10-Q 1 d10q.htm FORM 10-Q Form 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarter Ended March 31, 2004

 

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 of

incorporation or organization)

 

(I.R.S. Employer

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

 


 

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

 

At April 23, 2004, the Registrant had issued and outstanding an aggregate of 54,447,108 shares of its Common Stock.

 



PART 1 - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

Amounts expressed in thousands, except share amounts

 

 

    

March 31,

2004


  

December 31,

2003


     
     (unaudited)     
ASSETS              

Investments:

             

Fixed maturities available for sale (amortized cost $1,978,494 in 2004 and $1,856,083 in 2003)

   $ 2,077,509    $ 1,945,309

Equity securities available for sale (cost $224,058 in 2004 and $223,113 in 2003)

     266,742      264,393

Short-term cash investments, at cost, which approximates market

     287,549      329,812
    

  

Total investments

     2,631,800      2,539,514

Cash

     51,220      36,964

Receivables:

             

Premiums receivable

     246,452      231,277

Premium notes

     23,096      22,620

Accrued investment income

     26,840      26,585

Other

     21,231      18,612
    

  

Total receivables

     317,619      299,094

Deferred policy acquisition costs

     142,126      132,059

Fixed assets, net

     81,274      79,286

Other assets

     34,600      32,849
    

  

Total assets

   $ 3,258,639    $ 3,119,766
    

  

LIABILITIES AND SHAREHOLDERS’ EQUITY              

Losses and loss adjustment expenses

   $ 805,651    $ 797,927

Unearned premiums

     700,708      663,004

Notes payable

     124,721      124,714

Loss drafts payable

     79,204      79,960

Accounts payable and accrued expenses

     100,994      99,389

Current income taxes

     24,249      11,441

Deferred income taxes

     24,354      17,808

Other liabilities

     86,660      70,020
    

  

Total liabilities

     1,946,541      1,864,263
    

  

Commitments and contingencies

             

Shareholders’ equity:

             

Common stock without par value or stated value.

             

Authorized 70,000,000 shares; issued and outstanding 54,447,108 shares in 2004 and 54,424,128 shares in 2003

     58,091      57,453

Accumulated other comprehensive income

     92,117      84,833

Retained earnings

     1,161,890      1,113,217
    

  

Total shareholders’ equity

     1,312,098      1,255,503
    

  

Total liabilities and shareholders’ equity

   $ 3,258,639    $ 3,119,766
    

  

 

2


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

(Unaudited)

 

Three Months Ended March 31,

 

Amounts expressed in thousands, except share and per share data

 

     2004

   2003

 

Revenues:

               

Earned premiums

   $ 591,937    $ 500,666  

Net investment income

     25,728      26,926  

Net realized investment gains (losses)

     5,674      (759 )

Other

     1,117      1,241  
    

  


Total revenues

     624,456      528,074  
    

  


Expenses:

               

Incurred losses and loss adjustment expenses

     371,996      341,546  

Policy acquisition costs

     132,162      110,289  

Other operating expenses

     23,300      20,751  

Interest

     713      717  
    

  


Total expenses

     528,171      473,303  
    

  


Income before income taxes

     96,285      54,771  

Income taxes

     27,469      12,663  
    

  


Net income

   $ 68,816    $ 42,108  
    

  


BASIC EARNINGS PER SHARE (weighted average shares outstanding 54,430,277 in 2004 and 54,378,897 in 2003)

   $ 1.26    $ 0.77  
    

  


DILUTED EARNINGS PER SHARE (weighted average shares 54,606,916 as adjusted by 176,639 for the dilutive effect of options in 2004 and 54,489,585 as adjusted by 110,688 for the dilutive effect of options in 2003)

   $ 1.26    $ 0.77  
    

  


Dividends declared per share

   $ 0.37    $ 0.33  
    

  


 

3


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

(Unaudited)

 

Three Months Ended March 31,

 

Amounts expressed in thousands

 

     2004

    2003

Net income

   $ 68,816     $ 42,108

Other comprehensive income, before tax:

              

Unrealized gains on securities:

              

Unrealized holding gains arising during period

     15,352       13,712

Reclassification adjustment for net (gains) losses included in net income

     (4,130 )     1,100
    


 

Other comprehensive income before tax

     11,222       14,812

Income tax expense related to unrealized holding gains arising during period

     5,383       4,803

Income tax (benefit) expense related to reclassification adjustment for (gains) losses included in net income

     (1,445 )     385
    


 

Comprehensive income, net of tax

   $ 76,100     $ 51,732
    


 

 

4


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(Unaudited)

 

Three Months Ended March 31,

 

Amounts expressed in thousands

 

     2004

    2003

 

Cash flows from operating activities:

                

Net income

   $ 68,816     $ 42,108  

Adjustments to reconcile net income to net cash provided from operating activities:

                

Depreciation

     3,910       3,520  

Net realized investment (gains) losses

     (5,674 )     759  

Bond amortization (accretion), net

     2,212       (779 )

Increase in premiums receivable

     (15,175 )     (14,942 )

Increase in premium notes receivable

     (476 )     (616 )

Increase in deferred policy acquisition costs

     (10,067 )     (7,688 )

Increase in unpaid losses and loss adjustment expenses

     7,724       18,320  

Increase in unearned premiums

     37,704       34,277  

(Decrease) increase in loss drafts payable

     (756 )     4,070  

Increase in accounts payable and accrued expenses

     1,606       939  

Increase in accrued income taxes, excluding deferred tax on change in unrealized gain

     15,436       5,512  

Other, net

     9,773       15,797  
    


 


Net cash provided from operating activities

     115,033       101,277  

Cash flows from investing activities:

                

Fixed maturities available for sale:

                

Purchases

     (285,516 )     (123,715 )

Sales

     91,118       2,440  

Calls or maturities

     75,363       64,248  

Equity securities available for sale:

                

Purchases

     (80,399 )     (24,620 )

Sales

     77,393       30,979  

Increase in payable for securities

     4,439       7,289  

Decrease (increase) in short-term cash investments, net

     42,263       (29,651 )

Purchase of fixed assets

     (5,921 )     (9,272 )

Sale of fixed assets

     146       182  
    


 


Net cash used in investing activities

   $ (81,114 )   $ (82,120 )

 

(Continued)

 

5


MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(Continued)

 

     2004

    2003

 

Cash flows from financing activities:

                

Increase in notes payable

   $ —       $ 79  

Dividends paid to shareholders

     (20,143 )     (17,948 )

Proceeds from stock options exercised

     480       712  

Net decrease in ESOP loan

     —         (1,000 )
    


 


Net cash used in financing activities

     (19,663 )     (18,157 )
    


 


Net increase in cash

     14,256       1,000  

Cash:

                

Beginning of the period

     36,964       13,191  
    


 


End of the period

   $ 51,220     $ 14,191  
    


 


Supplemental disclosures of cash flow information and non-cash financing activities:

                

Interest paid during the period

   $ 1,450     $ 1,598  

Income taxes paid during the period

   $ 11,876     $ 7,054  

Tax benefit realized on stock options exercised included in cash provided from operations

   $ 157     $ 87  

 

6


MERCURY GENERAL CORPORATION & SUBSIDIARIES

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues 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 materially from those estimates (See Note 1 “Significant Accounting Policies” of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).

 

The financial data of Mercury General Corporation (“Mercury General”) and its subsidiaries (collectively, the “Company”), included herein have been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature necessary to present fairly the Company’s financial position at March 31, 2004 and the results of operations, comprehensive income and cash flows for the periods presented have been made. Operating results and cash flows for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

 

Certain reclassifications have been made to the prior year balances to conform to the current year presentation.

 

2. Investments

 

The Company monitors investments that have declined in fair value below net book value and if the decline is judged to be other-than-temporary, the asset is written down to fair value in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. During the first quarter of 2004, the Company did not recognize any write downs of its investments as other than temporary declines. The Company wrote down $1.7 million ($1.1 million after tax) of its investments as other than temporary declines during the first quarter of 2003.

 

7


MERCURY GENERAL CORPORATION & SUBSIDIARIES

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

3. Stock Option Plan Accounting

 

The Company applies APB No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Consolidated Statements of Income. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition of SFAS No. 123:

 

    

Quarter Ended

March 31,


 
     2004

    2003

 
    

(Amounts in thousands,

except per share)

 

Net income, as reported

   $ 68,816     $ 42,108  

Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effect

     (127 )     (140 )
    


 


Proforma net income

   $ 68,689     $ 41,968  
    


 


Earnings per share:

                

Basic – as reported

   $ 1.26     $ .77  
    


 


Basic – pro forma

   $ 1.26     $ .77  
    


 


Diluted – as reported

   $ 1.26     $ .77  
    


 


Diluted – pro forma

   $ 1.26     $ .77  
    


 


 

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 2003: dividend yield of 3.2 percent in 2003, expected volatility of 33.6 percent in 2003, and expected lives of 6 years in 2003. The risk-free interest rates used was 4.4 percent for options granted during 2003. No options have been granted in 2004.

 

8


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

General

 

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, as do most property and casualty insurance companies, utilizes measurements which are standard industry-required measures to report operating results that may not be presented in accordance with GAAP. Included within Management’s Discussion and Analysis of Financial Condition and Results of Operations is net premiums written, a non-GAAP financial measure, which represents the premiums charged on policies issued during a fiscal period less any reinsurance. This measure is not intended to replace, and should be read in conjunction with, the GAAP financial results and is reconciled to the most directly comparable GAAP measure below in Results of Operations.

 

Mercury General Corporation and its subsidiaries (collectively, the “Company”) is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents and brokers. The Company also offers homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. Private passenger automobile lines of insurance accounted for approximately 88% of the Company’s $630.3 million of net written premiums in 2004.

 

The Company operates primarily in the state of California, which was the only state it produced business in prior to 1990. The Company has since expanded its operations into the following states: Georgia (1990), Illinois (1990), Oklahoma (1996), Texas (1996), Florida (1998), Virginia (2001), New York (2001) and New Jersey (2003). During 2004, California accounted for approximately 79% of the Company’s net premiums written compared to approximately 85% for the first quarter of 2003.

 

In April 2004, the Company commenced writing private passenger automobile insurance in the state of Arizona marking the 10th state where the Company sells automobile insurance.

 

The Department of Insurance (“DOI”), in each state for which the Company operates, conducts periodic financial examinations of the Company’s insurance subsidiaries domiciled within the respective state. In 2004, the Illinois DOI and the Florida DOI issued reports on their examinations for the periods ended December 31, 2000 and December 31, 2002, respectively. These examinations resulted in no adjustments or material findings. The California DOI, the Georgia DOI and the Florida DOI have commenced financial examinations for the periods ended December 31, 2003.

 

On June 25, 2003, the California State Board of Equalization (“SBE”) upheld Notices of Proposed Assessment (“NPAs”) issued against the Company for tax years 1993 through 1996. In the NPAs, the California Franchise Tax Board (“FTB”) disallowed a portion of the Company’s expenses related to management services provided to its insurance company subsidiaries on grounds that such expenses were allocable to the Company’s tax-deductible dividends from such subsidiaries. The total tax liability and interest on the expenses amount to approximately $14 million (approximately $7 million tax liability plus $7 million of interest through March 31, 2004). The potential net liability, after federal tax benefit, amounts to approximately $9 million.

 

9


The Company continues to believe that its deduction of the expenses related to management services provided to its insurance company subsidiaries is meritorious and will continue to defend its position vigorously before the SBE and, if necessary, in the courts. The Company has filed a Petition for Rehearing with the SBE based both on procedural and substantive grounds, and both the Company and the FTB have filed briefs relating to the Petition. The SBE is expected to consider the matter sometime after the second quarter of 2004.

 

The SBE decision on the NPAs for tax years 1993 through 1996 also resulted in a smaller disallowance of the Company’s interest expense deductions than was proposed by the FTB in those years. The Company has decided not to continue to challenge this issue and has established a small accrual for the tax liability and related interest.

 

As a result of the court ruling in Ceridian vs. Franchise Tax Board, the FTB has issued NPAs for tax years 1997 through 2000 disallowing all Dividend Received Deductions (DRD) taken by the Company for those tax years. The ruling in Ceridian vs. Franchise Tax Board held a statute permitting the tax deductibility of dividends received from wholly-owned insurance subsidiaries unconstitutional because it discriminated against out-of-state holding companies. The FTB interpretation of the ruling concludes that the discriminatory sections of the statute are not severable and the entire statute is invalid. As a result, the FTB’s position in the NPAs is that all dividends received by the Company from its insurance company subsidiaries are subject to California franchise taxes. The DRD disallowance could result in approximately $17 million of additional California state franchise taxes plus $8 million of related interest through March 31, 2004. The potential net liability, after federal tax benefit, amounts to approximately $16 million.

 

The Company intends to vigorously challenge these potential tax liabilities on 2001 and future inter-company dividends. However, if the Company’s challenges are ineffective or the issue is not resolved favorably with the State of California, additional state taxes of approximately 9% (6% after the federal tax benefit of deducting state taxes) could be owed on dividends Mercury General receives from its insurance subsidiaries. While the Company intends to continue paying dividends to its shareholders, an unsatisfactory conclusion to the inter-company dividend issue could affect future dividend policy.

 

The Company is closely following the progress of legislation that if enacted would resolve the issues on expense disallowance and eliminate the uncertainty created by the court ruling in Ceridian vs. Franchise Tax Board for all tax years through December 31, 2003. Without a legislative solution, years of future litigation may be required to determine the ultimate outcome of the expense disallowance and DRD issues. Because of the uncertainty surrounding these issues, it is difficult to predict the ultimate amount the Company may be required to pay, if any. Consistent with the proposed legislation and the Company’s expectations of a legislative solution, the Company has established a tax contingency reserve of approximately $3 million, net of federal tax benefits, for all California franchise tax issues including the disallowance of expenses and DRD issues.

 

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 has established reserves for lawsuits which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. 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. Also, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

10


In Robert Krumme, On Behalf Of The General Public vs. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company (Superior Court for the City and County of San Francisco), initially filed June 30, 2000, the plaintiff has asserted an unfair trade practices claim under Section 17200 of the California Business and Professions Code. Specifically, the case involves a dispute over the legality of broker fees (generally less than $100 per policy) charged by independent brokers who sell the Company’s products to consumers that purchase insurance policies written by the Mercury Insurance Company, Mercury Casualty Company and California Automobile Insurance Company (collectively, the “California Companies”). The plaintiff asserts that the brokers who sell the Company’s products should not charge broker fees and that the Company benefits from these fees and should be liable for them. The plaintiff sought an elimination of the broker fees and restitution of previously paid broker fees. In April 2003, the court ruled that the brokers involved in the suit were in fact agents of the Company; however, the court also held that the Company was not responsible for retroactive restitution. The court issued an injunction on May 16, 2003 that prevents Mercury from either (a) selling auto or homeowners insurance through any producer that is not appointed as an agent under Insurance Code, Section 1704, (b) selling auto or homeowners insurance through any producer that charges broker fees and (c) engaging in comparative rate advertising and failing to disclose the possibility that a broker fee may be charged. Mercury has appealed, which has the effect of staying all but the advertising aspects of the court’s injunction. The Company’s appeal is based on the fact that the broker fees are subject to direct – and, if they could be attributed to Mercury, exclusive – regulation by the Insurance Commissioner. The law allows a broker to perform agent functions without giving up broker status. In the past, the California Insurance Commissioner never found broker fees were either being improperly charged or attributable to Mercury. The appeal has been fully briefed and the Company is awaiting a court date for oral arguments which is expected no sooner than June 2004.

 

In February 2004, the California DOI issued a Notice of Non-Compliance (“NNC”) to the California Companies based on the outcome of the Robert Krumme litigation. The NNC alleges that the California Companies willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumer’s insurance broker. The California Companies filed a Notice of Defense which is based on the same grounds forming the Company’s defense in the Robert Krumme case. The administrative proceeding has been stayed at the California DOI’s request until a decision is reached in the Robert Krumme case. The impact of this NNC can not be determined at the present time. However, the Company intends to continue to vigorously defend this case.

 

Sam Donabedian, individually, and on behalf of those similarly situated vs. Mercury Insurance Company (Los Angeles Superior Court), initially filed April 20, 2001, involves a dispute over insurance rates/premiums charged to the plaintiff and the legality of persistency discounts. The action was dismissed when Mercury’s Demurrer to the plaintiff’s First Amended Complaint was sustained without leave to amend. The dismissal of this case was appealed and then overruled by an Appellate Court on the basis that there is a factual issue as to whether the persistency discounts as applied comply with the Company’s class plan and the California Insurance Code. The Company believes that the conclusion reached by the Appellate Court lacks merit, that the case was properly decided as an issue of law by the Superior Court, and has requested the California Supreme Court to hear this case rather than return it to the Superior Court for trial. The Company intends to vigorously defend this case.

 

Critical Accounting Policies

 

The preparation of the Company’s financial statements requires judgment and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting

 

11


and Reporting by Insurance Enterprises” (“SFAS No. 60”) and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). 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 period 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. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

 

The Company performs its own loss reserve analysis and also engages the services of an independent actuary to assist in the estimation of loss reserves. The Company and the actuary do not calculate a range of loss reserve estimates but rather calculate a point estimate. Management reviews the underlying factors and assumptions that serve as the basis for preparing the reserve estimate. These include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information. At March 31, 2004, the Company recorded $805.7 million in loss and loss adjustment expense reserves. 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, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). 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 when recovery of the net book value appears doubtful. 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 Statement of Income.

 

The Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These

 

12


include claims, assessments or lawsuits incidental to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them or discloses them 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.

 

Certain statements in this report on Form 10-Q that are not historical fact 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-Q 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 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, the outcome of tax position challenges by the California FTB, decisions of courts, regulators and governmental bodies, particularly in California, our ability to obtain and the timing of 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, the level of investment yields we are able to obtain with our investments in comparison to recent yields and the market risk associated with our investment portfolio, the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies, uncertainties related to assumptions and projections generally, inflation and changes in economic conditions, changes in driving patterns and loss trends, acts of war and terrorist activities, court decisions and trends in litigation and health care and auto repair costs, and other uncertainties, all of which are difficult to predict and many of which are beyond our control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when an accrual is established for a major contingency. Reported results may therefore appear to be volatile in certain periods. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Form 10-Q 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.

 

Results of Operations

 

Three Months Ended March 31, 2004 compared to Three Months Ended March 31, 2003

 

Premiums earned in the first quarter of 2004 increased approximately 18% from the corresponding period in 2003. Net premiums written in the first quarter of 2004 increased 17% from the corresponding period in 2003. Net premiums written on the California automobile lines of business were $462.0 million in the first quarter of 2004, an increase of approximately 10% over the same period in 2003. Net premiums written by the non-California

 

13


operations were $130.2 million in the first quarter, an increase of 52% over the same period in 2003. The growth in net premiums written is primarily due to an increase in unit sales and rate increases taken during 2003.

 

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned (000s) for the quarters ended March 31, 2004 and 2003, respectively:

 

    

Quarter Ended

March 31,


     2004

   2003

Net premiums written

   $ 630,283    $ 538,750

Increase in unearned premiums

     38,346      38,084
    

  

Earned premiums

   $ 591,937    $ 500,666
    

  

 

The loss ratio (GAAP basis) in the first quarter (loss and loss adjustment expenses related to premiums earned) was 62.8% in 2004 and 68.2% in 2003. The lower loss ratio in the quarter, as compared to the first quarter of 2003, is largely attributable to rate increases taken during 2003 and positive development of approximately $15 million on the 2003 and prior period accident year loss reserves.

 

The expense ratio (GAAP basis) (policy acquisition costs and other expenses related to premiums earned) in the first quarter of 2004 was 26.3% compared to 26.2% in the corresponding period of 2003. Total expenses increased at essentially the same rate as premium volume.

 

The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 89.1% in the first quarter of 2004 compared with 94.4% in 2003, which indicates that the Company’s underwriting performance contributed $64.5 million to the Company’s income before income taxes of $96.3 million during 2004 versus contributing $28.1 million to the Company’s income before income tax of $54.8 million in 2003.

 

Investment income for the first quarter 2004 was $25.7 million, compared with $26.9 million in the first quarter of 2003. The after-tax yield on average investments (fixed maturities and equities valued at cost) was 3.66% in the first quarter of 2004 compared to 4.33% in the corresponding period of 2003 on average invested assets of $2,507.4 million and $2,208.2 million, respectively. The decrease in after-tax yield is largely due to overall lower yields earned on the portfolio which is reflective of current market conditions.

 

Interest expense was $0.7 million for the first quarter of 2004 compared to $0.7 million for the first quarter of 2003.

 

The income tax provision in the first quarter of 2004 of $27.5 million represented an effective tax rate of 29%, compared with an effective rate of 23% in the corresponding period of 2003. The higher rate in 2004 is primarily attributable to the increased proportion of underwriting income which is taxed at the full corporate rate of 35%, in contrast with investment income which includes tax exempt interest and tax sheltered dividend income.

 

Net income for the first quarter 2004 of $68.8 million, or $1.26 per share (diluted), compares with $42.1 million, or $0.77 per share (diluted), in the corresponding period of 2003. Basic net income per share was $1.26 in 2004 and $0.77 in 2003.

 

14


Liquidity and Capital Resources

 

Net cash provided from operating activities in 2004 was $115.0 million, an increase of $13.8 million over the same period in 2003. This increase was primarily due to the growth in premiums reflecting increases in both policy sales and rates partially offset by an increase in losses and loss adjustment expense paid in 2004. The Company has utilized the cash provided from operating activities primarily to increase its investment in fixed maturity securities, the purchase and development of information technology and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $166.5 million, was reinvested by the Company generally in higher-rated fixed maturity securities.

 

The Company’s cash and short-term cash investment portfolio totaled $338.8 million at March 31, 2004. Together with cash flows from operations, the Company believes that such liquid assets are adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

 

The market value of all investments (fixed-maturities and equities) held at market as “Available for Sale” exceeded amortized cost of $2,490.1 million at March 31, 2004 by $141.7 million. That net unrealized gain of $141.7 million, reflected in shareholders’ equity, net of applicable tax effects, was $92.1 million at March 31, 2004, compared with a net unrealized gain of $130.5 million or $84.8 million, net of applicable tax effects, at December 31, 2003. The increase in unrealized gains is largely due to an increase in the market value of bond holdings resulting from the current interest rate environment and the partial recovery in value of previously written down equity securities.

 

At March 31, 2004, the average rating of the $2,066.3 million bond portfolio at market (amortized cost $1,967.4 million) was AA, the same average rating at December 31, 2003. Bond holdings are broadly diversified geographically, within the tax-exempt sector. California state bonds represent 4.4% of the total bond portfolio and carry a net unrealized gain of $2.8 million at March 31, 2004. Holdings in the taxable sector consist principally of investment grade issues. At March 31, 2004, bond holdings rated below investment grade totaled $51.6 million at market (cost $52.0 million) representing approximately 2% of total investments. This compares to approximately $52.8 million at market (cost $53.3 million) representing 2% of total investments at December 31, 2003.

 

The following table sets forth the composition of the investment portfolio of the Company as of March 31, 2004:

 

    

Amortized

cost


  

Market

value


     (Amounts in thousands)

Fixed maturity securities:

             

U.S. government bonds and agencies

   $ 317,525    $ 319,807

Municipal bonds

     1,540,119      1,630,133

Corporate bonds

     109,779      116,342

Redeemable preferred stock

     11,071      11,227
    

  

     $ 1,978,494    $ 2,077,509
    

  

Equity securities:

             

Common Stock:

             

Public utilities

   $ 77,324    $ 94,422

Banks, trusts and insurance companies

     12,853      17,219

Industrial and other

     67,500      81,670

Non-redeemable preferred stock

     66,381      73,431
    

  

     $ 224,058    $ 266,742
    

  

 

15


The Company writes covered call options through listed exchanges and over the counter with the intent of generating additional income or return on capital. The total underlying investment under the covered call program in the first quarter of 2004 was approximately $35 million. The Company as a writer of an option bears the market risk of an unfavorable change in the price of the security underlying the written option. The Board of Directors has authorized the Company’s management to commence selling put options in 2004 and to increase its option writing program up to $40 million.

 

The Company monitors its investments closely. If an unrealized loss is determined to be other than temporary it is written off as a realized loss through the Consolidated Statement of Income. The Company’s methodology of assessing other than temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s intent to hold the investment for a period of time sufficient to allow the Company to recover its costs. The Company did not recognize any write-down of its investments as other than temporary declines during the first quarter of 2004.

 

During the first quarter of 2004, the Company recognized approximately $5.7 million in net realized gains from the disposal (sale, call or maturity) of securities which is comprised of realized gains of $6.9 million offset by realized losses of $1.2 million. These realized losses were derived from the disposal of securities with a total amortized cost of approximately $47.0 million. Approximately $0.8 million of the $1.2 million total realized loss relates to securities held as of December 2003 with no loss on any one individual security exceeding $0.1 million.

 

At March 31, 2004, the Company had a net unrealized gain on all investments of $141.7 million before income taxes which is comprised of gross unrealized gains of $152.0 million offset by unrealized losses of $10.3 million. Unrealized losses represent 0.5% of total investments at amortized cost. Of these unrealized losses, approximately $6.4 million relate to fixed maturity investments and the remaining $3.9 million relate to equity securities.

 

The following table illustrates the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of March 31, 2004.

 

     Less than 12 months

   12 months or more

   Total

    

Unrealized

Losses


  

Fair

Value


  

Unrealized

Losses


  

Fair

Value


  

Unrealized

Losses


  

Fair

Value


     (Amounts in thousands)

U.S. Treasury Securities and obligations of U.S. government corporations and agencies

   $ 980    $ 97,565    $ 139    $ 3,146    $ 1,119    $ 100,711

Obligations of states and political subdivisions

     1,822      180,872      2,151      22,259      3,973      203,131

Corporate securities

     195      30,658      855      4,338      1,050      34,996

Redeemable Preferred Stock

     9      1,262      220      4,935      229      6,197
    

  

  

  

  

  

Subtotal, debt securities

   $ 3,006    $ 310,357    $ 3,365    $ 34,678    $ 6,371    $ 345,035

Equity Securities

     2,577      89,830      1,315      19,178      3,892      109,008
    

  

  

  

  

  

Total temporarily impaired securities

   $ 5,583    $ 400,187    $ 4,680    $ 53,856    $ 10,263    $ 454,043
    

  

  

  

  

  

 

16


Approximately $9.0 million of the unrealized losses are represented by a large number of individual securities with unrealized losses of less than 20% of each security’s amortized cost. Of these, the most significant unrealized losses relate to one corporate bond and one equity security with unrealized losses of approximately $0.9 million and $0.7 million, respectively, representing market value declines of 16% and 10% of amortized cost. The remaining $1.3 million represents unrealized losses that exceed 20% of amortized costs which includes two bond obligations and eight equity securities. Of these securities, the most significant relates to a single, non-investment grade bond obligation of a major airline with a gross unrealized loss of $0.8 million. This bond is supported by gate lease revenues at the Dallas-Fort Worth (“DFW”) airport. Given the status of DFW as the third busiest airport in the world, the Company believes that these gates are of vital strategic importance to the airline. The airline is current on their interest obligations for these bonds and the bond has shown some recovery over the recent six months. The Company has the ability and intent to hold securities with unrealized losses until they recover their value. In the future, information may come to light or circumstances may change that would cause the Company to write-down or sell these securities and incur a realized loss.

 

The Company has concluded that the gross unrealized losses of $10.3 million at March 31, 2004 were temporary in nature. However, facts and circumstances may change which could result in a decline in market value considered to be other than temporary.

 

The amortized cost and estimated market value of fixed maturities available for sale with unrealized losses exceeding 20% of amortized cost as of March 31, 2004 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

    

Amortized

Cost


  

Estimated
Market

Value


     (Amounts in thousands)

Fixed maturities available for sale:

             

Due in one year or less

   $ —      $ —  

Due after one year through five years

     —        —  

Due after five years through ten years

     —        —  

Due after ten years

   $ 3,476    $ 2,613

 

The Company has no material direct investments in real estate. The Company intends to fund the expansion into Arizona and any future personal automobile markets and related capital requirements through the use of internally generated funds.

 

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 to 1. Based on the combined surplus of all of the

 

17


licensed insurance subsidiaries of $1,204.2 million at March 31, 2004 and net written premiums for the twelve months ended on that date of $2,360.3 million, the ratio of writings to surplus was approximately 2.0 to 1.

 

The Company’s book value per share at March 31, 2004 was $24.10 per share.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

There have been no material changes in the Company’s investment strategies, types of financial instruments held or the risks associated with such instruments which would materially alter the market risk disclosures made in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

Item 4. Disclosure Controls and Procedures

 

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures.

 

As required by Securities and Exchange Commission Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

 

There has been no change in the Company’s internal controls over financial reporting during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the Company’s internal controls over financial reporting.

 

PART II - OTHER INFORMATION

 

Item 1. 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 has established reserves for lawsuits which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. 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. Also, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

18


In Robert Krumme, On Behalf Of The General Public vs. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company (Superior Court for the City and County of San Francisco), initially filed June 30, 2000, the plaintiff has asserted an unfair trade practices claim under Section 17200 of the California Business and Professions Code. Specifically, the case involves a dispute over the legality of broker fees (generally less than $100 per policy) charged by independent brokers who sell the Company’s products to consumers that purchase insurance policies written by the Mercury Insurance Company, Mercury Casualty Company and California Automobile Insurance Company (collectively, the “California Companies”). The plaintiff asserts that the brokers who sell the Company’s products should not charge broker fees and that the Company benefits from these fees and should be liable for them. The plaintiff sought an elimination of the broker fees and restitution of previously paid broker fees. In April 2003, the court ruled that the brokers involved in the suit were in fact agents of the Company; however, the court also held that the Company was not responsible for retroactive restitution. The court issued an injunction on May 16, 2003 that prevents Mercury from either (a) selling auto or homeowners insurance through any producer that is not appointed as an agent under Insurance Code, Section 1704, (b) selling auto or homeowners insurance through any producer that charges broker fees and (c) engaging in comparative rate advertising and failing to disclose the possibility that a broker fee may be charged. Mercury has appealed, which has the effect of staying all but the advertising aspects of the court’s injunction. The Company’s appeal is based on the fact that the broker fees are subject to direct – and, if they could be attributed to Mercury, exclusive – regulation by the California Insurance Commissioner. The law allows a broker to perform agent functions without giving up broker status. In the past, the Insurance Commissioner never found broker fees were either being improperly charged or attributable to Mercury. The appeal has been fully briefed and the Company is awaiting a court date for oral arguments which is expected no sooner than June 2004.

 

In February 2004, the California DOI issued a Notice of Non-Compliance (“NNC”) to the California Companies based on the outcome of the Robert Krumme litigation. The NNC alleges that the California Companies willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumer’s insurance broker. The California Companies filed a Notice of Defense which is based on the same grounds forming the Company’s defense in the Robert Krumme case. The administrative proceeding has been stayed at the California DOI’s request until a decision is reached in the Robert Krumme case. The impact of this NNC can not be determined at the present time. However, the Company intends to continue to vigorously defend this case.

 

Sam Donabedian, individually, and on behalf of those similarly situated vs. Mercury Insurance Company (Los Angeles Superior Court) involves a dispute over insurance rates/premiums charged to the plaintiff and the legality of persistency discounts. The action was dismissed when Mercury’s Demurrer to the plaintiff’s First Amended Complaint was sustained without leave to amend. The dismissal of this case was appealed and then overruled by an Appellate Court on the basis that there is a factual issue as to whether the persistency discounts as applied comply with the Company’s class plan and the California Insurance Code. The Company believes that the conclusion reached by the Appellate Court lacks merit, that the case was properly decided as an issue of law by the Superior Court, and has requested the California Supreme Court to hear this case rather than return it to the Superior Court for trial. The Company intends to vigorously defend this case.

 

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

 

Period


   Total Number
of Shares
Purchased


   Average
Price Paid
per Share


   Total Number of
Shares
Purchased as
part of Publicly
Announced
Plans or
Programs


   Maximum Number
(or Approximate
Dollar Value) of
Shares that May
Be Purchased
Under the Plans or
Programs


January

   —        —      —        —  

February

   19,835    $ 50.23    —      $ 200,000,000

March

   —        —      —        —  

Total

   19,835    $ 50.23    —      $ 200,000,000

 

During the first quarter of 2004, the Mercury General Corporation Profit Sharing Plan acquired 19,835 shares of the Company’s common stock in open market transactions. These shares were contributed to the Company’s employee stock ownership plan as authorized by the Board of Directors. The purchase of this stock was not made pursuant to the Company’s stock repurchase program whereby the Company may purchase over a one-year period up to $200 million of Mercury General common stock. Initially announced and approved in 1998, the Company’s stock repurchase program is re-approved annually by the Board of Directors and will expire in July, 2004, unless extended by the Board of Directors. The last purchase of common stock by the Company under its stock repurchase program was made in 2000.

 

Item 3. Defaults Upon Senior Securities

 

None

 

19


Item 4. Submission of Matters to a Vote of Securities Holders

 

None

 

Item 5. Other Information

 

None

 

Item 6. Exhibits and Reports on Form 8-K

 

15.1   Letter regarding unaudited interim financial information
23.1   Independent Accountant’s Consent
31.1   Certifications of Registrant’s Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1   Certifications of Registrant’s Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002. These certifications are being furnished solely to accompany this Quarterly Report on Form 10-Q and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and are not to be incorporated by reference into any filing of the Company.

 

20


SIGNATURES

 

Pursuant to the requirements 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

Date: May 3, 2004

 

By:

 

/s/ George Joseph


       

George Joseph

       

Chairman and Chief Executive Officer

Date: May 3, 2004

 

By:

 

/s/ Theodore Stalick


       

Theodore Stalick

       

Vice President and Chief Financial Officer

 

21