Mercury Insurance 2010 Annual Report Download - page 81

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a
claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of
litigation, medical costs, the cost of repair materials, or labor rates, among other factors, can all impact ultimate
claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between
the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement
amount can be. Accordingly, short-tail property damage claims tend to be more reasonably predictable than long-
tail liability claims. Management believes that the liability for losses and loss adjustment expenses is adequate to
cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions for loss
reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count, average
severity, and paid loss development methods described below. The Company uses the paid loss development
method to analyze loss adjustment expenses reserves as part of its reserve analysis. When deciding which method
to use in estimating its reserves, the Company evaluates the credibility of each method based on the maturity of
the data available and the claims settlement practices for each particular line of business or coverage within a line
of business. When establishing the reserve, the Company will generally analyze the results from all of the
methods used rather than relying on one method. While these methods are designed to determine the ultimate
losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use
historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis
in estimating loss reserves.
• The incurred loss development method analyzes historical incurred case loss (case reserves plus paid
losses) development to estimate ultimate losses. The Company applies development factors against
current case incurred losses by accident period to calculate ultimate expected losses. The Company
believes that the incurred loss development method provides a reasonable basis for evaluating ultimate
losses, particularly in the Company’s larger, more established lines of business which have a long
operating history.
• The claim count development method analyzes historical claim count development to estimate future
incurred claim count development for current claims. The Company applies development factors
against current claim counts by accident period to calculate ultimate expected claim counts.
• 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 provide meaningful information regarding inflation and frequency trends
that the Company believes is useful in establishing reserves.
• The paid loss development method analyzes historical payment patterns to estimate the amount of
losses yet to be paid. The Company uses this method for losses and loss adjustment expenses.
The Company analyzes catastrophe losses separately from non-catastrophe losses. For catastrophe losses,
the Company determines claim counts based on claims reported and development expectations from previous
catastrophes and applies an average expected loss per claim based on reserves established by adjusters and
average losses on previous similar catastrophes.
Derivative Financial Instruments
The Company accounts for all derivative instruments, other than those that meet the normal purchases and
sales exception, as either an asset or liability measured at fair value, which is based on information obtained from
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