Mercury Insurance 2007 Annual Report Download - page 44

42 MERCURYNOW 2007
MANAGEMENT’S DISCUSSION & ANALYSIS
MANAGEMENT’S DISCUSSION & ANALYSIS
Overview
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, including the effect of natural disasters on losses, general economic
conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates and other factors
such as changes in tax laws.
The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through
a network of independent agents and brokers in thirteen states. The Company also offers homeowners insurance, mechanical breakdown
insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile and commercial property insurance. Private
passenger automobile lines of insurance accounted for approximately 84% of the $3 billion of the Company’s direct premiums written in 2007,
with approximately 79% of the private passenger automobile premiums written in California. The Company operates primarily in the state of
California, the only state in which it operated prior to 1990. The Company has since expanded its operations into the following states: Georgia
and Illinois (1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001), New Jersey (2003), and Arizona, Pennsylvania,
Michigan and Nevada (2004).
This overview discusses some of the relevant factors that management considers in evaluating the Company’s 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 and in the Company’s filings with
the Securities and Exchange Commission (“SEC”).
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 and establishing minimum capital and surplus requirements. In many states, insurance
commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners. The Company has
a successful track record of working with difficult regulations and new insurance commissioners. However, 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 analysis shows that they are needed.
• Inflation — The largest cost component for automobile insurers is losses, which include medical costs, replacement automobile parts and labor
costs. There can be significant variation in the overall increases in medical cost inflation and it is often a year or more 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. The
Company currently estimates low to mid single digit inflation rates on bodily injury coverages for its major California personal automobile lines
for the 2007 accident year. The inflation rate for this accident year is the most difficult to estimate because there remain many open claims.
Should actual inflation be higher, the Company could be under-reserved for its losses and profit margins would be lower.
• Loss Frequency —Another component of overall loss costs is loss frequency, which is the number of claims per risks insured. There has been
a long-term trend of declining loss frequency in the personal automobile insurance industry, followed by relatively flat loss frequency in more
recent years, which has benefited the industry as a whole. It is unknown if loss frequency in the future will decline, remain flat or increase.
• Underwriting Cycle and Competition — The property and casualty insurance industry is highly cyclical, with a hard market condition followed
by a soft market. The Company has historically seen premium growth in excess of 20% during hard markets. Premium growth rates in soft
markets have been in the single digits and in 2007 they were negative 2%. In management’s view, 2004 through 2007 was a period of very
profitable results for companies underwriting automobile insurance. Many in the industry began experiencing declining profitability in 2007 and
have initiated plans to increase rates. Consequently, the Company expects that the market will begin to transition from soft to hard in 2008.