Mercury Insurance 2010 Annual Report Download - page 54

fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date. Due to their short-term maturity,
the carrying value of receivables and accounts payable approximate their fair market values. All investments are
carried on the balance sheets at fair value, as disclosed in Note 1 of Notes to Consolidated Financial Statements.
The Company’s financial instruments include securities issued by the U.S. government and its agencies,
securities issued by state and municipal governments and agencies, certain corporate and other debt securities,
corporate equity securities, and exchange traded funds. Over 98% of the fair value of the financial instruments
held at December 31, 2010 is based on observable market prices, observable market parameters, or is derived
from such prices or parameters. The availability of observable market prices and pricing parameters can vary
across different financial instruments. Observable market prices and pricing parameters for a financial
instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
Certain financial instruments that the Company holds or acquires may lack observable market prices or
market parameters currently or in future periods because they are less actively traded. The fair value of such
instruments is determined using techniques appropriate for each particular financial instrument. These techniques
may involve some degree of judgment. The price transparency of the particular financial instrument will
determine the degree of judgment involved in determining the fair value of the Company’s financial instruments.
Price transparency is affected by a wide variety of factors, including, for example, the type of financial
instrument, whether it is a new financial instrument and not yet established in the marketplace, and the
characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing
parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will
generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or
not quoted will generally have diminished price transparency. Even in normally active markets, the price
transparency for actively quoted instruments may be reduced at times during periods of market
dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and
sell a financial instrument provides a source of transparency for products that otherwise is not actively
quoted. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.
Income Taxes
At December 31, 2010, the Company’s deferred income taxes were in a net asset position materially due to
unearned premiums, expense accruals, loss reserve discounting, tax credit carryforward, and deferred tax
recognition of capital losses. The Company assesses the likelihood that its deferred tax assets will be realized
and, to the extent management does not believe these assets are more likely than not to be realized, a valuation
allowance is established.
Management’s recoverability assessment of its deferred tax assets which are ordinary in character takes into
consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation
that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to
recoup its ordinary deferred tax assets against taxes paid in prior years. Finally, the Company has various
deferred tax liabilities which represent sources of future ordinary taxable income.
Management’s recoverability assessment with regards to its capital deferred tax assets is based on estimates
of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of
which would contribute to the realization of deferred tax benefits. The Company expects to hold certain
quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes
unrealized losses related to the majority of these debt securities are not subject to default risk. Thus, the principal
amounts are believed to be fully realizable at maturity. The Company has a long-term horizon for holding these
securities, which management believes will allow avoidance of forced sales prior to maturity. The Company also
has unrealized gains in its investment portfolio which could be realized through asset dispositions, at
management’s discretion. Further, the Company has the capability to generate additional realized capital gains by
entering into a sale-leaseback transaction using one or more of its appreciated real estate holdings. Finally, the
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