest on short-term cash investments ...... 3,295 3,380 2,840 -------- -------- -------- Total investment income ............... 115,562 107,160 100,284 Investment expense ........................... 1,051 694 910 -------- -------- -------- Net investment income ................. $114,511 $106,466 $ 99,374 ======== ======== ======== A summary of net realized investment gains (losses) is as follows: Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 ------ -------- -------- Net realized investment gains (losses): Fixed maturities ...................... $4,561 $ 549 $ 67 Equity securities ..................... 1,951 3,395 (11,996) ------ -------- -------- $6,512 $ 3,944 $(11,929) ====== ======== ======== 49 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (2) Investments and Investment Income (Continued) Gross gains and losses realized on the sales of investments (excluding calls and other than temporarily impaired securities) are shown below: Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 ------- ------- -------- Fixed maturities available for sale: Gross realized gains .................. $ 5,558 $ 1,740 $ 865 Gross realized losses ................. (1,608) (908) (259) ------- ------- -------- Net ............................. $ 3,950 $ 832 $ 606 ======= ======= ======== Equity securities available for sale: Gross realized gains .................. $ 5,205 $ 5,259 $ 5,506 Gross realized losses ................. (2,760) (1,621) (11,536) ------- ------- -------- Net ............................. $ 2,445 $ 3,638 $ (6,030) ======= ======= ======== A summary of the net increase (decrease) in unrealized investment gains and losses less applicable income tax expense (benefit), is as follows: Year ended December 31, (Amounts in thousands) ------------------------------- 2001 2000 1999 -------- -------- --------- Net increase (decrease) in net unrealized investment gains and losses: Fixed maturities available for sale ... $(19,324) $ 77,288 $(111,179) Income tax expense (benefit) .......... (6,763) 27,051 (38,912) -------- -------- --------- $(12,561) $ 50,237 $ (72,267) ======== ======== ========= Equity securities ..................... $ (2,055) $ 30,930 $ (28,309) Income tax expense (benefit) .......... (720) 10,825 (9,909) -------- -------- --------- $ (1,335) $ 20,105 $ (18,400) ======== ======== ========= 50 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (2) Investments and Investment Income (Continued) Accumulated unrealized gains and losses on securities available for sale is as follows: December 31, (Amounts in thousands) 2001 2000 -------- -------- Fixed maturities available for sale: Unrealized gains ...................... $ 56,541 $ 60,318 Unrealized losses ..................... (30,288) (14,741) Tax effect ............................ (9,188) (15,952) -------- -------- $ 17,065 $ 29,625 ======== ======== Equity securities available for sale: Unrealized gains ...................... $ 15,898 $ 16,799 Unrealized losses ..................... (16,036) (14,882) Tax effect ............................ 48 (671) -------- -------- $ (90) $ 1,246 ======== ======== Net unrealized investment gains (classified as accumulated other comprehensive income on the balance sheet) ................ $ 16,975 $ 30,871 ======== ======== The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2001 are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ---------- ---------- ---------- ---------- (Amounts in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ....... $ 8,043 $ 329 $ 22 $ 8,350 Obligations of states and political subdivisions .................... 1,297,320 51,554 12,874 1,336,000 Corporate securities .............. 239,113 4,230 17,131 226,212 Redeemable preferred stock ........ 15,704 428 261 15,871 ---------- ------- ------- ---------- Totals ........................ $1,560,180 $56,541 $30,288 $1,586,433 ========== ======= ======= ==========
51 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (2) Investments and Investment Income (Continued) The amortized costs and estimated market values of investments in fixed maturities available for sale as of December 31, 2000 are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ---------- ---------- ---------- ---------- (Amounts in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies ....... $ 7,897 $ 187 $ 16 $ 8,068 Obligations of states and political subdivisions .................... 1,315,024 57,686 13,318 1,359,392 Corporate securities .............. 121,071 1,838 1,110 121,799 Redeemable preferred stock ........ 19,905 607 297 20,215 ---------- ------- ------- ---------- Totals ....................... $1,463,897 $60,318 $14,741 $1,509,474 ========== ======= ======= ==========
At December 31, 2001, bond holdings rated below investment grade totaled approximately 1.7% of total investments. The average Standard and Poor's rating of the bond portfolio was A. The amortized cost and estimated market value of fixed maturities available for sale at December 31, 2001 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Estimated Amortized Market Cost Value ---------- ---------- (Amounts in thousands) ----------------------- Fixed maturities available for sale: Due in one year or less ....................... $ 2,392 $ 2,459 Due after one year through five years ......... 89,275 90,451 Due after five years through ten years ........ 267,464 262,046 Due after ten years ........................... 1,201,049 1,231,477 ---------- ---------- $1,560,180 $1,586,433 ========== ========== 52 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (3) Fixed Assets A summary of fixed assets follows: December 31, (Amounts in thousands) ---------------------- 2001 2000 -------- -------- Land ....................................... $ 10,524 $ 6,084 Buildings .................................. 25,088 23,291 Furniture and equipment .................... 56,880 46,666 Leasehold improvements ..................... 415 598 -------- -------- 92,907 76,639 Less accumulated depreciation .............. (48,459) (41,431) -------- -------- Net fixed assets ........................... $ 44,448 $ 35,208 ======== ======== In November 2001, the Company purchased twelve acres of land in Rancho Cucamonga, California. Construction of a 100,000 square foot office building to house Company personnel is planned to begin in 2002 with completion anticipated in early 2003. Any space in the building that is not occupied by the Company will be leased to outside parties. (4) Deferred Policy Acquisition Costs Policy acquisition costs incurred and amortized are as follows: Year ended December 31, (Amounts in thousands) --------------------------------- 2001 2000 1999 --------- --------- --------- Balance, beginning of year ........... $ 71,126 $ 63,975 $ 61,947 Costs deferred during the year ....... 313,984 275,808 269,427 Amortization charged to expense ...... (301,670) (268,657) (267,399) --------- --------- --------- Balance, end of year ................. $ 83,440 $ 71,126 $ 63,975 ========= ========= ========= (5) Notes Payable The Company had outstanding debt at December 31, 2001 of $129.5 million. Included in the total debt is the proceeds from an August 7, 2001, public debt offering where the Company issued $125 million of senior notes payable under a $300 million shelf registration filed with the SEC in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year commencing February 15, 2002. The notes mature on August 15, 2011. The Company incurred debt issuance costs of approximately $1.3 million, inclusive of underwriter's fees. These costs are deferred and then amortized as a component of interest expense over the term of the notes. The notes were issued at a slight discount at 99.723%, making the effective annualized interest rate including debt issuance costs 53 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (5) Notes Payable (Continued) approximately 7.44%. At December 31, 2001, the book value of the debt was $124.7 million and the fair market value was $125.4 million. Prior to the issuance of the senior notes, the Company used short-term floating rate bank debt as part of its capital structure. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a floating rate of LIBOR plus 107 basis points. The Company believes that the swap will significantly reduce interest expense in 2002, but does expose it to higher interest expense in future periods, should LIBOR rates increase. The swap will be accounted for as a fair value hedge under SFAS No. 133. As part of the Elm County Mutual transaction, the Company agreed to make annual $1 million payments to Employers Reinsurance Corporation over 7 years beginning September 30, 2001. At December 31, 2001, the Company was carrying a note payable for $4.8 million, which represents the discounted value of the six remaining annual payments using a 7% rate. Prior to the $125 million senior note issuance, the Company had $75 million payable under a revolving credit facility due November 21, 2001 and $27 million payable under a $30 million revolving credit facility due October 26, 2001. The interest rate on these two loans was variable and through August 7, 2001 was priced off of the Eurodollar London Interbank Rate (LIBOR) making the effective interest rate 5.77% and 5.78%, respectively. On August 7, 2001, the Company repaid the entire balance of both the $75 million and $27 million borrowings with proceeds received from the $125 million senior note issuance. The Company also terminated the $75 million revolving credit facility. The $30 million facility that expired on October 26, 2001 was not renewed. 54 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (6) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. The provision for income tax expense (benefit) consists of the following components: Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 -------- -------- -------- Federal Current ............... $ 21,377 $ 20,270 $ 36,535 Deferred .............. (2,546) (1,236) (2,123) -------- -------- -------- $ 18,831 $ 19,034 $ 34,412 ======== ======== ======== State Current ............... $ 196 $ 155 $ 418 Deferred .............. 443 -- -- -------- -------- -------- $ 639 $ 155 $ 418 ======== ======== ======== Total Current ............... $ 21,573 $ 20,425 $ 36,953 Deferred .............. (2,103) (1,236) (2,123) -------- -------- -------- Total ............ $ 19,470 $ 19,189 $ 34,830 ======== ======== ======== The income tax provision reflected in the consolidated statements of income is less than the expected federal income tax on income before income taxes as shown in the table below:
Year ended December 31, (Amounts in thousands) ------------------------------ 2001 2000 1999 -------- -------- -------- Computed tax expense at 35% ..................... $ 43,683 $ 44,994 $ 58,989 Tax-exempt interest income ...................... (25,694) (27,295) (25,398) Dividends received deduction .................... (3,054) (3,152) (3,953) Reduction of losses incurred deduction for 15% of income on securities purchased after August 7, 1986 ................................. 4,272 4,496 4,348 Other, net ...................................... 263 146 844 -------- -------- -------- Income tax expense ......................... $ 19,470 $ 19,189 $ 34,830 ======== ======== ========
55 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (6) Income Taxes (Continued) The temporary differences that give rise to a significant portion of the deferred tax asset (liability) relate to the following: December 31, (Amounts in thousands) ---------------------- 2001 2000 -------- -------- Deferred tax assets 20% of net unearned premium ................... $ 30,363 $ 25,920 Discounting of loss reserves and salvage and subrogation recoverable for tax purposes ..................................... 10,553 9,445 Other deferred tax assets ................... 8,850 5,966 -------- -------- Total gross deferred tax assets ........... 49,766 41,331 Less valuation allowance ................. -- -- -------- -------- Net deferred tax assets .................. 49,766 41,331 -------- -------- Deferred tax liabilities Deferred acquisition costs .................. (32,652) (27,623) Tax liability on net unrealized gain on securities carried at market value ......... (9,140) (16,623) Tax depreciation in excess of book depreciation ............................... (941) (1,167) Accretion on bonds .......................... (3,629) (2,962) Other deferred tax liabilities .............. (2,152) (1,292) -------- -------- Total gross deferred tax liabilities ...... (48,514) (49,667) -------- -------- Net deferred tax assets (liabilities) ..... $ 1,252 $ (8,336) ======== ======== Realization of the net deferred tax assets is dependent on generating sufficient taxable income prior to their expiration. Although realization is not assured, management believes it is more likely than not that the net deferred tax asset will be realized. The State of California has completed income tax audits on Mercury General Corporation for tax years ended December 31, 1993 through 1996. As part of these audits the California Franchise Tax Board ("FTB") is challenging the Company's ability to deduct a portion of its management and interest expenses. Upon completion of the audits for tax years ended December 31, 1993 through 1996, the FTB proposed assessments of approximately $7,600,000, plus interest. The Company has formally appealed the proposed assessments and is currently awaiting a hearing before the California State Board of Equalization ("SBE"). 56 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (6) Income Taxes (Continued) The State of California is also performing audits for tax years ended December 31, 1997 through 2000. The FTB is challenging the Company's ability to deduct a portion of its management and interest expenses. Alternatively, based partly on the recent California Court of Appeal decision in Ceridian vs. Franchise Tax Board, the FTB is challenging the Company's ability to exclude intercompany dividends from income tax. No formal assessments have been made for tax years December 31, 1997 through 2000. However, management believes the FTB will assert similar challenges and could propose additional assessments of approximately $17 million, plus interest. Although the ultimate outcome of these audits is uncertain, management believes the Company will prevail for all years under audit. Accordingly, no provision for additional state income tax liabilities has been made in the consolidated financial statements. (7) Reserves for Losses and Loss Adjustment Expenses Activity in the reserves for losses and loss adjustment expenses is summarized as follows:
Year ended December 31, (Amounts in thousands) ---------------------------------- 2001 2000 1999 ---------- --------- --------- Gross reserves for losses and loss adjustment expenses at beginning of year .. $ 492,220 $ 434,843 $ 405,976 Less reinsurance recoverable ............... (28,417) (16,043) (20,160) ---------- --------- --------- Net reserves, beginning of year ............ 463,803 418,800 385,816 Incurred losses and loss adjustment expenses related to: Current year ........................... 993,510 878,144 781,316 Prior years ............................ 16,929 23,637 7,787 ---------- --------- --------- Total incurred losses and loss adjustment expenses .................................. 1,010,439 901,781 789,103 ---------- --------- --------- Loss and loss adjustment expense payments related to: Current year ........................... 636,007 562,163 492,314 Prior years ............................ 321,643 294,615 263,805 ---------- --------- --------- Total payments ............................. 957,650 856,778 756,119 ---------- --------- --------- Net reserves for losses and loss adjustment expenses at end of year ................... 516,592 463,803 418,800 Reinsurance recoverable .................... 18,334 28,417 16,043 ---------- --------- --------- Gross reserves, end of year ................ $ 534,926 $ 492,220 $ 434,843 ========== ========= =========
57 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (7) Reserves for Losses and Loss Adjustment Expenses (Continued) Increases in prior years incurred losses in 2001, 2000 and 1999 largely relate to increases in the severity estimates on bodily injury and physical damage coverages over what was originally recorded in the prior year. The increases in these claims relate to increased severity over what was recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs. (8) Concord Transaction In December 1999, the Company acquired control of Concord Insurance Services, Inc. ("Concord"), a Texas insurance agency headquartered in Houston, Texas. The effective date of the transaction was October 31, 1999. Concords' results of operations are included in the Consolidated Financial Statements of the Company effective October 31, 1999. The transaction was accounted for using the purchase method of accounting, and resulted in a small amount of goodwill. As required by SFAS No. 142, the Company has assessed the asset which at December 31, 2001 was $7.3 million and determined that it is not impaired. Also, per SFAS No. 142, the Company will no longer amortize this asset after 2001. Total amortization expense in 2001 related to this asset was $0.9 million. (9) Mercury County Mutual Insurance Company Transaction Effective September 30, 2000, the Company completed a transaction with Employers Reinsurance Corporation purchasing the authority and right to manage and control Elm County Mutual Insurance Company. Effective January 2, 2001, the name was changed to Mercury County Mutual Insurance Company ("MCM"). The results of operations of MCM, which are not material to the Company, are included in the consolidated financial statements of the Company effective September 30, 2000. In 2001, the Company began writing Texas automobile risks that were previously placed through third-party Texas county mutual insurers and 100% reinsured by the Company, directly with MCM. Risks produced by the Company that are written directly through MCM are 100% ceded to affiliated Mercury Companies. The MCM transaction was accounted for using the purchase method of accounting and resulted in a small amount of an intangible asset. As required by SFAS No. 142, the Company has assessed the asset which at December 31, 2001 was $9.3 million and determined that it is not impaired. Also, per SFAS No. 142, the Company will no longer amortize this asset after 2001 as it has an indefinite life. Total amortization expense in 2001 related to this asset was $1.0 million. 58 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (10) Dividend Restrictions The Insurance Companies are subject to the financial capacity guidelines established by the Office of the Commissioner of Insurance of their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For the year 2002, the direct insurance subsidiaries of the Company are permitted to pay approximately $102 million in dividends to the Company without the prior approval of the Commissioner of Insurance of the state of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay dividends. During 2001 and 2000, the Insurance Companies paid dividends to Mercury General Corporation of $60.0 million and $62.5 million, respectively. (11) Statutory Balances and Accounting Practices The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include primarily those published as statements of Statutory Accounting Principles by the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2001, there were no material permitted statutory accounting practices utilized by the Insurance Companies. The Insurance Companies' statutory net income, as reported to regulatory authorities, was $93,720,000, $103,937,000 and $135,667,000 for the years ended December 31, 2001, 2000 and 1999, respectively. The statutory policyholders' surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 2001 and 2000 was $1,045,104,000 and $954,753,000, respectively. The Company has estimated the Risk-Based Capital Requirements of each of the Insurance Companies as of December 31, 2001 according to the formula issued by the NAIC. Each of the Companies' policyholders' surplus exceeded the highest level of minimum required capital. Codification Codification became effective January 1, 2001. At December 31, 2001 the Company realized a surplus increase of approximately $41 million due to Codification. This increase primarily relates to the establishment of a net deferred tax asset. 59 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (12) Commitments and Contingencies The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2008. Total rent expense under these lease agreements, all of which are operating leases, was $4,428,000, $4,138,000 and $3,320,000 for the years ended December 31, 2001, 2000 and 1999, respectively. The annual rental commitments, expressed in thousands, are shown as follows: Rent Year Expense - ---- ------- 2002................................................................. $3,788 2003................................................................. $2,537 2004................................................................. $2,312 2005................................................................. $1,572 2006................................................................. $ 727 Thereafter........................................................... $2,322 In addition to the commitments above, the Company will be investing approximately $10 million in 2002 for construction of a 100,000 square foot office building in Rancho Cucamonga, California. Completion of the project is projected for early 2003. The Company and its subsidiaries are defendants in various lawsuits generally incidental to their business. In most of these actions, plaintiffs assert claims for exemplary and punitive damages which are not insurable under judicial decisions. The Company vigorously defends these actions unless a reasonable settlement appears appropriate. Management does not expect the ultimate disposition of these lawsuits to have a material effect on the Company's consolidated operations or financial position. (13) Profit Sharing Plan The Company, at the option of the Board of Directors, may make annual contributions to an employee profit sharing plan. The contributions are not to exceed the greater of the Company's net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed an amount equal to 15% of the compensation paid or accrued during the year to all participants under the plan. The annual contribution was $1,300,000, $1,100,000 and $1,100,000 for plan years ended December 31, 2001, 2000 and 1999, respectively. The Profit Sharing Plan also includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $1,787,000, $1,805,000, and $1,878,000 for the plan years ended December 31, 2001, 2000 and 1999. 60 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (13) Profit Sharing Plan (Continued) Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan ("ESOP") that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends received by the ESOP. Dividends received by the ESOP on unallocated shares are used to pay debt service and the ESOP shares serve as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the debt of the ESOP, which was $2,000,000, $3,000,000, and $4,000,000 at December 31, 2001, 2000 and 1999, respectively, is recorded in the balance sheet as other liabilities. The shares pledged as collateral are reported as unearned ESOP compensation in the shareholders' equity section of the balance sheet. As shares are committed to be released from collateral, the Company reports compensation expense equal to the market price of the shares, and reduces unearned ESOP compensation by the original cost of the shares. The difference between the market price and cost of the shares is charged to common stock. As shares are committed to be released from collateral, the shares become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of accrued interest. ESOP compensation expense was $862,000, $642,000, and $746,000 in 2001, 2000 and 1999, respectively. The ESOP shares as of December 31 were as follows: 2001 2000 ---- ---- Allocated shares 69,000 46,000 Shares committed-to-be released 23,000 23,000 Unreleased shares 23,000 46,000 ---------- ---------- Total ESOP shares 115,000 115,000 ========== ========== Market value of unreleased shares at December 31, $1,004,000 $2,018,000 ========== ========== (14) Common Stock Dividends paid per-share in 2001, 2000 and 1999 were $1.06, $0.96 and $0.84, respectively and dividends paid in total in 2001, 2000 and 1999 were $57,430,000, $51,910,000 and $45,854,000, respectively. The Company adopted a stock option plan in October 1985 (the "1985 Plan") under which 5,400,000 shares were reserved for issuance. Options granted during 1985 were exercisable immediately. Subsequent options granted become exercisable 20% per year beginning one year from the date granted. All options were granted at the market price on the date of the grant and expire in 10 years. 61 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (14) Common Stock (Continued) In May 1995 the Company adopted The 1995 Equity Participation Plan (the "1995 Plan") which succeeds the 1985 Plan. Under the 1995 Plan, 5,400,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. During 1995, the Company granted incentive stock options under both the 1995 Plan and the 1985 Plan. The options granted become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date of the grant. The options expire in 10 years. At December 31, 2001 no awards other than options have been granted. As explained in Note 1, the Company applies APB Opinion No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Consolidated Statements of Income. Had compensation cost for the Company's Plans been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's net income would have been reduced by $459,000, $395,000 and $542,000 in 2001, 2000 and 1999, respectively, and earnings per share (basic and diluted) would have been reduced by $.01 in 2001, 2000 and 1999. Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2001, 2000 and 1999: dividend yield of 2.4 percent for 2001, 2.2 percent for 2000 and 3.8 percent for 1999, expected volatility of 34.2 percent in 2001, 33.4 percent in 2000 and 31.6 percent for 1999 and expected lives of 6 years in 2001 and 7 years in 2000 and 1999. The risk-free interest rates used were 4.9 percent for the options granted during 2001, 6.4 percent for the options granted during 2000 and 5.6 percent for the options granted during 1999. A summary of the status of the Company's plans as of December 31, 2001, 2000 and 1999 and changes during the years ending on those dates is presented below:
2001 2000 1999 ------------------- ------------------ ------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price -------- -------- ------- -------- -------- -------- Outstanding at beginning of year 538,675 $23.104 597,875 $22.370 539,146 $20.575 Granted during the year 125,500 39.912 77,000 26.386 102,100 28.800 Exercised during the year (83,375) 16.118 (83,000) 15.706 (37,371) 15.129 Canceled or expired -- -- (53,200) 31.144 (6,000) 15.625 -------- ------- -------- Outstanding at end of year 580,800 27.739 538,675 23.104 597,875 22.370 ======== ======= ======== Options exercisable at year-end 328,460 346,855 329,575 Weighted-average fair value of options granted during the year $ 12.96 $ 9.95 $ 8.12
62 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2001 and 2000 (14) Common Stock (Continued) The following table summarizes information regarding the stock options outstanding at December 31, 2001:
Number Weighted Avg. Weighted Avg. Number Weighted Avg. Range of Outstanding Remaining Exercise Exercisable Exercise Exercise Prices at 12/31/01 Contractual Life Price at 12/31/01 Price - ---------------- ----------- ---------------- ------------- ----------- -------------- $15.00 to 15.9375 141,500 2.62 $15.347 141,500 $15.347 $21.75 to 29.77 227,800 6.21 24.522 144,260 24.045 $31.22 to 44.8209 211,500 8.58 39,494 42,700 39.638 ------- ------- $15.00 to 44.8209 580,800 6.20 27.739 328,460 22.325 ======= =======
(15) Earnings Per Share A reconciliation of the numerator and denominator used in the basic and diluted earnings per share calculation is presented below:
2001 2000 1999 -------------------------------- -------------------------------- -------------------------------- (000's) (000's) (000's) (000's) (000's) (000's) Weighted Weighted Weighted Income Shares Income Shares Income Shares (Numera- (Denomi- Per-Share (Numera- (Denomi- Per-Share (Numera- (Denomi- Per-Share tor) nator) Amount tor) nator) Amount tor) nator) Amount -------- --------- --------- -------- --------- --------- --------- -------- --------- Basic EPS - --------- Income available to common stockholders $105,339 54,182 $1.94 $109,366 54,100 $2.02 $133,709 54,596 $2.45 Effect of dilutive securities Options -- 200 -- 158 -- 219 Diluted EPS - ----------- Income available to common stockholders after assumed conversions $105,339 54,382 $1.94 $109,366 54,258 $2.02 $133,709 54,815 $2.44 ======== ====== ===== ======== ====== ===== ======== ====== =====
The diluted weighted shares excludes incremental shares of 104,000, 126,000 and 94,000 for 2001, 2000 and 1999, respectively. These shares are excluded due to their antidilutive effect. 63 Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- None. PART III Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- Item 11. Executive Compensation ---------------------- Item 12. Security ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- Item 13. Certain Relationships and Related Transactions ---------------------------------------------- Information regarding executive officers of the Company is included in Part I. For this and other information called for by Items 10, 11, 12 and 13, reference is made to the Company's definitive proxy statement for its Annual Meeting of Shareholders, to be held on May 8, 2002, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2001, and which is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K --------------------------------------------------------------- (a) The following documents are filed as a part of this report: 1. Financial Statements: The Consolidated Financial Statements for the year ended December 31, 2001 are contained herein as listed in the Index to Consolidated Financial Statements on page 35. 2. Financial Statement Schedules: Title ----- Independent Auditors' Report on Financial Statement Schedules Schedule I -- Summary of Investments -- Other than Investments in Related Parties Schedule II -- Condensed Financial Information of Registrant Schedule IV -- Reinsurance All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or Notes thereto. 64 3. Exhibits: 3.1(1) Articles of Incorporation of the Company, as amended to date. 3.2(2) By-laws of the Company, as amended to date. 4.1(3) Shareholders' Agreement dated as of October 7, 1985 among the Company, George Joseph and Gloria Joseph. 4.2(4) Indenture between the Company and Bank One Trust Company, N.A., as Trustee dated as of June 1, 2001. 4.3(5) Officers' Certificate establishing the Company's 7.25% Senior Notes due 2011 as a series of securities under the Indenture dated as of June 1, 2001 between Mercury General Corporation and Bank One Trust Company, N.A. 10.1(1) Form of Agency Contract. 10.2(6) Profit Sharing Plan, as Amended and Restated as of March 11, 1994. 10.3(7) Amendment 1994-I to the Mercury General Corporation Profit Sharing Plan. 10.4(7) Amendment 1994-II to the Mercury General Corporation Profit Sharing Plan. 10.5(8) Amendment 1996-I to the Mercury General Corporation Profit Sharing Plan. 10.6(8) Amendment 1997-I to the Mercury General Corporation Profit Sharing Plan. 10.7(1) Amendment 1998-I to the Mercury General Corporation Profit Sharing Plan. 10.8(9) Amendment 1999-I and Amendment 1999-II to the Mercury General Corporation Profit Sharing Plan. 10.9 Amendment 2001-I to the Mercury General Corporation Profit Sharing Plan. 10.10(10) The 1995 Equity Participation Plan. 10.11(8) Stock Purchase Agreement between Mercury General Corporation as Purchaser and AFC as Seller dated November 15, 1996. 10.12(9) ESOP Master Trust Agreement between the Company and BNY Western Trust Company, as Trustee, effective January 1, 1998. 10.13(9) ESOP Loan Agreement between Union Bank and BNY Western Trust Company, as Trustee, of the Mercury General Corporation ESOP Master Trust dated as of September 29, 1998. 10.14(9) Continuing Guaranty, dated as of August 29, 1998, executed by Mercury General Corporation in favor of Union Bank. 10.15(9) Multiple Line Excess of Loss Reinsurance Agreement between Swiss Reinsurance America Corporation and Mercury Casualty Company, effective January 1, 1999. 10.16(9) Multiple Line Excess of Loss Reinsurance Agreement between Swiss Reinsurance America Corporation and American Mercury Insurance Company, effective January 1, 2000. 10.17(11) Credit agreement dated as of October 27, 2000 between Mercury General Corporation and Bank of America, N.A. 10.18(11) Management agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company and California General Underwriters Insurance Company. 10.19(11) Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and American Mercury Insurance Company. 10.20(11) Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Insurance Company of Georgia. 10.21(11) Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Indemnity Company of Georgia. 10.22(11) Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Insurance Company of Illinois. 65 10.23(11) Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Indemnity Company of Illinois. 10.24 Management Agreement effective January 2, 2002 between Mercury Insurance Services LLC and Mercury Insurance Company of Florida and Mercury Indemnity Company of Florida. 21.1 Subsidiaries of the Company. 23.1 Accountants' Consent. (1) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1997 and is incorporated herein by this reference. (2) This document was filed as an exhibit to Registrant's Form 8-K filed on September 14, 1999 and is incorporated herein by this reference. (3) This document was filed as an exhibit to Registrant's Registration Statement on Form S-1, File No. 33-899, and is incorporated herein by this reference. (4) This document was filed as an exhibit to Registrant's Form S-3 filed on June 4, 2001 and is incorporated herein by this reference. (5) This document was filed as an exhibit to Registrant's Form 8-K filed on August 6, 2001 and is incorporated herein by this reference. (6) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1993, and is incorporated herein by this reference. (7) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1994, and is incorporated herein by this reference. (8) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1996 and is incorporated herein by this reference. (9) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1999 and is incorporated herein by this reference. (10) This document was filed as an exhibit to Registrant's Form S-8 filed on March 8, 1996 and is incorporated herein by this reference. (11) This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 2000 and is incorporated herein by this reference. (b) Reports on Form 8-K: None 66 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MERCURY GENERAL CORPORATION By /s/ GEORGE JOSEPH ------------------------------------- George Joseph Chairman of the Board and Chief Executive Officer March 27, 2002 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- Chairman of the Board and Chief Executive Officer /s/ GEORGE JOSEPH (Principal Executive Officer) March 27, 2002 - --------------------------- George Joseph Vice President and Chief Financial Officer /s/ THEODORE R. STALICK (Principal Financial Officer) March 27, 2002 - --------------------------- Theodore R. Stalick /s/ NATHAN BESSIN Director March 27, 2002 - --------------------------- Nathan Bessin /s/ BRUCE A. BUNNER Director March 27, 2002 - --------------------------- Bruce A. Bunner /s/ MICHAEL D. CURTIUS Director March 27, 2002 - --------------------------- Michael D. Curtius 67 Signature Title Date --------- ----- ---- /s/ RICHARD E. GRAYSON Director March 27, 2002 - --------------------------- Richard E. Grayson /s/ GLORIA JOSEPH Director March 27, 2002 - --------------------------- Gloria Joseph /s/ CHARLES MCCLUNG Director March 27, 2002 - --------------------------- Charles McClung /s/ DONALD P. NEWELL Director March 27, 2002 - --------------------------- Donald P. Newell /s/ DONALD R. SPUEHLER Director March 27, 2002 - --------------------------- Donald R. Spuehler 68 INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors Mercury General Corporation: Under date of February 1, 2002, we reported on the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 2001, as contained in the annual report on Form 10-K for the year 2001. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed under Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG LLP Los Angeles, California February 1, 2002 S-1 SCHEDULE I MERCURY GENERAL CORPORATION SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 2001 Amounts in Thousands
Amount at which shown in the Type of Investment Cost Value balance sheet - ------------------ ---------- ---------- -------------- Fixed maturities available for sale Bonds: U.S. Government .......................... $ 8,043 $ 8,350 $ 8,350 States, municipalities ................... 1,297,320 1,336,000 1,336,000 All other corporate bonds ................ 239,113 226,212 226,212 Redeemable preferred stock ................. 15,704 15,871 15,871 ---------- ---------- ---------- Total fixed maturities available for sale ................................... 1,560,180 1,586,433 1,586,433 ---------- ---------- ---------- Equity securities: Common stocks: Public utilities ......................... 79,267 84,072 84,072 Banks, trust and insurance companies ..... 8,673 10,157 10,157 Industrial, miscellaneous and all other ............................... 31,205 30,880 30,880 Nonredeemable preferred stocks ............. 158,780 152,678 152,678 ---------- ---------- ---------- Total equity securities available for sale ................................... 277,925 277,787 277,787 ---------- ---------- ---------- Short-term investments ......................... 71,951 71,951 ---------- ---------- Total investments ........................ $1,910,056 $1,936,171 ========== ==========
S-2 SCHEDULE I, Continued MERCURY GENERAL CORPORATION SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 2000 Amounts in Thousands
Amount at which shown in the Type of Investment Cost Value balance sheet - ------------------ ---------- ---------- ------------- Fixed maturities available for sale Bonds: U.S. Government....................... $ 7,897 $ 8,068 $ 8,068 States, municipalities................ 1,315,024 1,359,392 1,359,392 All other corporate bonds............. 121,071 121,799 121,799 Redeemable preferred stock.............. 19,905 20,215 20,215 ---------- ---------- ---------- Total fixed maturities available for sale................................ 1,463,897 1,509,474 1,509,474 ---------- ---------- ---------- Equity securities: Common stocks: Public utilities...................... 59,445 69,880 69,880 Banks, trust and insurance companies.. 5,974 8,153 8,153 Industrial, miscellaneous and all other............................ 15,792 16,576 16,576 Nonredeemable preferred stocks.......... 169,382 157,901 157,901 ---------- ---------- ---------- Total equity securities available for sale................................ 250,593 252,510 252,510 ---------- ---------- ---------- Short-term investments...................... 32,977 32,977 ---------- ---------- Total investments..................... $1,747,467 $1,794,961 ========== ==========
S-3 SCHEDULE II MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS December 31, 2001 and 2000 Amounts in thousands ASSETS
2001 2000 ----------- ----------- Investments: Fixed maturities available for sale (amortized cost $8,378 in 2001 and $2,150 in 2000) ...... $ 6,685 $ 2,080 Equity securities, available for sale (cost $27,169 in 2001 and $26,702 in 2000) ......... 26,360 25,566 Short-term cash investments ...................... 9,297 3,486 Investment in subsidiaries ....................... 1,160,708 1,111,382 Total investments ...................... 1,203,050 1,142,514 ----------- ----------- Amounts due from affiliates .......................... (232) 8,806 Income taxes ......................................... 831 8,373 Other assets ......................................... 1,720 2,912 ----------- ----------- $ 1,205,369 $ 1,162,605 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Notes payable ........................................ $ 129,513 $ 107,889 Accounts payable and accrued expenses ................ 3,434 12,695 Other liabilities .................................... 2,711 9,116 ----------- ----------- Total liabilities ..................... 135,658 129,700 ----------- ----------- Shareholders' equity: Common stock ..................................... $ 53,955 52,162 Accumulated other comprehensive income ........... 16,975 30,871 Unearned ESOP compensation ....................... (1,000) (2,000) Retained earnings ................................ 999,781 951,872 ----------- ----------- Total shareholders' equity ............. 1,069,711 1,032,905 ----------- ----------- $ 1,205,369 $ 1,162,605 =========== ===========
See notes to condensed financial information S-4 SCHEDULE II, Continued MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME Three years ended December 31, 2001 Amounts in thousands
2001 2000 1999 --------- --------- --------- Revenues: Net investment income .................... $ 3,133 2,230 $ 1,867 Management fee income from subsidiaries .. -- 216,413 208,245 Other .................................... (273) 12 11 --------- --------- --------- Total revenues ....................... 2,860 218,655 210,123 --------- --------- --------- Expenses: Loss adjustment expenses ................. -- 136,835 128,474 Policy acquisition costs ................. -- 34,567 35,527 Other operating expenses ................. 1,528 46,274 45,302 Interest ................................. 7,727 7,292 4,958 --------- --------- --------- Total expenses ....................... 9,255 224,968 214,261 --------- --------- --------- Loss before income taxes and equity in net income of subsidiaries .................. (6,395) (6,313) (4,138) Income tax benefit ......................... (2,355) (2,446) (1,380) --------- --------- --------- Loss before equity in net income of subsidiaries ......................... (4,040) (3,867) (2,758) Equity in net income of subsidiaries ....... 109,379 113,233 136,467 --------- --------- --------- Net income ........................... $ 105,339 $ 109,366 $ 133,709 ========= ========= =========
See notes to condensed financial information. S-5 SCHEDULE II, Continued MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS Three Years ended December 31, 2001 Amounts in thousands
2001 2000 1999 --------- -------- -------- 0ash flows from operating activities: Net cash privided by (used in) operating activities ................................. $ 5,922 $ (8,570) $(10,553) Cash flows from investing activities: Capital contribution to controlled entity ... (12,000) (3,000) (7,550) Dividends from subsidiaries ................. 60,000 62,500 61,000 Mercury County Mutual Insurance Company (ELM) transaction ................................ -- (7,000) -- Fixed maturities, at market: Purchases ................................. (6,087) (2,042) (2,008) Calls or maturities ....................... 23 2,028 854 Equity securities: Purchases ................................. (3,507) (4,067) (41,004) Sales ..................................... 2,187 3,359 36,759 Calls ..................................... 802 -- 1,119 (Increase) decrease in short term cash investments, net ............................ (5,811) 2,470 3,233 --------- -------- -------- Net cash provided by investing activities ............................. 35,607 54,248 52,403 Cash flows from financing activities: Net proceeds from issuance of senior notes .. 123,309 -- -- Increase in notes payable ................... -- 37,000 17,000 Net payments under credit arrangements ...... (103,039) (27,000) (3,000) Dividends paid to shareholders .............. (57,430) (51,910) (45,854) Purchase and retirement of common stock ..... -- (6,979) (8,435) Stock options exercised ..................... 1,344 1,303 565 Net decrease of ESOP loan ................... (1,000) (1,000) (1,000) --------- -------- -------- Net cash used in financing activities .... (36,816) (48,586) (40,724) Net increase (decrease) in cash ............... 4,713 (2,908) 1,126 Cash: Beginning of the year ....................... (5,392) (2,484) (3,610) --------- -------- -------- End of the year ............................. $ (679) $ (5,392) $ (2,484) ========= ======== ========
See notes to condensed financial information. S-6 SCHEDULE II, Continued MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION December 31, 2001 and 2000 The accompanying condensed financial information should be read in conjunction with the consolidated financial statements and notes included in this statement. Management Fee Income Through December 31, 2000, under a management agreement, the Company performed management services which included all underwriting and claims servicing functions for its subsidiaries. Since January 1, 2001 these management services have been provided by Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company. Dividends Received From Subsidiaries Dividends of $60,000,000, $62,500,000, and $61,000,000 were received by the Company from its wholly-owned subsidiaries in 2001, 2000 and 1999, respectively, and are recorded as a reduction to Investment in Subsidiaries. Cash Overdraft At December 31, 2001 and 2000, the Company had cash overdrafts of $679,000 and $5,392,000 respectively which are classified in "other liabilities" in the accompanying condensed balance sheet. Capitalization of Subsidiaries In 2001, the Company contributed $7 million and $5 million, respectively, for the formation and initial capitalization of Mercury Insurance Company of Florida and Mercury Indemnity Company of Florida. S-7 SCHEDULE IV MERCURY GENERAL CORPORATION REINSURANCE Three years ended December 31, 2001 Amounts in thousands Ceded to Direct other Net amount companies Assumed amount ---------- --------- ------- ---------- Property and Liability insurance earned premiums 2001......................... $1,374,988 $ 7,233 $12,806 $1,380,561 2000......................... $1,233,263 $ 8,659 $24,655 $1,249,259 1999......................... $1,186,385 $ 8,844 $10,766 $1,188,307 S-8 EX-10.9 3 dex109.txt AMENDMENT 2001-I TO PROFIT SHARING PLAN EXHIBIT 10.9 AMENDMENT 2001-1 MERCURY GENERAL CORPORATION PROFIT SHARING PLAN WHEREAS, Mercury General Corporation (the "Company") maintains the Mercury General Corporation Profit Sharing Plan (the "Plan"); and WHEREAS, pursuant to Section 9.1 of the Plan, the Company is authorized to amend the Plan; and WHEREAS, the Company has previously determined that it is in the best interests of the Company to merge the Plan with the Concord Insurance Services, Inc. 401(k) Plan (the "Concord Plan") (the "Merger"), with the Plan to be the survivor of the Merger; and WHEREAS, the Company desires to amend the Plan to effectuate the Merger. NOW, THEREFORE, this Amendment 2001-1 is hereby adopted effective October 1, 2001: 1. The following Appendix is added to the Plan: "APPENDIX D: SPECIAL PROVISIONS FOR FORMER PARTICIPANTS IN THE CONCORD PLAN D.1 Participants Subject to this Appendix. ------------------------------------- Effective October 1, 2001 (the "Concord Merger Date"), the Concord Insurance Services, Inc. 401(k) Plan (the "Concord Plan") merged with the Plan. The Plan is the survivor of the merger. Each Eligible Employee who, prior to the Concord Merger Date, was a participant in the Concord Plan is subject to the provisions of this Appendix D (a "Concord Participant"). D.2 Service. ------- With respect to a Concord Participant, service under the Plan shall include such employee's period of service taken into consideration under the Concord Plan as of the Concord Merger Date. 1 D.3 Investments. ----------- The Committee shall adopt such rules as it deems appropriate for the transfer of investments under the Concord Plan to the Plan's investments. D.4 Vesting. ------- (a) Each Concord Participant who has not previously forfeited the unvested portion of his accounts under the Concord Plan (his "Concord Account") shall continue to vest in such Concord Account according to the following schedule: Nonforfeitable Years of Service Percentage --------------------------- -------------- Less than 2 0% At least 2, but less than 3 20% At least 3, but less than 4 40% At least 4, but less than 5 60% At least 5, but less than 6 80% 6 or more 100% (b) A Concord Participant's interest in the balance of his or her accounts accrued under the Plan will vest in accordance with Article VI of the Plan. D.5 Distributions. ------------- (a) Concord Transition Period. The Concord Transition Period is the ------------------------- period between the adoption of Amendment 2001-1 to the Plan and April 1, 2002. (b) Distributions. Distributions of a Concord Participant's entire ------------- account during the Concord Transition Period shall be paid in accordance with payment provisions of the Concord Plan as in effect prior to the Concord Merger Date (notwithstanding the lump sum payment provisions of Article VII of the Plan). Distributions of a Concord Participant's entire account made after the Concord Transition Period shall be paid in accordance with Article VII of the Plan, notwithstanding any former provision of the Concord Plan. (c) Early Withdrawals. Upon written request to the Committee, and in ----------------- accordance with rules established by the Committee, a Concord Participant may withdraw all or any portion of his Concord Account at any time after the Concord Participant has reached the age of 59 1/2. Notwithstanding the foregoing, a Concord Participant may not cumulatively withdraw any amount greater than such Concord Participant's balance in his Concord Account at the Concord Merger Date. 2 (d) Loans. Loans to a Concord Participant made under the Concord Plan ----- before the Concord Merger Date shall be governed by the loan provisions of the Concord Plan as in effect immediately before the Concord Merger Date, notwithstanding any contrary provision in the Plan. No new loans shall be made to any Concord Participant under the provisions of the Concord Plan after the Concord Merger Date." IN WITNESS WHEREOF, this Amendment 2001-1 is hereby adopted this 30th day of October, 2001. MERCURY GENERAL CORPORATION By: /s/ George Joseph ------------------------ 3 EX-10.24 4 dex1024.txt MANAGEMENT AGREEMENT EXHIBIT 10.24 MANAGEMENT AGREEMENT This Agreement is entered into on January 2, 2002 effective as of the 2nd day of January 2002, by and among Mercury Insurance Company of Florida and Mercury Indemnity Company of Florida (hereinafter collectively referred to as "Insurers") and Mercury Insurance Services, LLC (hereinafter referred to as "Manager"). In consideration of the promises, conditions, and covenants herein contained, the parties agree as follows: 1. The Manager promises to manage the Insurers, and to conduct on their behalf any and all duties of management as shall be necessary for the complete operation of the Insurers. 2. The Insurers promise and hereby delegate to the Manager all of the duties of management which they are allowed to so delegate by the laws of the State of Florida, including, but not limited to, the following duties: to issue and underwrite insurance policies, which the Insurers may be so authorized to do by law, in accordance with the rules and regulations as delineated in the underwriting manuals of the Insurers, settle and adjust any and all losses and claims, defend lawsuits, establish premium rates, establish and choose sales agents and brokers, determine agents' and brokers' commissions, prepare the records necessary for the conduct of the insurance business, furnish all forms, supplies and agents' manuals necessary for the conduct of the insurance business. 3. The Manager promises to perform all of the operating functions on behalf of the Insurers including, but not limited to, the following: A. To acquire, license and appoint sales agents and brokers for the production of the insurance business of and for the Insurers, provided that the Insurers shall retain the right to refuse the appointment of any agent or broker and the right to terminate any agent or broker. B. To issue and underwrite policies on behalf of the Insurers and to choose and obtain the necessary application and policy forms. C. To furnish for the Insurers all of the operating forms, printing supplies, agents' manuals and any other related items which may become necessary for the operation of the insurance business. D. To pay on behalf of the Insurers all of their operating expenses, including but not limited to rent, supplies, salaries of all personnel, telephone, advertising costs, costs of settling and adjusting all insurance claims, legal defense costs, court costs, costs of loss analysis, accounting costs (other than auditing), premium collection costs; provided, however, the Insurer shall pay, and be responsible for, the costs of management fees, premium taxes, losses, reserves for unpaid losses, reserves for unpaid loss adjustment expense, audit fees, assigned risk or similar 1 assessments, bureau fees, Fair Plan or similar assessments, directors' fees, agents' commissions, reinsurance premiums, investment counsel fees, assessments by any Florida guarantee association, political contributions, premiums paid for insurance policies in which the Insurer is the beneficiary and the owner, such as fidelity bonds, taxes of all types and costs which may be levied on insurance companies by the governmental authorities having jurisdiction over the same and agents' bonuses (contingency commissions). 4. The Manager shall be reimbursed monthly, on a cost basis, for all expenses incurred on behalf of the Insurers. 5. The ownership and legal title to the insurance policies, insurance policy records, data processing tapes, disks, programs and documentation, and account records of the Insurers, compiled on behalf of the Insurers by the Manager, shall remain in and with the Insurers, however, the Manager shall have joint custody with the Insurers of said records. 6. This Agreement shall be in effect until terminated by either party upon ninety (90) days prior written notice to the nonterminating party. 7. Allocation method for shared expenses (facilities, equipment, personnel, computers, etc.) are to be consistent with statutory accounting principles. 8. All underwriting, claims and investment services provided the Insurers are to be based upon the written criteria, standards and guidelines of the Insurers. However, the Insurers shall have the ultimate and final authority over decisions and policies; to include, but not be limited to, the acceptance, rejection or canceling of risks, the payment or non-payment of claims and the purchase and sale of securities. 9. Notwithstanding any other provision of this Agreement, it is understood that the business and affairs of the Insurers shall be managed by its Board of Directors, and to the extent delegated by such Board, by its appropriately designated officers. The Board of Directors and officers of the Manager shall not have any management prerogatives with respect to the business affairs and operations of the Insurers. [Signature Page Follows] 2 IN WITNESS WHEREOF, we have set our hands this 2nd day of January, 2002. MERCURY INSURANCE COMPANY MERCURY INDEMNITY COMPANY OF FLORIDA OF FLORIDA By: /s/ George Joseph By: /s/ George Joseph ------------------------ ------------------------ George Joseph, President George Joseph, President MERCURY INSURANCE SERVICES, LLC By: /s/ George Joseph ------------------------ George Joseph, President 3 EX-21.1 5 dex211.txt SUBSIDIARIES OF THE COMPANY Exhibit 21.1 Subsidiaries Mercury Casualty Company Mercury Insurance Company Mercury Insurance Company of Illinois Mercury Indemnity Company of Illinois Mercury Insurance Company of Georgia Mercury Indemnity Company of Georgia Mercury Insurance Company of Florida Mercury Indemnity Company of Florida California Automobile Insurance Company California General Underwriters Insurance Company, Inc. Concord Insurance Services, Inc. Mercury Insurance Services, LLC Mercury County Mutual Insurance Company * American Mercury Insurance Company American Mercury Lloyds Insurance Company * AFI Management Company, Inc. American Mercury MGA, Inc. * Controlled by Mercury General Corporation EX-23.1 6 dex231.txt ACCOUNTANTS' CONSENT EXHIBIT 23.1 The Board of Directors Mercury General Corporation We consent to incorporation by reference in the registration statement (No. 333- 62228) on Form S-3 of Mercury General Corporation and the registration statement (No. 333-01583) on Form S-8 of Mercury General Corporation of our reports dated February 1, 2002, relating to the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the years in the three year period ended December 31, 2001, and all related schedules, which report appears in the December 31, 2001, annual report on Form 10-K of Mercury General Corporation. /s/ KPMG LLP Los Angeles, California March 25, 2002 -----END PRIVACY-ENHANCED MESSAGE-----