Item 1A.Risk Factors
The Company’s business involves various risks and uncertainties in addition to the normal risks of business, some of which are discussed in this section. It should be noted that the Company’s business and that of other insurers may be adversely affected by a downturn in general economic conditions and other forces beyond the Company’s control. In addition, other risks and uncertainties not presently known or that the Company currently believes to be immaterial may also adversely affect the Company’s business. Any such risks or uncertainties, or any of the following risks or uncertainties, that develop into actual events could result in a material and adverse effect on the Company’s business, financial condition, results of operations, or liquidity.
The information discussed below should be considered carefully with the other information contained in this Annual Report on Form 10-K and the other documents and materials filed by the Company with the SEC, as well as news releases and other information publicly disseminated by the Company from time to time.
Risks Related to the Company’s Business
The Company remains highly dependent upon California to produce revenues and operating profits.
For the year ended December 31, 2021, the Company generated approximately 85% of its direct automobile insurance premiums written in California. The Company’s financial results are subject to prevailing regulatory, legal, economic, demographic, competitive, and other conditions in the states in which the Company operates and changes in any of these
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conditions could negatively impact the Company’s results of operations.
Mercury General is a holding company that relies on regulated subsidiaries for cash flows to satisfy its obligations.
As a holding company, Mercury General maintains no operations that generate cash flows sufficient to pay operating expenses, shareholders’ dividends, or principal or interest on its indebtedness. Consequently, Mercury General relies on the ability of the Insurance Companies, particularly the California Companies, to pay dividends for Mercury General to meet its obligations. The ability of the Insurance Companies to pay dividends is regulated by state insurance laws, which limit the amount of, and in certain circumstances may prohibit the payment of, cash dividends. Generally, these insurance regulations permit the payment of dividends only out of earned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. The inability of the Insurance Companies to pay dividends in an amount sufficient to enable the Company to meet its cash requirements at the holding company level could have a material adverse effect on the Company’s results of operations, financial condition, and its ability to pay dividends to its shareholders.
The Insurance Companies are subject to minimum capital and surplus requirements, and any failure to meet these requirements could subject the Insurance Companies to regulatory action.
The Insurance Companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under the applicable laws of their states of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the NAIC, require the Insurance Companies to report their results of RBC calculations to state departments of insurance and the NAIC. If any of the Insurance Companies fails to meet these standards and requirements, the DOI regulating such subsidiary may require specified actions by the subsidiary.
The Company’s success depends on its ability to accurately underwrite risks and to charge adequate premiums to policyholders.
The Company’s financial condition, results of operations, and liquidity depend on its ability to underwrite and set premiums accurately for the risks it assumes. Premium rate adequacy is necessary to generate sufficient premium to offset losses, loss adjustment expenses, and underwriting expenses and to earn a profit. In order to price its products accurately, the Company must collect and properly analyze a substantial volume of data; develop, test, and apply appropriate rating formulae; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. The Company’s ability to undertake these efforts successfully, and as a result, price accurately, is subject to a number of risks and uncertainties, including but not limited to:
•availability of sufficient reliable data;
•incorrect or incomplete analysis of available data;
•uncertainties inherent in estimates and assumptions, generally;
•selection and application of appropriate rating formulae or other pricing methodologies;
•successful innovation of new pricing strategies;
•recognition of changes in trends and in the projected severity and frequency of losses;
•the Company’s ability to forecast renewals of existing policies accurately;
•unanticipated court decisions, legislation or regulatory action;
•ongoing changes in the Company’s claim settlement practices;
•changes in operating expenses;
•changing driving patterns;
•extra-contractual liability arising from bad faith claims;
•catastrophes, including those which may be related to climate change;
•unexpected medical inflation; and
•unanticipated inflation in automobile repair costs, automobile parts prices, and used car prices.
Such risks and uncertainties may result in the Company’s pricing being based on outdated, inadequate or inaccurate data, or inappropriate analyses, assumptions or methodologies, and may cause the Company to estimate incorrectly future changes in
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the frequency or severity of claims. As a result, the Company could underprice risks, which would negatively affect the Company’s margins, or it could overprice risks, which could reduce the Company’s volume and competitiveness. In either event, the Company’s financial condition, results of operations, and liquidity could be materially and adversely affected.
The Company’s insurance rates are subject to approval by the departments of insurance in most of the states in which the Company operates, and to political influences.
In five of the states in which it operates, including California, the Company must obtain the DOI’s prior approval of insurance rates charged to its customers, including any increases in those rates. If the Company is unable to receive approval of the rate changes it requests, or if such approval is delayed, the Company’s ability to operate its business in a profitable manner may be limited and its financial condition, results of operations, and liquidity may be adversely affected. Additionally, in California, the law allows for consumer groups to intervene in rate filings, which frequently causes delays in rate approvals and implementation of rate changes and can impact the rate that is ultimately approved.
From time to time, the automobile insurance industry comes under pressure from state regulators, legislators, and special interest groups to reduce, freeze, or set rates at levels that do not correspond with underlying costs, in the opinion of the Company’s management. The homeowners insurance business faces similar pressure, particularly as regulators in catastrophe-prone states seek an acceptable methodology to price for catastrophe exposure. In addition, various insurance underwriting and pricing criteria regularly come under attack by regulators, legislators, and special interest groups. The result could be legislation, regulations, or new interpretations of existing regulations that adversely affect the Company’s business, financial condition, and results of operations.
The effects of emerging claim and coverage issues on the Company’s business are uncertain and may have an adverse effect on the Company’s business.
As industry practices and legal, judicial, social, and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect the Company’s business by either extending coverage beyond its underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until sometime after the Company has issued insurance policies that are affected by the changes. As a result, the full extent of liability under the Company’s insurance policies may not be known for many years after a policy is issued.
Loss of, or significant restriction on, the use of credit scoring in the pricing and underwriting of personal lines products could reduce the Company’s future profitability.
The Company uses credit scoring as a factor in pricing and underwriting decisions where allowed by state law. Some consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against some groups of people and are seeking to prohibit or restrict the use of credit scoring in underwriting and pricing. Laws or regulations that significantly curtail or regulate the use of credit scoring, if enacted in a large number of states in which the Company operates, could negatively impact the Company’s future results of operations.
If the Company cannot maintain its A.M. Best ratings, it may not be able to maintain premium volume in its insurance operations sufficient to attain the Company’s financial performance goals.
The Company’s ability to retain its existing business or to attract new business in its Insurance Companies is affected by its rating by A.M. Best. A.M. Best currently rates all of the Insurance Companies with sufficient operating history as either A (Excellent) or A- (Excellent). On February 10, 2022, A.M. Best affirmed the Financial Strength Rating ("FSR") of A (Excellent) with Stable outlook for the Company's A rated entities and A- (Excellent) with Stable outlook for the Company's A- rated entities. The Company believes that if it is unable to maintain its A.M. Best ratings within the A ratings range, it may face greater challenges to grow its premium volume sufficiently to attain its financial performance goals, which may adversely affect the Company’s business, financial condition, and results of operations.
The Company may require additional capital in the future, which may not be available or may only be available on unfavorable terms.
The Company’s future capital requirements, including to fund future growth opportunities, depend on many factors, including its ability to underwrite new business successfully, its ability to establish premium rates and reserves at levels sufficient to cover losses, the success of its expansion plans, the performance of its investment portfolio and its ability to obtain financing. The Company may seek to obtain financing through equity or debt issuances, or sales of all or a portion of its investment portfolio or other assets. The Company’s ability to obtain financing also depends on economic conditions affecting
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financial markets and financial strength and claims-paying ability ratings, which are assigned based upon an evaluation of the Company’s ability to meet its financial obligations. The Company’s current financial strength rating with Fitch and Moody's is A and A2, respectively. If the Company were to seek financing through the capital markets in the future, there can be no assurance that the Company would obtain favorable ratings from rating agencies. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company. In the case of equity financing, the Company’s shareholders could experience dilution. In addition, such securities may have rights, preferences, and privileges that are senior to those of the Company’s current shareholders. If the Company cannot obtain adequate capital on favorable terms or at all, its business, financial condition, and results of operations could be adversely affected.
Changes in market interest rates, defaults on securities and tax considerations may have an adverse effect on the Company’s investment portfolio, which may adversely affect the Company’s financial results.
The Company’s financial results are affected, in part, by the performance of its investment portfolio. The Company’s investment portfolio contains interest rate sensitive-investments, such as municipal and corporate bonds. Increases in market interest rates may have an adverse impact on the value of the investment portfolio by decreasing the value of fixed income securities. Declining market interest rates could have an adverse impact on the Company’s investment income as it invests positive cash flows from operations and as it reinvests proceeds from maturing and called investments in new investments that could yield lower rates than the Company’s investments have historically generated. Defaults in the Company’s investment portfolio may produce operating losses and negatively impact the Company’s results of operations.
Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions, and other factors beyond the Company’s control. Market interest rates have been at historic lows for the last several years. Many observers, including the Company, believe that market interest rates will rise as the economy improves. Although the Company takes measures to manage the risks of investing in a changing interest rate environment, it may not be able to mitigate interest rate sensitivity effectively. The Company’s mitigation efforts include maintaining a high quality portfolio and managing the duration of the portfolio to reduce the effect of interest rate changes. Despite its mitigation efforts, a significant change in interest rates could have a material adverse effect on the Company’s financial condition and results of operations. Although the Company monitors the timing and recognition of capital gains and losses in an effort to maximize the realization of deferred tax assets arising from capital losses, no guaranty can be provided that such monitoring or the Company's tax strategies will be effective.
The Company’s valuation of financial instruments may include methodologies, estimates, and assumptions that are subject to differing interpretations and could result in changes to valuations that may materially adversely affect the Company’s financial condition or results of operations.
The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date using the exit price. Accordingly, when market observable data are not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value are categorized based on the level of judgment associated with the inputs used to measure their fair value and the level of market price observability.
During periods of market disruption, including periods of significantly changing interest rates, rapidly widening credit spreads, inactivity or illiquidity, it may be difficult to value certain of the Company’s securities if trading becomes less frequent and/or market data become less observable. There may be certain asset classes in historically active markets with significant observable data that become illiquid due to changes in the financial environment. In such cases, the valuations associated with such securities may rely more on management's judgment and include inputs and assumptions that are less observable or require greater estimation as well as valuation methods that are more sophisticated or require greater estimation. The valuations generated by such methods may be different from the value at which the investments ultimately may be sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Company’s consolidated financial statements, and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on the Company’s financial condition or results of operations.
Changes in the method for determining London Interbank Offered Rate ("LIBOR") and the eventual replacement of LIBOR may affect the Company's cost of capital, the value of its investment portfolio, and its net investment income.
On July 27, 2017, the U.K. Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will no longer persuade or compel banks to submit rates for the calculation of LIBOR after 2021. On March 5, 2021, the FCA announced it will cease publication of the most commonly used U.S. dollar LIBOR tenors after June 30, 2023, though the less
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commonly used tenors will cease publication after December 31, 2021. The Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate (“SOFR”) in April 2018 as an alternative for LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. On July 29, 2021, the U.S. Federal Reserve formally recommended the forward-looking SOFR term rates as the replacement for U.S. dollar LIBOR. A transition away from the widespread use of LIBOR to SOFR and/or other benchmark rates is expected to occur by June 30, 2023.
The Company has exposure to LIBOR-based financial instruments, such as LIBOR-based securities held in its investment portfolio and its unsecured revolving credit facility. Alternative reference rates have different characteristics than LIBOR, and may demonstrate less predictable behavior over time and across different monetary, market, and economic environments. Although the full impact of transition remains unclear, this change could have an adverse impact on the securities markets, the value of the Company's investment portfolio, and its net investment income. In addition, although the Company's LIBOR-based unsecured credit facility agreement, as amended and restated as of March 31, 2021, contains alternative interest rate provisions specifying rate calculations to be used at such time LIBOR ceases to be available as a benchmark due to reference rate reform, the Company may need to amend this agreement to accommodate any replacement rate. See Note 8. Notes Payable, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data" for additional information on the unsecured credit facility.
Changes in the financial strength ratings of financial guaranty insurers issuing policies on bonds held in the Company’s investment portfolio may have an adverse effect on the Company’s investment results.
In an effort to enhance the bond rating applicable to certain bond issues, some bond issuers purchase municipal bond insurance policies from private insurers. The insurance generally guarantees the payment of principal and interest on a bond issue if the issuer defaults. By purchasing the insurance, the financial strength ratings applicable to the bonds are based on the credit worthiness of the insurer as well as the underlying credit of the bond issuer. These financial guaranty insurers are subject to DOI oversight. As the financial strength ratings of these insurers are reduced, the ratings of the insured bond issues correspondingly decrease. Although the Company has determined that the financial strength ratings of the underlying bond issues in its investment portfolio are within the Company’s investment policy without the enhancement provided by the insurance policies, any further downgrades in the financial strength ratings of these insurance companies or any defaults on the insurance policies written by these insurance companies may reduce the fair value of the underlying bond issues and the Company’s investment portfolio or may reduce the investment results generated by the Company’s investment portfolio, which could have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
Deterioration of the municipal bond market in general or of specific municipal bonds held by the Company may result in a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
At December 31, 2021, approximately 47% of the Company’s total investment portfolio at fair value and approximately 60% of its total fixed maturity securities at fair value were invested in tax-exempt municipal bonds. With such a large percentage of the Company’s investment portfolio invested in municipal bonds, the performance of the Company’s investment portfolio, including the cash flows generated by the investment portfolio, is significantly dependent on the performance of municipal bonds. If the value of municipal bond markets in general or any of the Company’s municipal bond holdings deteriorates, the performance of the Company’s investment portfolio, financial condition, results of operations, and liquidity may be materially and adversely affected.
If the Company’s loss reserves are inadequate, its business and financial position could be harmed.
The process of establishing property and liability loss reserves is inherently uncertain due to a number of factors, including underwriting quality, the frequency and amount of covered losses, variations in claims settlement practices, the costs and uncertainty of litigation, and expanding theories of liability. While the Company believes that its actuarial techniques and databases are sufficient to estimate loss reserves, the Company’s approach may prove to be inadequate. If any of these contingencies, many of which are beyond the Company’s control, results in loss reserves that are not sufficient to cover its actual losses, the Company’s financial condition, results of operations, and liquidity may be materially and adversely affected.
There is uncertainty involved in the availability of reinsurance and the collectability of reinsurance recoverable.
The Company reinsures a portion of its potential losses on the policies it issues to mitigate the volatility of the losses on its financial condition and results of operations. The availability and cost of reinsurance is subject to market conditions, which are outside of the Company’s control. From time to time, market conditions have limited, and in some cases, prevented insurers from obtaining the types and amounts of reinsurance that they consider adequate for their business needs. As a result, the Company may not be able to successfully purchase reinsurance and transfer a portion of the Company’s risk through reinsurance arrangements. In addition, as is customary, the Company initially pays all claims and seeks to recover the reinsured losses from its reinsurers. Although the Company reports as assets the amount of claims paid which the Company expects to
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recover from reinsurers, no assurance can be given that the Company will be able to collect from its reinsurers. If the amounts actually recoverable under the Company’s reinsurance treaties are ultimately determined to be less than the amount it has reported as recoverable, the Company may incur a loss during the period in which that determination is made.
The failure of any loss limitation methods employed by the Company could have a material adverse effect on its financial condition or results of operations.
Various provisions of the Company’s policies, such as limitations or exclusions from coverage which are intended to limit the Company’s risks, may not be enforceable in the manner the Company intends. In addition, the Company’s policies contain conditions requiring the prompt reporting of claims and the Company’s right to decline coverage in the event of a violation of that condition. While the Company’s insurance product exclusions and limitations reduce the Company’s loss exposure and help eliminate known exposures to certain risks, it is possible that a court or regulatory authority could nullify or void an exclusion or legislation could be enacted modifying or barring the use of such endorsements and limitations in a way that would adversely affect the Company’s loss experience, which could have a material adverse effect on its financial condition or results of operations.
The Company’s business is vulnerable to significant catastrophic property loss, which could have an adverse effect on its financial condition and results of operations.
The Company faces a significant risk of loss in the ordinary course of its business for property damage resulting from natural disasters, man-made catastrophes and other catastrophic events, particularly hurricanes, earthquakes, hail storms, explosions, tropical storms, rain storms, fires, mudslides, sinkholes, war, acts of terrorism, severe weather and other natural and man-made disasters. Such events typically increase the frequency and severity of automobile and other property claims. Because catastrophic loss events are by their nature unpredictable, historical results of operations may not be indicative of future results of operations, and the occurrence of claims from catastrophic events may result in substantial volatility in the Company’s financial condition and results of operations from period to period. Although the Company attempts to manage its exposure to such events, the occurrence of one or more major catastrophes in any given period could have a material and adverse impact on the Company’s financial condition and results of operations and could result in substantial outflows of cash as losses are paid.
The Company depends on independent agents who may discontinue sales of its policies at any time.
The Company sells its insurance policies primarily through a network of approximately 8,190 independent agents. The Company must compete with other insurance carriers for these agents’ business. Some competitors offer a larger variety of products, lower prices for insurance coverage, higher commissions, or more attractive non-cash incentives. To maintain its relationship with these independent agents, the Company must pay competitive commissions, be able to respond to their needs quickly and adequately, and create a consistently high level of customer satisfaction. If these independent agents find it preferable to do business with the Company’s competitors, it would be difficult to renew the Company’s existing business or attract new business. State regulations may also limit the manner in which the Company’s producers are compensated or incentivized. Such developments could negatively impact the Company’s relationship with these parties and ultimately reduce revenues.
The Company’s expansion plans may adversely affect its future profitability.
The Company intends to continue to expand its operations in several of the states in which the Company has operations and may expand into states in which it has not yet begun operations. The intended expansion will necessitate increased expenditures. The Company intends to fund these expenditures out of cash flows from operations. The expansion may not occur, or if it does occur, may not be successful in providing increased revenues or profitability. If the Company’s cash flows from operations are insufficient to cover the costs of the expansion, or if the expansion does not provide the benefits anticipated, the Company’s financial condition, results of operations, and ability to grow its business may be harmed.
Any inability of the Company to realize its deferred tax assets, if and when they arise, may have a material adverse effect on the Company’s financial condition and results of operations.
The Company recognizes deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. The Company evaluates its deferred tax assets for recoverability based on available evidence, including assumptions about future profitability and capital gain generation. Although management believes that it is more likely than not that the deferred tax assets will be realized, some or all of the Company’s deferred tax assets could expire unused if the Company is unable to generate taxable income of an appropriate character and in a sufficient amount to utilize these tax benefits in the future. Any determination that the Company would not be able to realize all or a portion of its deferred tax assets in the future would result
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in a charge to earnings in the period in which the determination is made. This charge could have a material adverse effect on the Company’s results of operations and financial condition. In addition, the assumptions used to make this determination are subject to change from period to period based on changes in tax laws or variances between the Company’s projected operating performance and actual results. As a result, significant management judgment is required in assessing the possible need for a deferred tax asset valuation allowance. The changes in the estimates and assumptions used in such assessments and decisions can materially affect the Company’s results of operations and financial condition.
The carrying value of the Company’s goodwill and other intangible assets could be subject to an impairment write-down.
At December 31, 2021, the Company’s consolidated balance sheets reflected approximately $43 million of goodwill and $10 million of other intangible assets. The Company evaluates whether events or circumstances have occurred that suggest that the fair values of its goodwill and other intangible assets are below their respective carrying values. The determination that the fair values of the Company’s goodwill and other intangible assets are less than their carrying values may result in an impairment write-down. An impairment write-down would be reflected as expense and could have a material adverse effect on the Company’s results of operations during the period in which it recognizes the expense. In the future, the Company may incur impairment charges related to goodwill and other intangible assets already recorded or arising out of future acquisitions.
Uncertain economic conditions may negatively affect the Company’s business and operating results.
Uncertain economic conditions could adversely affect the Company in the form of consumer behavior and pressure on its investment portfolio. Consumer behavior could include policy cancellations, modifications, or non-renewals, which may reduce cash flows from operations and investments, may harm the Company’s financial position, and may reduce the Insurance Companies’ statutory surplus. Uncertain economic conditions also may impair the ability of the Company’s customers to pay premiums as they become due, and as a result, the Company’s bad debt reserves and write-offs could increase. It is also possible that claims fraud may increase. The Company’s investment portfolios could be adversely affected as a result of financial and business conditions affecting the issuers of the securities in the Company’s investment portfolio. In addition, declines in the Company’s profitability could result in a charge to earnings for the impairment of goodwill, which would not affect the Company’s cash flows but could decrease its earnings, and could adversely affect its stock price.
The Company may be adversely affected if economic conditions result in either inflation or deflation. In an inflationary environment, established reserves may become inadequate and increase the Company’s loss ratio, and market interest rates may rise and reduce the value of the Company’s fixed maturity portfolio. The departments of insurance may not approve premium rate increases in time for the Company to adequately mitigate inflated loss costs. In a deflationary environment, some fixed maturity issuers may have difficulty meeting their debt service obligations and thereby reduce the value of the Company’s fixed maturity portfolio; equity investments may decrease in value; and policyholders may experience difficulties paying their premiums to the Company, which could adversely affect premium revenue.
Risks Related to the Company’s Industry
The private passenger automobile insurance industry is highly competitive, and the Company may not be able to compete effectively against larger or better-capitalized companies.
The Company competes with many property and casualty insurance companies selling private passenger automobile insurance in the states in which the Company operates. Many of these competitors are better capitalized than the Company, have higher A.M. Best ratings, and have a larger market share in the states in which the Company operates. The superior capitalization of the competitors may enable them to offer lower rates, to withstand larger losses, and to more effectively take advantage of new marketing opportunities. The Company’s competition may also become increasingly better capitalized in the future as the traditional barriers between insurance companies and banks and other financial institutions erode and as the property and casualty industry continues to consolidate. The Company’s ability to compete against these larger, better-capitalized competitors depends on its ability to deliver superior service and its strong relationships with independent agents.
The Company may undertake strategic marketing and operating initiatives to improve its competitive position and drive growth. If the Company is unable to successfully implement new strategic initiatives or if the Company’s marketing campaigns do not attract new customers, the Company’s competitive position may be harmed, which could adversely affect the Company’s business and results of operations. Additionally, in the event of a failure of any competitor, the Company and other insurance companies would likely be required by state law to absorb the losses of the failed insurer and would be faced with an unexpected surge in new business from the failed insurer’s former policyholders.
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The Company may be adversely affected by changes in the private passenger automobile insurance industry.
Approximately 68% of the Company’s direct premiums written for the year ended December 31, 2021 were generated from private passenger automobile insurance policies. Adverse developments in the market for personal automobile insurance or the personal automobile insurance industry in general, whether related to changes in competition, pricing or regulations, could cause the Company’s results of operations to suffer. The property-casualty insurance industry is also exposed to the risks of severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, wild fires, sinkholes, earthquakes and, to a lesser degree, explosions, terrorist attacks, and riots. The automobile insurance business is also affected by cost trends that impact profitability. Factors which negatively affect cost trends include inflation in automobile repair costs, automobile parts costs, new and used car valuations, medical costs, and changes in non-economic costs due to changes in the legal and regulatory environments. In addition, the advent of driverless cars and usage-based insurance could materially alter the way that automobile insurance is marketed, priced, and underwritten.
The Company cannot predict the impact that changing climate conditions, including legal, regulatory and social responses thereto, may have on its business.
Various scientists, environmentalists, international organizations, regulators and other commentators believe that global climate change has added, and will continue to add, to the unpredictability, frequency and severity of natural disasters (including, but not limited to, hurricanes, tornadoes, freezes, droughts, other storms and fires) in certain parts of the world. In response, a number of legal and regulatory measures and social initiatives have been introduced in an effort to reduce greenhouse gas and other carbon emissions that may be chief contributors to global climate change. The Company cannot predict the impact that changing climate conditions, if any, will have on its business or its customers, although the impact on the Company's results of operations or financial condition of incurred losses related to natural disasters that may result from changing climate conditions is mitigated to the extent its reinsurance programs provide coverage for such losses. See "Reinsurance" in "Item 1. Business" for information regarding the Company's reinsurance programs. It is also possible that the legal, regulatory and social responses to climate change could have a negative effect on the Company’s results of operations or financial condition.
Changes in federal or state tax laws could adversely affect the Company’s business, financial condition, results of operations, and liquidity.
The Company’s financial condition, results of operations, and liquidity are dependent in part on tax policy implemented at the federal and/or state level. For example, a significant portion of the Company’s investment portfolio consists of municipal securities that receive beneficial tax treatment under applicable federal tax law. The Company’s results are also subject to federal and state tax rules applicable to dividends received from its subsidiaries and its equity holdings. Additionally, changes in tax laws could have an adverse effect on deferred tax assets and liabilities included in the Company’s consolidated balance sheets and results of operations. The Company cannot predict whether any tax legislation will be enacted in the near future or whether any such changes to existing federal or state tax law would have a material adverse effect on the Company's financial condition and results of operations.
The insurance industry is subject to extensive regulation, which may affect the Company’s ability to execute its business plan and grow its business.
The Company is subject to extensive regulation and supervision by government agencies in each of the states in which its Insurance Companies are domiciled, sell insurance products, issue policies, or manage claims. Some states impose restrictions or require prior regulatory approval of specific corporate actions, which may adversely affect the Company’s ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow its business profitably. These regulations provide safeguards for policyholders and are not intended to protect the interests of shareholders. The Company’s ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner is, and will continue to be, critical to its success. Some of these regulations include:
Required Licensing. The Company operates under licenses issued by the DOI in the states in which the Company sells insurance. If a regulatory authority denies or delays granting a new license, the Company’s ability to enter that market quickly or offer new insurance products in that market may be substantially impaired. In addition, if the DOI in any state in which the Company currently operates suspends, non-renews, or revokes an existing license, the Company would not be able to offer affected products in that state.
Transactions Between Insurance Companies and Their Affiliates. Transactions between the Insurance Companies and their affiliates (including the Company) generally must be disclosed to state regulators, and prior approval of the applicable regulator is required before any material or extraordinary transaction may be consummated. State regulators may refuse to
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approve or delay approval of some transactions, which may adversely affect the Company’s ability to innovate or operate efficiently.
Regulation of Insurance Rates and Approval of Policy Forms. The insurance laws of most states in which the Company conducts business require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. If, as permitted in some states, the Company begins using new rates before they are approved, it may be required to issue refunds or credits to the Company’s policyholders if the new rates are ultimately deemed excessive or unfair and disapproved by the applicable state regulator. In other states, prior approval of rate changes is required and there may be long delays in the approval process or the rates may not be approved. Accordingly, the Company’s ability to respond to market developments or increased costs in that state can be adversely affected.
Restrictions on Cancellation, Non-Renewal or Withdrawal. Most of the states in which the Company operates have laws and regulations that limit its ability to exit a market, or reduce risk by cancellation or non-renewal of individual policies. For example, these states may, for public policy reasons, limit an insurer’s ability to cancel and non-renew private passenger automobile or homeowners insurance policies. They may also prohibit the Company from withdrawing one or more lines of insurance business from the state unless prior approval is received from the state DOI. In some states, the regulations restricting withdrawal extend to significant reductions in the amount of insurance written, not only to a complete withdrawal. Laws and regulations that limit the Company’s ability to cancel and non-renew policies in some states or locations and that subject withdrawal plans to prior approval requirements may restrict the Company’s ability to control its risk exposure or exit unprofitable markets, which may harm its business and results of operations.
Other Regulations. The Company must also comply with regulations involving, among other matters:
•the use of non-public consumer information and related privacy issues;
•the use of credit history in underwriting and rating;
•limitations on the ability to charge policy fees;
•limitations on types and amounts of investments;
•the payment of dividends;
•the acquisition or disposition of an insurance company or of any company controlling an insurance company;
•involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;
•reporting with respect to financial condition;
•periodic financial and market conduct examinations performed by state insurance department examiners; and
•the other regulations discussed in this Annual Report on Form 10-K.
The failure to comply with these laws and regulations may also result in regulatory actions, fines and penalties, and in extreme cases, revocation of the Company’s ability to do business in that jurisdiction. In addition, the Company may face individual and class action lawsuits by insured and other parties for alleged violations of certain of these laws or regulations.
In addition, from time to time, the Company may support or oppose legislation or other amendments to insurance regulations in California or other states in which it operates. Consequently, the Company may receive negative publicity related to its support or opposition of legislative or regulatory changes that may have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
Regulation may become more restrictive in the future, which may adversely affect the Company’s business, financial condition, and results of operations.
No assurance can be given that states will not make existing insurance-related laws and regulations more restrictive in the future or enact new restrictive laws. New or more restrictive regulation in any state in which the Company conducts business could make it more expensive for it to continue to conduct business in these states, restrict the premiums the Company is able to charge or otherwise change the way the Company does business. In such events, the Company may seek to reduce its writings in or to withdraw entirely from these states. In addition, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. The Company cannot predict whether and to what extent new laws and regulations that would affect its business will be adopted, the timing of any such adoption and what effects, if any, they may have on the Company’s business, financial
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condition, and results of operations.
Assessments and other surcharges for guaranty funds, second-injury funds, catastrophe funds, and other mandatory pooling arrangements may reduce the Company’s profitability.
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insured parties as the result of impaired or insolvent insurance companies. Many states also have laws that established second-injury funds to provide compensation to injured employees for aggravation of a prior condition or injury which are funded by either assessments based on paid losses or premium surcharge mechanisms. In addition, as a condition to the ability to conduct business in various states, the Insurance Companies must participate in mandatory property and casualty shared-market mechanisms or pooling arrangements, which provide various types of insurance coverage to individuals or other entities that otherwise are unable to purchase that coverage from private insurers. The effect of these assessments and mandatory shared-market mechanisms or changes in them could reduce the Company’s profitability in any given period or limit its ability to grow its business.
The insurance industry faces litigation risks, which, if resolved unfavorably, could result in substantial penalties and/or monetary damages, including punitive damages. In addition, insurance companies incur material expenses defending litigation and their results of operations or financial condition could be adversely affected if they fail to accurately project litigation expenses.
Insurance companies are subject to a variety of legal actions including breach of contract claims, tort claims, fraud and misrepresentation claims, employee benefit claims, and wage and hour claims. In addition, insurance companies incur and likely will continue to incur potential liability for claims related to the insurance industry in general and to the Company’s business in particular, such as those related to allegations for failure to pay claims, termination or non-renewal of coverage, interpretation of policy language, policy sales practices, reinsurance matters, and other similar matters. Such actions can also include allegations of fraud, misrepresentation, and unfair or improper business practices and can include claims for punitive damages.
Court decisions and legislative activity may increase exposures for any of the types of claims insurance companies face. There is a risk that insurance companies could incur substantial legal fees and expenses in any of the actions companies defend in excess of amounts budgeted for defense.
The Company and the Insurance Companies are named as defendants in a number of lawsuits. Those that management believes could have a material effect on the Company's consolidated financial statements are described more fully in "Overview—B. Regulatory and Legal Matters" in "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" and Note 18. Commitments and Contingencies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data." Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuit is uncertain and may negatively impact the manner in which the Company conducts its business, which could materially increase the Company’s legal expenses and negatively impact the results of operations. In addition, potential litigation involving new claim, coverage, and business practice issues could adversely affect the Company’s business by changing the way policies are priced, extending coverage beyond its underwriting intent, or increasing the size of claims.
Risks Related to Technology and Cybersecurity
The Company relies on its information technology systems to manage many aspects of its business, and any failure of these systems to function properly or any interruption in their operation could result in a material adverse effect on the Company’s business, financial condition, and results of operations.
The Company depends on the accuracy, reliability, and proper functioning of its information technology systems. The Company relies on these information technology systems to effectively manage many aspects of its business, including underwriting, policy acquisition, claims processing and handling, accounting, reserving and actuarial processes and policies, and to maintain its policyholder data. The Company has deployed, and continues to enhance, new information technology systems that are designed to manage many of these functions across the states in which it operates and the lines of insurance it offers. See "Overview—A. General—Technology" in "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations." The failure of hardware or software that supports the Company’s information technology systems, the loss of data contained in the systems, or any delay or failure in the full deployment of the Company’s information technology systems could disrupt its business and could result in decreased premiums, increased overhead costs, and inaccurate reporting, all of which could have a material adverse effect on the Company’s business, financial condition, and results of operations.
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In addition, despite system redundancy, the implementation of security measures, and the existence of a disaster recovery plan for the Company’s information technology systems, these systems are vulnerable to damage or interruption from:
•earthquake, fire, flood and other natural disasters;
•terrorist attacks and attacks by computer viruses, hackers, phishing, ransomware, or other exploits;
•power loss in areas not covered by backup power generators;
•unauthorized access; and
•computer systems, internet, telecommunications or data network failure.
It is possible that a system failure, accident, or security breach could result in a material disruption to the Company’s business. In addition, substantial costs may be incurred to remedy the damages caused by these disruptions. Following implementation of information technology systems, the Company may from time to time install new or upgraded business management systems. To the extent that a critical system fails or is not properly implemented and the failure cannot be corrected in a timely manner, the Company may experience disruptions to the business that could have a material adverse effect on the Company’s results of operations.
Cyber security risks and the failure to maintain the confidentiality, integrity, and availability of internal or policyholder systems and data could result in damages to the Company’s reputation and/or subject it to expenses, fines or lawsuits.
The Company collects and retains large volumes of internal and policyholder data, including personally identifiable information, for business purposes including underwriting, claims and billing purposes, and relies upon the various information technology systems that enter, process, summarize and report such data. The Company also maintains personally identifiable information about its employees. The confidentiality and protection of the Company’s policyholder, employee and Company data are critical to the Company’s business. The Company’s policyholders and employees have a high expectation that the Company will adequately protect their personal information. The regulatory environment, as well as the requirements imposed by the payment card industry and insurance regulators, governing information, security and privacy laws is increasingly demanding and continues to evolve. Maintaining compliance with applicable information security and privacy regulations may increase the Company’s operating costs and adversely impact its ability to market products and services to its policyholders. Furthermore, a penetrated or compromised information technology system or the intentional, unauthorized, inadvertent or negligent release or disclosure of data could result in theft, loss, fraudulent or unlawful use of policyholder, employee or Company data which could harm the Company’s reputation or result in remedial and other expenses, fines or lawsuits. Although the Company seeks to mitigate the impact and severity of potential cyber threats through cyber insurance coverage, not every risk or liability can be insured, and for risks that are insurable, the policy limits and terms of coverage reasonably obtainable in the market may not be sufficient to cover all actual losses or liabilities incurred. In addition, disputes with insurance carriers, including over policy terms, reservation of rights, the applicability of coverage (including exclusions), compliance with provisions (including notice) and/or the insolvency of one or more of our insurers, may significantly affect the amount or timing of recovery.
Risks Related to the COVID-19 Pandemic and Other Widespread Health Emergencies
Pandemics, epidemics, widespread health emergencies, or outbreaks of infectious diseases could disrupt the Company's business and adversely affect its results of operations and financial condition.
The Company's operations may be subject to disruptions due to the occurrence of public health emergencies, such as the COVID-19 pandemic, or other similar unexpected events, some of which may be intensified by the effects of a government response to such an event. In March 2020, the outbreak of COVID-19 was recognized as a pandemic by the World Health Organization and shortly thereafter, the President of the United States declared a National Emergency. While still evolving, the COVID-19 pandemic has caused significant economic and financial turmoil both in the United States and globally.
The implementation of restrictions by federal, state and local authorities to slow the spread of COVID-19 could disrupt the Company's business and operations. As providers of essential services, the Company may be required to continue to provide services to its policyholders regardless of the ability of certain policyholders affected by COVID-19 to make timely payments for such services, due to the moratoriums issued by the DOIs of certain states on the cancellation or non-renewal of insurance policies for the non-payment of premiums. The inability to collect, or delays in collecting payments for services provided could have a material adverse effect on the Company's business, results of operations or financial condition. In addition, the DOIs of
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certain states have issued and may continue to issue directives requiring insurers to refund a portion of premiums to their policyholders due to reduced driving and business activities during the pandemic, which could adversely impact the Company's financial condition, operating results and cash flows.
The COVID-19 pandemic has caused, and could continue to cause, substantial disruptions to the Company's employees, distribution channels involving a network of independent agents, and policyholders due to factors such as self-isolation, travel limitations, and business restrictions, among others, which could result in significant declines in its premiums. Although the Company has activated its Business Continuity Plan and most of its employees are able to work remotely, there can be no assurance that the Plan will adequately mitigate the risks of business disruptions and interruptions. In addition, the Company relies on various third party service providers for certain functions of its operations, including, but not limited to, technology support, legal services and office supplies. The Company's operations could be negatively impacted by disruptions at these service providers caused by the pandemic. The COVID-19 pandemic has caused, and could continue to cause, labor shortages in the automobile repair industry and disruptions to the automotive parts supply chain, resulting in delays in automobile repairs and/or higher repair costs, which could adversely impact the Company's results of operations. These effects, individually or in the aggregate, could adversely impact the Company's business, financial condition, operating results and cash flows, and such adverse impacts may be material.
Market disruptions and dislocations caused by the COVID-19 pandemic or other similar events, leading to instability in the global credit markets, could have additional adverse effects on the Company's business and results of operations, including, but not limited to, substantial realized and unrealized losses on its investment portfolio, reduced liquidity, and increased uncertainty in its ability to raise capital. Market volatility may also make it more difficult to value certain of the Company's investments if trading becomes less frequent. In addition, these adverse conditions could heighten the credit risk of some of the Company's reinsurers, and could negatively impact their ability to pay for the losses under certain reinsurance agreements.
While it is not possible at this time to estimate the duration of the COVID-19 pandemic and the ultimate impact it could have on the Company's business, the continued spread of COVID-19 and its variants, along with the measures taken by certain countries and state and local governments in the United States, could adversely impact the Company's business, results of operations or financial condition. The extent to which the COVID-19 pandemic further impacts the Company's business will depend on future developments, including the duration and spread of COVID-19 and its variants, the acceptance and effectiveness of vaccines, and the impact of the pandemic and related containment and mitigation measures on the Company's policyholders and employees, all of which are highly uncertain and unpredictable.
General Risk Factors
The Company is controlled by a small number of shareholders who will be able to exert significant influence over matters requiring shareholder approval, including change of control transactions.
George Joseph and Gloria Joseph collectively own more than 50% of the Company’s common stock. Accordingly, George Joseph and Gloria Joseph have the ability to exert significant influence on the actions the Company may take in the future, including change of control transactions. From time to time, certain institutional investors also each own over 5% of the Company's common stock. This concentration of ownership may conflict with the interests of the Company’s other shareholders and lenders.
Future equity or debt financing may affect the market price of the Company’s common stock and rights of the current shareholders, and the future exercise of options and granting of shares will result in dilution in the investment of the Company’s shareholders.
The Company may raise capital in the future through the issuance and sale of its common stock or debt securities. The Company cannot predict what effect, if any, such future financing will have on the market price of its common stock. Sales of substantial amounts of its common stock in the public market or issuance of substantial amounts of debt securities could adversely affect the market price of the Company’s outstanding common stock, and may make it more difficult for shareholders to sell common stock at a time and price that the shareholder deems appropriate. Furthermore, holders of some of the Company's securities may have rights, preferences, and privileges that are senior to those of the Company’s current shareholders. In addition, the Company has issued and may issue options to purchase shares of its common stock as well as restricted stock units ("RSUs") to incentivize its executives and key employees. In the event that any options to purchase common stock are exercised or any shares of common stock are issued when the RSUs vest, shareholders will suffer dilution in their investment.
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Applicable insurance laws may make it difficult to effect a change of control of the Company or the sale of any of its Insurance Companies.
Before a person can acquire control of a U.S. insurance company or any holding company of a U.S. insurance company, prior written approval must be obtained from the DOI of the state where the insurer is domiciled. Prior to granting approval of an application to acquire control of the insurer or holding company, the state DOI will consider a number of factors relating to the acquirer and the transaction. These laws and regulations may discourage potential acquisition proposals and may delay, deter or prevent a change of control of the Company or the sale by the Company of any of its Insurance Companies, including transactions that some or all of the Company’s shareholders might consider to be desirable.
Although the Company has consistently paid increasing cash dividends in the past, it may not be able to pay or continue to increase cash dividends in the future.
The Company has consistently paid cash dividends since the public offering of its common stock in November 1985 and has consistently increased the dividend per share during that time. However, future cash dividends will depend upon a variety of factors, including the Company’s profitability, financial condition, capital needs, future prospects, and other factors deemed relevant by the Board of Directors. The Company’s ability to pay dividends or continue to increase the dividend per share may also be limited by the ability of the Insurance Companies to make distributions to the Company, which may be restricted by financial, regulatory or tax constraints, and by the terms of the Company’s debt instruments. In addition, there can be no assurance that the Company will continue to pay dividends or increase the dividend per share even if the necessary financial and regulatory conditions are met and if sufficient cash is available for distribution.
Changes in accounting standards issued by the Financial Accounting Standards Board (the "FASB") or other standard-setting bodies may adversely affect the Company’s consolidated financial statements.
The Company’s consolidated financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, the Company is required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes the Company is required to adopt could change the current accounting treatment that the Company applies to its consolidated financial statements and that such changes could have a material adverse effect on the Company’s financial condition and results of operations.
The Company’s disclosure controls and procedures may not prevent or detect acts of fraud.
The Company’s disclosure controls and procedures are designed to reasonably assure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to management and is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company’s management, including its Chief Executive Officer and Chief Financial Officer, believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, the Company cannot provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been prevented or detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by an unauthorized override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and the Company cannot assure that any design will succeed in achieving its stated goals under all potential future conditions. Accordingly, because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and not be detected.
Failure to maintain an effective system of internal control over financial reporting may have an adverse effect on the Company’s stock price.
The Company is required to include in its Annual Report on Form 10-K a report by its management regarding the effectiveness of the Company’s internal control over financial reporting, which includes, among other things, an assessment of the effectiveness of the Company’s internal control over financial reporting as of the end of its fiscal year, including a statement as to whether or not the Company’s internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in the Company’s internal control over financial reporting identified by management. Areas of the Company’s internal control over financial reporting may require improvement from time to time. If management is unable to assert that the Company’s internal control over financial reporting is effective now or in any future period, or if the Company’s independent auditors are unable to express an opinion on the effectiveness of those internal controls, investors may lose confidence in the accuracy and completeness of the Company’s financial reports, which could have an adverse effect on the Company’s stock price.
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The ability of the Company to attract, develop and retain talented employees, managers and executives, and to maintain appropriate staffing levels, is critical to the Company’s success.
The Company is constantly hiring and training new employees and seeking to retain current employees. An inability to attract, retain and motivate the necessary employees for the operation and expansion of the Company’s business could hinder its ability to conduct its business activities successfully, develop new products and attract customers.
The Company’s success also depends upon the continued contributions of its executive officers, both individually and as a group. The Company’s future performance will be substantially dependent on its ability to retain and motivate its management team. The loss of the services of any of the Company’s executive officers could prevent the Company from successfully implementing its business strategy, which could have a material adverse effect on the Company’s business, financial condition, and results of operations.
Item 1B.Unresolved Staff Comments
None.
Item 2.Properties
The Company owns the following buildings which support all business segments. Space not occupied by the Company may be leased to independent third party tenants.
Brea, CA Home office and I.T. facilities (2 buildings) 236,000 100 %
Folsom, CA Administrative and Data Center 88,000 100 %
Los Angeles, CA Executive offices 41,000 95 %
Rancho Cucamonga, CA Administrative 127,000 100 %
Clearwater, FL Administrative 162,000 51 %
Oklahoma City, OK Administrative 100,000 25 %
The Company leases additional office space for operations. Office location is not crucial to the Company’s operations. In addition, the Company owns 5.9 acres of land in Rancho Cucamonga, California.
The Company’s properties are well maintained, adequately meet its needs, and are being utilized for their intended purposes.
Item 3.Legal Proceedings
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see "Overview-C. Critical Accounting Estimates" in "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" and Note 1. Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition or cash flows.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see "Overview—B. Regulatory and Legal Matters" in "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations" and Note 18. Commitments and Contingencies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data," which is incorporated herein by reference.
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There are no environmental proceedings arising under federal, state, or local laws or regulations to be discussed.
Item 4.Mine Safety Disclosures
Not applicable.
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PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The shares of the Company's common stock are listed and traded on the New York Stock Exchange (trading symbol: MCY).
The closing price of the Company’s common stock on February 10, 2022 was $52.17.
Holders
As of February 10, 2022, there were approximately 247 holders of record of the Company’s common stock.
Dividends
For financial statement purposes, the Company records dividends on the declaration date. The Company intends to continue paying quarterly dividends; however, the continued payment and amount of cash dividends will depend upon the Company’s operating results, overall financial condition, capital requirements, and general business conditions.
Holding Company Act
Pursuant to the Holding Company Act, California-domiciled insurance companies are required to notify the California DOI of any dividend after declaration, but prior to payment. There are similar limitations imposed by other states on the Insurance Companies’ ability to pay dividends. As of December 31, 2021, the Insurance Companies are permitted to pay in 2022, without obtaining DOI approval for extraordinary dividends, $252 million in dividends to Mercury General, of which $223 million may be paid by the California Companies.
For a discussion of certain restrictions on the payment of dividends to Mercury General by some of its insurance subsidiaries, see Note 13. Dividends, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
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Performance Graph
The following graph compares the cumulative total shareholder returns on the Company’s common stock (trading symbol: MCY) with the cumulative total returns on the Standard and Poor’s 500 Composite Stock Price Index ("S&P 500 Index") and the Company’s industry peer group over the last five years. The graph assumes that $100 was invested on December 31, 2016 in each of the Company’s Common Stock, the S&P 500 Index and the industry peer group and the reinvestment of all dividends.
The industry peer group consists of Alleghany Corporation, Allstate Corporation, American Financial Group, Arch Capital Group Ltd, Berkley (W.R.), Berkshire Hathaway 'B', Chubb Corporation, Cincinnati Financial Corporation, CNA Financial Corporation, Erie Indemnity Company, Hanover Insurance Group, Markel Corporation, Old Republic International, Progressive Corporation, RLI Corporation, Selective Insurance Group, Travelers Companies, Inc., and XL Group, plc.
Recent Sales of Unregistered Securities
None.
Share Repurchases
On July 30, 2021, the Board extended its authorization of the repurchase of up to $200 million of the Company’s Common Stock for an additional one-year period, which the Board originally authorized on July 31, 2020. The purchases may be made from time to time in the open market at the discretion of management at a price approved by the Board prior to the purchase. The Company may use its own funds, borrowings against a bank credit facility, and dividends received from the
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Insurance Companies to fund the share repurchases. The Company has not repurchased any of its Common Stock since 2000.
Item 6.Reserved
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Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-looking Statements
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. Certain statements contained in this report are forward-looking statements based on the Company’s current expectations and beliefs concerning future developments and their potential effects on the Company. There can be no assurance that future developments affecting the Company will be those anticipated by the Company. Actual results may differ from those projected in the forward-looking statements. These forward-looking statements involve significant risks and uncertainties (some of which are beyond the control of the Company) and are subject to change based upon various factors, including but not limited to the following risks and uncertainties: changes in the demand for the Company’s insurance products, inflation and general economic conditions, including general market risks associated with the Company’s investment portfolio; the accuracy and adequacy of the Company’s pricing methodologies; catastrophes in the markets served by the Company; uncertainties related to estimates, assumptions and projections generally; the possibility that actual loss experience may vary adversely from the actuarial estimates made to determine the Company’s loss reserves in general; the Company’s ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in states where the Company operates; legislation adverse to the automobile insurance industry or business generally that may be enacted in the states where the Company operates; the Company’s success in managing its business in non-California states; the presence of competitors with greater financial resources and the impact of competitive pricing and marketing efforts; the Company's ability to successfully manage its claims organization outside of California; the Company's ability to successfully allocate the resources used in the states with reduced or exited operations to its operations in other states; changes in driving patterns and loss trends; acts of war and terrorist activities; pandemics, epidemics, widespread health emergencies, or outbreaks of infectious diseases; court decisions and trends in litigation and health care and auto repair costs; and legal, cyber security, regulatory and litigation risks.
From time to time, forward-looking statements are also included in the Company’s quarterly reports on Form 10-Q and current reports on Form 8-K, in press releases, in presentations, on its web site, and in other materials released to the public. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report or statement. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise.
OVERVIEW
A. General
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty insurance industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a significant impact on the Company’s ability to grow and retain business.
The Company is headquartered in Los Angeles, California and writes primarily personal automobile lines of business selling policies through a network of independent agents, 100% owned insurance agents and direct channels, in 11 states: Arizona, California, Florida, Georgia, Illinois, Nevada, New Jersey, New York, Oklahoma, Texas, and Virginia. The Company also offers homeowners, commercial automobile, commercial property, mechanical protection, fire, and umbrella insurance. Private passenger automobile lines of insurance business accounted for approximately 68% of the $3.9 billion of the Company’s direct premiums written in 2021, and approximately 87% of the private passenger automobile premiums were written in California.
In 2021, the Company ceased accepting new business and renewing existing policies for the commercial automobile line of insurance business in Arizona, Georgia, Illinois and Nevada. The commercial automobile line of insurance business in those states has been volatile and challenged the Company’s objective of growing the business profitably. The Company plans to focus resources on the states and lines of insurance business with better opportunities for sustainable growth. The combined net premiums written in 2021 and 2020 for the commercial automobile line of insurance business in those states was approximately $8 million and $20 million, respectively.
This section discusses some of the relevant factors that management considers in evaluating the Company’s
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performance, prospects, and risks. It is not all-inclusive and is meant to be read in conjunction with the entirety of management’s discussion and analysis, the Company’s consolidated financial statements and notes thereto, and all other items contained within this Annual Report on Form 10-K.
2021 Financial Performance Summary
The Company’s net income for the year ended December 31, 2021 was $247.9 million, or $4.48 per diluted share, compared to $374.6 million, or $6.77 per diluted share, for the same period in 2020. Included in net income was $129.7 million of pre-tax net investment income that was generated during 2021 on a portfolio of $5.1 billion, at fair value, at December 31, 2021, compared to $134.9 million of pre-tax net investment income that was generated during 2020 on a portfolio of $4.7 billion, at fair value, at December 31, 2020. Also included in net income were pre-tax net realized investment gains of $111.7 million and $85.7 million in 2021 and 2020, respectively, and pre-tax catastrophe losses, net of reinsurance and reinstatement premiums earned, of approximately $103.7 million and $60.9 million in 2021 and 2020, respectively.
During 2021, the Company continued its marketing efforts to enhance name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation, make its insurance products competitive in California and in other states.
The Company believes its thorough underwriting process gives it an advantage over its competitors. The Company’s agent relationships and underwriting and claims processes are its most important competitive advantages.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $502 million and $606 million in 2021 and 2020, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
Economic and Industry Wide Factors
•Regulatory Uncertainty—The insurance industry is subject to strict state regulation and oversight and is governed by the laws of each state in which each insurance company operates. State regulators generally have substantial power and authority over insurance companies including, in some states, approving rate changes and rating factors, restricting cancellation and non-renewal of insurance policies, and establishing minimum capital and surplus requirements. In many states, insurance commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners. There is no certainty that current or future regulations and the interpretation of those regulations by insurance commissioners and the courts will not have an adverse impact on the Company.
•Cost Uncertainty—Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned. Consequently, significant assumptions are made when establishing insurance rates and loss reserves. While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analyses indicate that they are needed.
•Economic Conditions—The Company’s financial condition, results of operations, and liquidity may be negatively impacted by global, national and local economic conditions, such as recessions, increased levels of unemployment, inflation, and large fluctuations in interest rates. Further, volatility in global capital markets could adversely affect the Company’s investment portfolio. The Company is not able to predict the timing and effect of these factors, or their duration and severity.
•Inflation—The largest cost component for automobile insurers is losses, which include medical, replacement automobile parts, and labor costs. There can be significant variation in the overall increases in medical cost inflation, and it is often years after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
•Loss Frequency—Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. Loss frequency trends are affected by many factors such as fuel prices, the economy, the prevalence of distracted driving, collision avoidance and other technology in vehicles, and stay-at-home orders issued by state and local governments due to the pandemic.
•Underwriting Cycle and Competition—The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company believes that the automobile insurance industry market
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conditions during the first half of 2021 were soft. The market in most states has hardened during the second half of 2021 as insurance carriers began to increase rates reflecting high loss severity and increasing loss frequency as the country emerged from the COVID-19 pandemic. In California, market conditions remain soft due to the difficulty in obtaining regulatory approval for rate increases.
Technology
Since March of 2020, the Company has been leveraging its information technology capabilities to enable most of its employees to work from home and anywhere in the U.S. using mobile and collaborative technologies. In 2021, the Company focused on improving its digital and customer self-service capabilities. Additionally, the Company enhanced its underwriting capabilities and decisioning using a modern rules engine and several AI-enabled technologies. The Company continued its core insurance platform modernization initiative in an effort to complete the migration of its insurance business from its legacy systems to Guidewire’s InsuranceSuite, a widely adopted industry-leading software for property and casualty insurance. In 2022, the Company intends to continue to invest in the modernization of its technology platforms. The Company also expects to complete the migration of its California private passenger automobile underwriting and umbrella insurance to its consolidated insurance core system.
Note on COVID-19
In March 2020, the outbreak of COVID-19 was recognized as a pandemic by the World Health Organization (the "WHO"), and the outbreak has become increasingly widespread in the United States, including in the markets in which the Company operates. The pandemic has had a notable impact on general economic conditions, including, but not limited to, the temporary closures of many businesses, “shelter in place” and other governmental orders, and reduced consumer spending. The Company is following guidelines established by the Centers for Disease Control, the WHO and orders issued by the state and local governments in which the Company operates. The Company has taken a number of precautionary steps to safeguard its customers, business and employees from COVID-19, including activating its Business Continuity Plan. Most of the Company's employees have been working remotely, with only certain operationally critical employees working on site at various locations. The Company is monitoring and assessing the impact of the COVID-19 pandemic daily, including recommendations and orders issued by federal, state and local governments. In November 2021, the Company extended its "work-from-home" policy indefinitely under the new "Mercury's My Workplace" policy, allowing most of its employees to work from anywhere in the U.S. beginning January 2022.
The Company’s automobile line of insurance business began experiencing a significant decrease in loss frequency in March of 2020, and it remained lower than historical levels through the first half of 2021, although it began to increase as more drivers returned to the road following the gradual reopening of businesses in California and other states. After bottoming out in the second quarter of 2020, loss frequency has been increasing and is near pre-pandemic levels for some coverages and exceeds pre-pandemic levels for the comprehensive coverage due to a rise in vehicle thefts and property crimes. The severity of accidents, for both bodily injury and the cost to repair vehicles, has increased following the outbreak of the COVID-19 pandemic primarily due to a higher percentage of high-speed serious accidents on less congested roads and freeways. The cost to repair vehicles may remain high due to supply chain and labor force issues exacerbated by the high overall inflation rate. The COVID-19 pandemic also created more uncertainty, and the total effect on losses occurring during the COVID-19 era will not be known for several years. The Company expects more late reported claims and a prolonged settlement period, particularly for bodily injury claims. Many courts have been closed, and claimants may have been reluctant to seek medical treatments due to the pandemic. The recent increases in loss frequency combined with sustained high loss severity have negatively impacted the Company's results of operations, when compared to other quarters following the first quarter of 2020, and the Company has submitted private passenger automobile rate filings in many states requesting rate increases.
Many businesses have been required by state and local governments to cease or substantially reduce operations, and have suffered severe financial losses as a result. Many of these businesses have submitted claims to their insurers under the business interruption coverage of their commercial property policies, resulting in coverage disputes in many states. While the Company does insure a modest number of businesses with this business interruption coverage, these pandemic-related losses are not covered under the Company's policy terms and conditions. The Company’s business interruption, or “business income” coverage, requires a “direct physical loss” to the property that results in suspension of operations, such as a fire or water loss. The coverage is not triggered under the present circumstances. Most of the Company’s policies also contain an exclusion for losses caused directly or indirectly by “virus or bacteria.” This exclusion was adopted by many insurers after the SARS outbreak of 2003-2004, upon recognition that such a pandemic could result in losses far exceeding the capacity of individual insurers and the private insurance market as a whole. The Company does not believe it has any material exposure to business interruption claims.
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Due to disruptions in the equity and fixed maturity securities markets following the outbreak of the COVID-19 pandemic, the Company's investment portfolio, along with the overall securities in the financial markets, substantially declined in value in the first quarter of 2020; however, its investment portfolio recovered in value during the subsequent quarters as the overall securities markets improved. In March 2020, the Federal Open Market Committee (“FOMC”) unveiled a set of aggressive measures to cushion the economic impact of the global COVID-19 crisis, including, among others, cutting the federal funds rate by 100 basis points to a range of 0.00% to 0.25% and establishing a series of emergency credit facilities in an effort to support the flow of credit in the economy, easing liquidity pressure and calming market turmoil. While volatility in the financial markets remains elevated, overall market liquidity concerns have eased following the actions taken by the FOMC. The Company believes that it will continue to have sufficient liquidity to support its business operations during the COVID-19 crisis and beyond without the forced sale of investments, based on its existing cash and short-term investments, future cash flows from operations, and $75 million of undrawn credit in its revolving credit facility.
On March 27, 2020, the President of the United States signed the Coronavirus Aid, Relief, and Economic Security ("CARES") Act, a substantial tax-and-spending package intended to provide economic stimulus to address the financial impact of the COVID-19 pandemic. The CARES Act includes, among other items, cash payments to individuals as well as emergency grants and forgivable loans to small businesses, if they meet certain criteria. On March 11, 2021, the President of the United States signed the American Rescue Plan Act of 2021, a $1.9 trillion COVID-19 relief bill, to provide additional relief to address the continued impact of COVID-19 on the economy, public health, state and local governments, individuals, and businesses. To the extent the Company's existing or potential policyholders and business partners are aided by such relief programs, the negative impact of the pandemic on its results of operations may be mitigated.
The Company will continue to monitor the impact of the COVID-19 pandemic, and the effects of the CARES Act, the American Rescue Plan Act of 2021 and any additional legislative relief. The extent of the impact of the pandemic on the Company's business and financial results will depend largely on future developments, including the duration of the pandemic, its impact on capital and financial markets and the related impact on consumer confidence and spending, the success of broad vaccine rollouts in the U.S. and around the world, and the impact of actions taken in response to new variants of COVID-19, most of which are highly uncertain and cannot be predicted. As the impact of the COVID-19 pandemic continues to evolve, additional impacts may arise.
B. Regulatory and Legal Matters
The process for implementing rate changes varies by state. For more detailed information related to insurance rate approval, see "Item 1. Business—Regulation."
During 2021, the Company implemented rate changes in 11 states. In California, the following rate increase was approved by the California DOI for lines of insurance business that exceeded 5% of the Company's total net premiums earned in 2021:
▪In March 2021, the California DOI approved a 6.99% rate increase on the California homeowners line of insurance business, which represented approximately 15% of the Company's total net premiums earned in 2021. The Company implemented this rate increase in June 2021.
The Company primarily sells its California private passenger automobile insurance business through two of its insurance subsidiaries, MIC and CAIC. MIC accepts only “Good Drivers” (as defined in the California Insurance Code) and provides lower rates, but its policy has narrower coverages than the CAIC policy. At the request of the California DOI, the Company intends to broaden the coverages in MIC, making the coverages the same as in CAIC. Once the coverages are standardized across these two insurance subsidiaries, the Company will automatically move qualified Good Drivers from CAIC to MIC. Good Drivers accounted for approximately 87% of the Company's California voluntary private passenger automobile policies-in-force at December 31, 2021, while higher risk categories accounted for approximately 13%. The implementation of the transfer of qualified Good Drivers from CAIC to MIC began in January 2022 and is expected to reduce the Company's annual California private passenger automobile insurance premiums earned by approximately $25 million over a 24-month period beginning in the first quarter of 2022. The increase in losses resulting from broadening the coverages in MIC is not estimable, but is not expected to be material.
In July 2019, the governor of California signed a bill that created a $21 billion fund (the "California Wildfire Fund") to help then bankrupt Pacific Gas and Electric Company ("PG&E") and the state's other investor-owned utility companies cover liabilities arising from future wildfires caused by their equipment. The bill requires investor-owned utility companies to fund half of the California Wildfire Fund. The other half is to be funded by surcharges paid by ratepayers across the state. On July 1, 2020, PG&E made an announcement that it emerged out of bankruptcy and made an initial deposit of approximately $5 billion
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to the California Wildfire Fund. It is expected that the Company and other insurers will be reimbursed for some portion of the claims paid for its policyholders if it is determined that a wildfire is caused by equipment failure. The announcement also confirmed that PG&E funded the Subrogation Trust Fund with $11 billion, which was set up to reimburse insurance companies and other entities that paid claims by individuals and businesses related to wildfires that occurred in the recent past years prior to July 1, 2020. The Company received approximately $23 million, net of fees, in 2020 from the Subrogation Trust Fund. However, this subrogation recovery was for losses and loss adjustment expenses previously ceded to the Company’s reinsurers, and therefore the recovery did not reduce losses and loss adjustment expenses net of reinsurance. The benefit to the Company recognized in 2020, net of reinsurance and before taxes, was approximately $3 million, representing a reduction to reinstatement premiums previously recognized. In addition, the Company received approximately $0.8 million, net of fees, in 2021 from the Subrogation Trust Fund. The benefit to the Company recognized in 2021 before taxes was the full $0.8 million, as this recovery was not related to losses and loss adjustment expenses previously ceded to the Company's reinsurers.
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see "Critical Accounting Estimates" below and Note 1. Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
The Company establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. For material loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition or cash flows.
For a discussion of additional regulatory and legal matters, see Note 18. Commitments and Contingencies of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data." In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate.
C. Critical Accounting Estimates
Loss and Loss Adjustment Expense Reserves ("Loss Reserves")
Preparation of the Company’s consolidated financial statements requires management’s judgment and estimates. The most significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the loss reserve that is required. A key assumption in estimating loss reserves is the degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact this assumption. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount could be. Accordingly, short-tail liability claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with loss reserve estimates. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory and legal environments, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its loss reserve by looking at historical patterns and trends and projecting these out to current loss reserves. The underlying factors and assumptions that serve as the basis for preparing the loss reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company also engages independent actuarial consultants to review the Company’s loss reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company analyzes loss reserves quarterly primarily using the incurred loss, paid loss, average severity coupled with the claim count development methods, and the generalized linear model ("GLM") described below. When deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of insurance business or coverage within a line of insurance business. The Company may also evaluate qualitative factors such
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as known changes in laws or legal rulings that could affect claims handling or other external environmental factors or internal factors that could affect the settlement of claims. When establishing the loss reserve, the Company generally analyzes the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
•The incurred loss method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of insurance business which have a long operating history.
•The paid loss method analyzes historical payment patterns to estimate the amount of losses yet to be paid.
•The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing loss reserves. The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
•The GLM determines an average severity for each percentile of claims that have been closed as a percentage of estimated ultimate claims. The average severities are applied to open claims to estimate the amount of losses yet to be paid. The GLM utilizes operational time, determined as a percentile of claims closed rather than a finite calendar period, which neutralizes the effect of changes in the timing of claims handling.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses, the Company generally determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on loss reserves established by adjusters and average losses on previous similar catastrophes. For catastrophe losses on individual properties that are expected to be total losses, the Company typically establishes reserves at the policy limits.
There are many factors that can cause variability between the ultimate expected loss and the actual developed loss. While there are certainly other factors, the Company believes that the following three items tend to create the most variability between expected losses and actual losses.
(1) Inflation
For the Company’s California automobile lines of insurance business, total reserves are comprised of the following:
•BI reserves—approximately 70% of total reserves
•Material damage ("MD") reserves, including collision and comprehensive property damage—approximately 10% of total reserves
•Loss adjustment expense reserves—approximately 20% of total reserves.
Loss development on MD reserves is generally insignificant because MD claims are generally settled in a shorter period than BI claims. The majority of the loss adjustment expense reserves are estimated costs to defend BI claims, which tend to require longer periods of time to settle as compared to MD claims.
BI loss reserves are generally the most difficult to estimate because they take longer to close than other coverages. BI coverage in the Company’s policies includes injuries sustained by any person other than the insured, except in the case of uninsured or underinsured motorist BI coverage, which covers damages to the insured for BI caused by uninsured or underinsured motorists. BI payments are primarily for medical costs and general damages.
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The following table presents the typical closure patterns of BI claims in the Company's California personal automobile insurance coverage:
% of Total
Claims Closed Dollars Paid
BI claims closed in the accident year reported 37% 12%
BI claims closed one year after the accident year reported 79% 51%
BI claims closed two years after the accident year reported 93% 75%
BI claims closed three years after the accident year reported 97% 88%
BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $6,000 to $7,000 on average, whereas the total average settlement, once all claims are closed for a particular accident year, is approximately $16,000 to $22,000. The Company creates incurred and paid loss triangles to estimate ultimate losses utilizing historical payment and reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI loss reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity. As a larger proportion of claims from an accident year are settled, there emerges a higher degree of certainty for the loss reserves established for that accident year. At December 31, 2021, the accident years that are most likely to develop are the 2019 through 2021 accident years; however, it is possible that older accident years could develop as well.
In general, the Company expects that historical claims trends will continue with costs tending to increase, which is generally consistent with historical data, and therefore the Company believes that it is reasonable to expect inflation to continue. Many potential factors can affect the BI inflation rate, including changes in claims handling process, changes in statutes and regulations, the number of litigated files, increased use of medical procedures such as MRIs and epidural injections, general economic factors, timeliness of claims adjudication, vehicle safety, weather patterns, social inflation, and gasoline prices, among other factors; however, the magnitude of the impact of such factors on the inflation rate is unknown.
The Company began experiencing a significant decrease in loss frequency in March of 2020 primarily resulting from the shelter-in-place orders issued by state and local governments in response to the COVID-19 pandemic, although it began to increase as more drivers returned to the road following the gradual reopening of businesses in California and other states. In addition, the COVID-19 pandemic created greater uncertainty in the reserve estimates: A greater number of large claims may emerge from the 2020 and 2021 accident years compared to the prior accident years as claimants may be reluctant to go to a medical provider due to the pandemic but subsequently seek monetary compensation to ease the economic hardship attributable to the pandemic. A lower percentage of minor accidents with lower average severity experienced during the pandemic are likely to push the total average severity higher. There is reduced subrogation potential due to increased single-vehicle accidents during 2020 and 2021. Automobile parts and labor costs will be higher if further supply shortages emerge due to the prolonged pandemic. Based on these factors and uncertainty attributable to the pandemic, the reserve estimates for the 2020 and 2021 accident years are subject to a greater degree of variability.
The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 12%, 8% and 6% for 2021, 2020 and 2019 accident years, respectively; however, the variation could be more or less than these amounts.
During the years 2017 through 2021, the changes in the loss severity amounts for the three preceding accident years from the prior year amounts (BI severity variance from prior year) have ranged as follows:
High Low
Immediate preceding accident year 2.0% (5.1)%
Second preceding accident year 7.5% 0.1%
Third preceding accident year 5.2% (1.0)%
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The following table presents the effects on the California automobile BI loss reserves for the 2021, 2020 and 2019 accident years based on possible variations in the severity recorded; however, the actual variations could be more or less than these amounts:
California Automobile Bodily Injury Inflation Reserve Sensitivity Analysis
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(1) Implied inflation rate is calculated by dividing the difference between the current and prior year actual recorded severity by the prior year actual recorded severity. The Company believes that severity increases are caused by litigation, medical costs, inflation, and increased utilization of medical procedures.
(2) The Company began experiencing a significant decrease in loss frequency in March of 2020 resulting from the shelter-in-place orders issued by state and local governments in response to the COVID-19 pandemic, although it began to increase as more drivers returned to the road following the gradual reopening of businesses in California and other states., which led to the smaller number of claims expected for the 2020 and 2021 accident years compared to the prior accident years. Conversely, a higher percentage of high-speed serious accidents on less congested roads combined with a lower percentage of minor accidents had the effect of increasing the actual recorded severity across the total claims population for the 2020 and 2021 accident years compared to the prior accident years.
(2) Claim Count Development
The Company generally estimates ultimate claim counts for an accident period based on development of claim counts in prior accident periods. Typically, almost every claim is reported within one year following the end of an accident year and at that point the Company has a high degree of certainty as to the ultimate claim count. There are many factors that can affect the number of claims reported after an accident period ends. These factors include changes in weather patterns, a change in the number of litigated files, the number of automobiles insured, and whether the last day of the accident period falls on a weekday or a weekend. However, the Company is unable to determine which, if any, of the factors actually impact the number of claims reported and, if so, by what magnitude.
The COVID-19 pandemic created greater uncertainty in the claims count development for the 2020 and 2021 accident years. The Company believes that the reduced services for non-critical cases at medical facilities and fear of infection during the pandemic combined with the economic hardship caused by the pandemic are likely to increase the late reporting of claims seeking settlement for monetary compensation. At December 31, 2021, there were 19,346 California automobile BI claims reported for the 2021 accident year and the Company estimates that these are expected to ultimately grow by approximately 6.0%. The Company believes that while actual development in recent years has ranged approximately from 3% to 7%, it is reasonable to expect that the range of the development for the 2021 accident year is subject to greater variability due to uncertainty related to the pandemic and could be as great as between 0% and 10%, as it expects an increase in late reporting of claims given the high level of uncertainty in claims reporting patterns associated with the COVID-19 pandemic. However, actual development may be more or less than the expected range.
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The following table presents the effects on loss development of different claim counts within the broader possible range at December 31, 2021:
California Automobile Bodily Injury Claim Count Reserve Sensitivity Analysis
Approximate average cost per claim Not meaningful $ 21,796 $ 21,796 $ 21,796
(3) Unexpected Losses From Older Accident Periods
Unexpected losses are generally not provided for in the current loss reserve because they are not known or expected and tend to be unquantifiable. Once known, the Company establishes a provision for the losses, but it is not possible to provide any meaningful sensitivity analysis as to the potential size of any unexpected losses. These losses can be caused by many factors, including unexpected legal interpretations of coverage, ineffective claims handling, regulations extending claims reporting periods, assumption of unexpected or unknown risks, adverse court decisions as well as many unknown factors. During 2021, the Company incurred losses totaling approximately $8 million on two separate large claims from accident periods prior to 2018. These are related to provisions made for the likelihood of adverse legal outcomes based on the latest information available.
Unexpected losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected losses in future periods. It is also possible that the Company has not identified and established a sufficient loss reserve for all material unexpected losses occurring in the older accident years, even though a comprehensive claims file review was undertaken. The Company may experience additional development on these loss reserves.
Discussion of Losses and Loss Reserves and Prior Period Loss Development
At December 31, 2021 and 2020, the Company recorded its point estimate of approximately $2.23 billion and $1.99 billion ($2.19 billion and $1.94 billion, net of reinsurance), respectively, in loss and loss adjustment expense reserves, which included approximately $1.03 billion and $0.89 billion ($1.01 billion and $0.86 billion, net of reinsurance), respectively, of incurred-but-not-reported liabilities ("IBNR"). IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2021 and 2020, and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company evaluates its loss reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For 2021, the Company reported favorable development of approximately $26 million on the 2020 and prior accident years’ loss and loss adjustment expense reserves. The favorable development in 2021 was primarily attributable to lower than estimated losses and loss adjustment expenses in the homeowners and private passenger automobile lines of insurance business, partially offset by unfavorable development in the commercial automobile and commercial property lines of insurance business.
The Company recorded catastrophe losses net of reinsurance of approximately $104 million in 2021. Catastrophe losses due to the events that occurred during 2021 totaled approximately $109 million, with no reinsurance benefits used for these losses. The majority of the 2021 catastrophe losses resulted from the deep freeze and other extreme weather events in Texas and Oklahoma, rainstorms, wildfires and winter storms in California, and the impact of Hurricane Ida in New Jersey and New York. These losses were partially offset by favorable development of approximately $5 million on prior years' catastrophe losses.
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RESULTS OF OPERATIONS
Year Ended December 31, 2021 Compared to Year Ended December 31, 2020
Revenues
Net premiums earned and net premiums written in 2021 increased 5.2% and 6.8%, respectively, from 2020. The Company's net premiums earned and written in 2020 were each reduced by approximately $128 million due to premium refunds and credits to its eligible policyholders associated with the "Mercury Giveback" program for reduced driving and business activities following the outbreak of the COVID-19 pandemic. The increase in net premiums earned and written was primarily due to these premium refunds and credits in 2020, higher average premiums per policy arising from rate increases in the California homeowners line of insurance business, and increases in the number of policies written outside of California, partially offset by a decrease in the number of private passenger automobile and homeowners policies written in California. Excluding premium refunds and credits in 2020, net premiums earned and net premiums written in 2021 increased 1.6% and 3.1%, respectively, from 2020.
Net premiums earned included ceded premiums earned of $65.0 million and $56.2 million in 2021 and 2020, respectively. Net premiums written included ceded premiums written of $65.5 million and $50.6 million in 2021 and 2020, respectively. The increase in ceded premiums earned and written resulted mostly from higher reinsurance coverage and rates and growth in the covered book of business.
Net premiums earned, a GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the periods presented and earned on a pro-rata basis over the term of the policies. Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels.
The following is a reconciliation of total net premiums earned to net premiums written:
Year Ended December 31,
(Amounts in thousands)
Expenses
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Company's consolidated loss, expense, and combined ratios determined in accordance with GAAP:
Year Ended December 31,
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by favorable development of approximately $26 million and unfavorable development of approximately $23 million on prior accident years’ loss and loss adjustment expense reserves for the years ended December 31, 2021 and 2020, respectively. The favorable development in 2021 was primarily attributable to lower than estimated losses and loss adjustment expenses in the homeowners and private passenger automobile lines of insurance business, partially offset by unfavorable development in the commercial automobile and commercial property lines of insurance business, while the unfavorable development in 2020 was primarily attributable to higher than estimated losses and loss adjustment expenses in the homeowners and commercial automobile lines of insurance business, partially offset by favorable development in the private passenger automobile line of insurance business.
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The 2021 loss ratio was negatively impacted by a total of approximately $109 million of catastrophe losses, excluding favorable development of approximately $5 million on prior years' catastrophe losses, primarily due to the deep freeze and other extreme weather events in Texas and Oklahoma, rainstorms, wildfires and winter storms in California, and the impact of Hurricane Ida in New Jersey and New York. The 2020 loss ratio was negatively impacted by a total of approximately $69 million of catastrophe losses, excluding favorable development of approximately $5 million on prior years' catastrophe losses, primarily due to wildfires and windstorms in California and extreme weather events outside of California.
Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 71.5% and 64.8% for the years ended December 31, 2021 and 2020, respectively. The increase in the loss ratio was primarily due to an increase in loss frequency and severity in the private passenger automobile line of insurance business, partially offset by higher average premiums per policy arising from rate increases in the California homeowners line of insurance business and a decrease in net premiums earned in 2020 related to premium refunds and credits under the "Mercury Giveback" program as described above. After bottoming out in the second quarter of 2020, loss frequency has been increasing and is near pre-pandemic levels for some coverages and exceeds pre-pandemic levels for the comprehensive coverage due to a rise in vehicle thefts and property crimes. Automobile loss severity is high due to inflationary pressures currently affecting the economy.
Expense ratio is calculated by dividing the sum of policy acquisition costs and other operating expenses by net premiums earned. The decrease in the expense ratio is largely due to a decrease in net premiums earned in 2020 related to premium refunds and credits under the "Mercury Giveback" program as described above, without a corresponding decrease in policy acquisition costs and other operating expenses. The Company did not recoup commissions from its agents on the premiums returned to its eligible policyholders under the "Mercury Giveback" program. In addition, expenses for profitability-related accruals and allowance for credit losses on premiums receivable decreased, partially offset by increases in advertising and legal expenses.
Combined ratio is equal to loss ratio plus expense ratio and is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results.
Income tax expense was $51.4 million and $83.9 million for the years ended December 31, 2021 and 2020, respectively. The $32.5 million decrease in income tax expense was mainly due to a significant decrease in pre-tax income of $159.2 million.
The Company’s effective income tax rate can be affected by several factors. These generally include large changes in fully-taxable income including net realized investment gains or losses, tax-exempt investment income, nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. Tax-exempt investment income of approximately $74 million coupled with pre-tax income of approximately $299 million resulted in an effective tax rate of 17.2%, below the statutory tax rate of 21%, in 2021, and tax-exempt investment income of approximately $78 million coupled with pre-tax income of approximately $459 million resulted in an effective tax rate of 18.3% in 2020.
Investments
The following table presents the investment results of the Company:
Year Ended December 31,
(Amounts in thousands)
Net investment income (2)
Average annual yield on investments (2)
Before income taxes 2.8 % 3.1 %
After income taxes 2.5 % 2.8 %
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(1)Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each period.
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(2)Net investment income before and after income taxes decreased primarily due to a lower average yield on investments, partially offset by higher average invested assets. Average annual yield on investments before and after income taxes decreased primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher with lower yielding investments, as a result of decreasing market interest rates.
The following tables present the components of net realized investment gains (losses) included in net income:
Gains (Losses) Recognized in Income
Sales Changes in fair value Total
(Amounts in thousands)
Net realized investment gains (losses):
Note receivable (1) — (4) (4)
Gains (Losses) Recognized in Income
Sales Changes in fair value Total
(Amounts in thousands)
Net realized investment gains (losses):
Note receivable (1) — 60 60
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(1)The changes in fair value of the investment portfolio and note receivable resulted from the application of the fair value option.
(2)The decrease in fair value of fixed maturity securities in 2021 was primarily due to increases in market interest rates, and the increase in fair value of fixed maturity securities in 2020 was primarily due to decreases in market interest rates.
(3)The increases in fair value of equity securities in 2021 and 2020 were primarily due to the overall improvement in equity markets.
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Net Income
Year Ended December 31,
(Amounts in thousands, except per share data)
Basic Per Share Data:
Net realized investment gains, net of tax $ 1.59 $ 1.22
Diluted Per Share Data:
Net realized investment gains, net of tax $ 1.59 $ 1.22
Year Ended December 31, 2020 Compared to Year Ended December 31, 2019
See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Form 10-K for the year ended December 31, 2020 for a discussion of changes in its results of operations from the year ended December 31, 2019 to the year ended December 31, 2020.
LIQUIDITY AND CAPITAL RESOURCES
A. General
The Company is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay ordinary dividends of approximately $252 million in 2022 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of $191 million during 2021. As of December 31, 2021, Mercury General had approximately $186 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The principal sources of funds for the Insurance Companies are premiums, sales and maturity of invested assets, and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General, and the purchase of investments.
B. Cash Flows
The Company has generated positive cash flow from operations since the public offering of its common stock in November 1985. The Company does not attempt to match the duration and timing of asset maturities with those of liabilities; rather, it manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $475.7 million at December 31, 2021 as well as a $75 million revolving credit facility, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs or for future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
Net cash provided by operating activities for the year ended December 31, 2021 was $501.6 million, a decrease of $104.0 million compared to the year ended December 31, 2020. The decrease was primarily due to increases in payments for losses and loss adjustment expenses, underwriting expenses and income taxes, and a decrease in collections from reinsurers on reinsurance recoverables, partially offset by an increase in premium collections. The Company utilized the cash provided by operating activities during the year ended December 31, 2021 primarily for the net purchases of investment securities and payment of dividends to its shareholders. The average annual net cash provided by operating activities for the past 10 years was
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approximately $344 million, and cash generated from operations was sufficient to meet the liquidity requirements over this period.
The following table presents the estimated fair value of fixed maturity securities at December 31, 2021 by contractual maturity in the next five years.
Fixed Maturity Securities
(Amounts in thousands)
Due in one year or less $ 403,269
Due after one year through two years 227,350
Due after two years through three years 105,851
Due after three years through four years 166,889
Due after four years through five years 291,789
See "D. Debt" below for cash flow related to outstanding debt.
C. Invested Assets
Portfolio Composition
An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well-diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company believes that this strategy enables the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a market risk and consistent asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.
The following table presents the composition of the total investment portfolio of the Company at December 31, 2021:
Cost(1) Fair Value
(Amounts in thousands)
Fixed maturity securities:
Equity securities:
Private equity funds measured at net asset value (2) 128,726 108,414
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(1)Fixed maturities and short-term bonds at amortized cost and equities and other short-term investments at cost.
(2)The fair value is measured using the net asset value practical expedient. See Note 4. Fair Value Measurements, of the
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Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data" for additional information.
At December 31, 2021, 46.7% of the Company’s total investment portfolio at fair value and 59.5% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 50% corporate dividend received deduction, and private equity funds. At December 31, 2021, 87.7% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis.
Fixed Maturity Securities and Short-Term Investments
Fixed maturity securities include debt securities, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations, or other economic factors. Short-term investments include money market accounts, options, and short-term bonds that are highly rated short duration securities and redeemable within one year.
A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The Company's portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity securities purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The holdings, that are heavily weighted with high coupon issues, are expected to be called prior to maturity. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a better indicator of price volatility than simple maturity alone.
The following table presents the maturities and durations of the Company's fixed maturity securities and short-term investments:
(in years)
Fixed Maturity Securities
Nominal average maturity:
excluding short-term investments 10.8 11.7
including short-term investments 10.4 10.6
Call-adjusted average maturities:
excluding short-term investments 4.6 4.1
including short-term investments 4.5 3.7
Modified duration reflecting anticipated early calls:
excluding short-term investments 3.5 3.4
including short-term investments 3.4 3.0
Short-Term Investments — —
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of A+, at fair valueat December 31, 2021, consistent with the average rating at December 31, 2020. The Company’s municipal bond holdings, of which 84.4% were tax exempt, represented 70.5% of its fixed maturity portfolio at December 31, 2021, at fair value, and were broadly diversified geographically.
To calculate the weighted-average credit quality ratings as disclosed throughout this Annual Report on Form 10-K, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each security’s average of ratings assigned by nationally recognized securities rating organizations.
Taxable holdings consist principally of investment grade issues. At December 31, 2021, fixed maturity holdings rated below investment grade and non-rated bonds totaled $7.1 million and $17.3 million, respectively, at fair value, and represented
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0.2% and 0.4%, respectively, of total fixed maturity securities. The majority of non-rated issues are a result of municipalities pre-funding and collateralizing those issues with U.S. government securities with an implicit AAA equivalent credit risk. At December 31, 2020, fixed maturity holdings rated below investment grade and non-rated bonds totaled $25.5 million and $38.4 million, respectively, at fair value, and represented 0.7% and 1.1%, respectively, of total fixed maturity securities.
Credit ratings for the Company's fixed maturity portfolio were stable in 2021, with 95.0% of fixed maturity securities at fair value experiencing no change in their overall rating. 2.5% of fixed maturity securities at fair value experienced upgrades in 2021, and approximately the same percentage experienced downgrades.
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The following table presents the credit quality ratings of the Company’s fixed maturity securities by security type at fair value:
Security Type AAA(1) AA(1) A(1) BBB(1) Non-Rated/Other (1) Total Fair Value(1)
(Dollars in thousands)
U.S. government bonds:
Municipal securities:
Mortgage-backed securities:
Non-agencies:
Corporate securities:
Basic materials — — — — — —
Collateralized loan obligations:
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(1)Intermediate ratings are included at each level (e.g., AA includes AA+, AA and AA-).
U.S. Government Bonds
The Company had $13.1 million and $13.8 million, or 0.3% and 0.4% of its fixed maturity portfolio, at fair value, in U.S. government bonds at December 31, 2021 and 2020, respectively. At December 31, 2021, Moody's and Fitch ratings for U.S.
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government issued debt were Aaa and AAA, respectively, although a significant increase in government deficits and debt could lead to a downgrade. The Company understands that market participants continue to use rates of return on U.S. government debt as a risk-free rate and have continued to invest in U.S. Treasury securities. The modified duration of the U.S. government bonds portfolio reflecting anticipated early calls was 0.9 years and 1.0 years at December 31, 2021 and 2020, respectively.
Municipal Securities
The Company had $2.84 billion and $2.79 billion, or 70.5% and 78.6% of its fixed maturity securities portfolio, at fair value, in municipal securities at December 31, 2021 and 2020, respectively, of which $424.1 million and $377.0 million, respectively, were insured by bond insurers. The underlying ratings for insured municipal bonds have been factored into the average rating of the securities by the rating agencies with no significant disparity between the absolute bond ratings and the underlying credit ratings as of December 31, 2021 and 2020.
At December 31, 2021 and 2020, respectively, 56.8% and 59.9% of the insured municipal securities, at fair value, most of which were investment grade, were insured by bond insurers that provide credit enhancement in addition to the ratings reflected by the financial strength of the underlying issuers. At December 31, 2021 and 2020, the average rating of the Company’s insured municipal securities was A+, which corresponded to the average rating of the investment grade bond insurers. The remaining 43.2% and 40.1% of insured municipal securities at December 31, 2021 and 2020, respectively, were insured by non-rated or below investment grade bond insurers that the Company believes did not provide credit enhancement. The modified duration of the municipal securities portfolio reflecting anticipated early calls was 3.1 years and 3.4 years at December 31, 2021 and 2020, respectively.
The Company considers the strength of the underlying credit as a buffer against potential market value declines which may result from future rating downgrades of the bond insurers. In addition, the Company has a long-term time horizon for its municipal bond holdings, which generally allows it to recover the full principal amounts upon maturity and avoid forced sales prior to maturity of bonds that have declined in market value due to the bond insurers’ rating downgrades. Based on the uncertainty surrounding the financial condition of these insurers, it is possible that there will be additional downgrades to below investment grade ratings by the rating agencies in the future, and such downgrades could impact the estimated fair value of those municipal bonds.
Mortgage-Backed Securities
At December 31, 2021 and 2020, respectively, the mortgage-backed securities portfolio of $137.0 million and $93.3 million, or 3.4% and 2.6% of the Company's fixed maturity securities portfolio, at fair value, was categorized as loans to "prime" residential and commercial real estate borrowers. The Company had holdings of $25.2 million and $17.6 million, at fair value, in commercial mortgage-backed securities at December 31, 2021 and 2020, respectively.
The weighted-average rating of the entire mortgage backed securities portfolio was AA at December 31, 2021 and 2020. The modified duration of the mortgage-backed securities portfolio reflecting anticipated early calls was 7.9 years and 6.4 years at December 31, 2021 and 2020, respectively.
Corporate Securities
At December 31, 2021 and 2020, respectively, the company had corporate securities of $523.9 million and $241.4 million, or 13.0% and 6.8% of its fixed maturity securities portfolio, at fair value. The weighted-average rating was BBB+ and A- at December 31, 2021 and 2020, respectively. The modified duration reflecting anticipated early calls was 3.8 years and 1.7 years at December 31, 2021 and 2020, respectively.
Collateralized Loan Obligations
The Company had collateralized loan obligations of $314.2 million and $256.9 million, which represented 7.8% and 7.2% of its fixed maturity securities portfolio, at fair value, at December 31, 2021 and 2020, respectively. The weighted-average rating was AA- at December 31, 2021 and 2020. The modified duration reflecting anticipated early calls was 6.3 years and 4.8 years at December 31, 2021 and 2020, respectively.
Other Asset-Backed Securities
The Company had other asset-backed securities of $200.2 million and $153.3 million, which represented 5.0% and 4.3% of its fixed maturity securities portfolio, at fair value, at December 31, 2021 and 2020, respectively. The weighted-average
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rating was AA- and AA+ at December 31, 2021 and 2020, respectively. The modified duration reflecting anticipated early calls was 2.6 years and 1.6 years at December 31, 2021 and 2020, respectively.
Equity Securities
Equity holdings of $970.9 million and $803.9 million, at fair value, as of December 31, 2021 and 2020, respectively, consisted of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 50% corporate dividend received deduction, and private equity funds. The net gains due to changes in fair value of the Company’s equity portfolio were $107.7 million and $32.2 million in 2021 and 2020, respectively. The primary cause for the increase in fair value of the Company's equity securities in 2021 and 2020 was the overall improvement in equity markets.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2021, 18.9% of the total investment portfolio, at fair value, was held in equity securities, compared to 17.0% at December 31, 2020.
The following table presents the equity security portfolio by industry sector at December 31, 2021 and 2020:
December 31,
Cost Fair Value Cost Fair Value
(Amounts in thousands)
Equity securities:
D. Debt
The Company's debt consists of the following:
December 31,
Lender Interest Rate Expiration 2021 2020
(Amounts in thousands)
Less unamortized discount and debt issuance costs(3) 2,069 2,468
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(1) On March 8, 2017, the Company completed a public debt offering issuing $375 million of senior notes. The notes are unsecured senior obligations of the Company, with a 4.4% annual coupon payable on March 15 and September 15 of each year commencing September 15, 2017. These notes mature on March 15, 2027. The Company used the proceeds from the notes to pay off the total outstanding balance of $320 million under the existing loan and credit facility agreements and terminated the agreements on March 8, 2017. The remainder of the proceeds from the notes was used for general corporate purposes. The Company incurred debt issuance costs of approximately $3.4 million, inclusive of underwriters' fees. The
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notes were issued at a slight discount of 99.847% of par, resulting in the effective annualized interest rate, including debt issuance costs, of approximately 4.45%.
(2) On March 29, 2017, the Company entered into an unsecured credit agreement (the "2017 Credit Agreement") that provided for revolving loans of up to $50 million and was set to mature on March 29, 2022. On March 31, 2021, the Company entered into an amended and restated credit agreement (the "Amended and Restated Credit Agreement") that amended and restated the 2017 Credit Agreement. The Amended and Restated Credit Agreement, among other things, extended the maturity date of the loan that was the subject of the 2017 Credit Agreement to March 31, 2026, added U.S. Bank as an additional lender, and increased the aggregate commitments by all the lenders to $75 million from $50 million under the 2017 Credit Agreement. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 20% to LIBOR plus 150.0 basis points when the ratio is greater than or equal to 30%. Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 20% to 22.5 basis points when the ratio is greater than or equal to 30%. The debt to total capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to total capital ratio was 14.9% at December 31, 2021, resulting in a 12.5 basis point commitment fee on the $75 million undrawn portion of the credit facility. As of February 15, 2022, there have been no borrowings under this facility.
(3) The unamortized discount and debt issuance costs are associated with the publicly traded $375 million senior unsecured notes. These are amortized to interest expense over the life of the notes, and the unamortized balance is presented in the Company's consolidated balance sheets as a direct deduction from the carrying amount of the debt. The unamortized debt issuance cost of approximately $0.2 million associated with the $75 million unsecured revolving credit facility maturing on March 31, 2026 is included in other assets in the Company's consolidated balance sheets and amortized to interest expense over the term of the credit facility.
The Company was in compliance with all of its financial covenants pertaining to minimum statutory surplus, debt to total capital ratio, and RBC ratio under the unsecured credit facility at December 31, 2021.
For a further discussion, see Note 8. Notes Payable, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
E. Uses of Capital
Dividends
Cash returned to shareholders through dividends in 2021, 2020 and 2019 totaled approximately $140.2 million, $139.6 million and $139.1 million, respectively. On February 11, 2022, the Board of Directors declared a $0.6350 quarterly dividend payable on March 30, 2022 to shareholders of record on March 16, 2022, with an expected payout of approximately $35 million. The Company currently expects quarterly dividends to continue in future periods and intends to increase its dividend on an annual basis, although the declaration and payment of any future cash dividends are at the discretion and subject to the approval of its Board of Directors. The decisions of the Company's Board of Directors regarding the amount and payment of dividends will depend on many factors, such as its financial condition, results of operations, capital requirements, business conditions, debt service obligations, industry practice, legal requirements, regulatory constraints, and other factors that its Board of Directors may deem relevant. The Company expects to fund its future dividend payments primarily with a combination of cash expected to be generated from future operations and cash and short-term investments on hand.