Mercury Insurance 2015 Annual Report Download - page 49

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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 financial instruments may be reduced 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 are not actively quoted. For a further discussion, see Note
4. Fair Value Measurement, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary
Data."
Income Taxes
At December 31, 2015, the Company’s deferred income taxes were in a net asset position mainly due to deferred tax assets
generated by unearned premiums, alternative minimum tax credit carryforwards, expense accruals and loss reserve discounting.
These deferred tax assets were substantially offset by deferred tax liabilities resulting from deferred acquisition costs and unrealized
gains on securities held. 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 the Company’s 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 through
tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities that represent
sources of future ordinary taxable income.
Management’s recoverability assessment with regard to its capital deferred tax assets is based on estimates of anticipated
capital gains, tax-planning strategies available to generate future taxable capital gains, and the Company's capacity to absorb
capital losses carried back to prior years, each of which would contribute to the realization of deferred tax benefits. The Company
has significant unrealized gains in its investment portfolio that could be realized through asset dispositions, at management’s
discretion. In addition, the Company expects to hold certain debt securities, which are currently in loss positions, to recovery or
maturity. Management believes unrealized losses related to these debt securities, which represent a portion of the unrealized loss
positions at period-end, are fully realizable at maturity. Management believes its long-term time horizon for holding these securities
allows it to avoid any forced sales prior to maturity. Further, the Company has the capability to generate additional realized capital
gains by entering into sale-leaseback transactions using one or more of its appreciated real estate holdings. Finally, the Company
has the capacity to recoup capital deferred tax assets through tax capital loss carryback claims for taxes paid within permitted
carryback periods.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash
flow from operations and believes that its cash flow needs can be met in future periods without the forced sale of its investments.
This capability assists management in controlling the timing and amount of realized losses generated during future periods. By
prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability to generate
capital gains and minimize tax losses in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management
will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management
believes it is more likely than not that the Company’s deferred tax assets will be realized.
The Company’s effective income tax rate can be affected by several factors. These generally include tax-exempt investment
income, other nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits
related to tax uncertainties. The effective tax rate was (5.5)% for 2015, compared to 28.1% for 2014. The decrease in the effective
tax rate is mainly due to a $176.9 million decrease in total pre-tax income for 2015 compared to the total pre-tax income for 2014,
while tax-exempt investment income, a component of total pre-tax income, remained relatively consistent. The decrease in pre-
tax income was primarily due to a shift from net realized investment gains of $81.2 million in 2014 to net realized investment
losses of $83.8 million in 2015. The Company’s effective tax rate for the year ended December 31, 2015 was lower than the
statutory tax rate primarily as a result of tax-exempt investment income earned.
Contingent Liabilities
The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or
regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities
and accrues for them and/or discloses them in the notes to the consolidated financial statements where required. 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, results of operations, or cash flows. See "Regulatory and