Mercury Insurance 2007 Annual Report Download - page 59

2007 MERCURYNOW 57
MANAGEMENT’S DISCUSSION & ANALYSIS
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The Company is subject to various market risk exposures including interest rate risk and equity price risk. The following disclosure reflects estimates
of future performance and economic conditions. Actual results may differ.
The Company invests its assets primarily in fixed maturity investments, which at December 31, 2007 comprised approximately 80% of total
investments at fair value. Tax-exempt bonds represent 85% of the fixed maturity investments with the remaining amount consisting of sinking
fund preferred stocks and taxable bonds. Equity securities account for approximately 12% of total investments at fair value. The remaining 8% of
the investment portfolio consists of highly liquid short-term investments which are primarily short-term money market funds.
The value of the fixed maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio increases
and vice versa. A common measure of the interest sensitivity of fixed maturity assets is modified duration, a calculation that utilizes maturity,
coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is
to market interest rate fluctuations.
The Company has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and holding assets
to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment
philosophy resulted in a portfolio with a moderate duration. Bond investments made by the Company typically have call options attached, which
further reduce the duration of the asset as interest rates decline. The modified duration of the bond portfolio is 4.4 years at December 31, 2007
compared to 4.0 years and 2.9 years at December 31, 2006 and 2005, respectively. Given a hypothetical parallel increase of 100 basis points in
interest rates, the fair value of the bond portfolio at December 31, 2007 would decrease by approximately $140 million.
At December 31, 2007, the Company’s primary objective for common equity investments is current income with a secondary objective of
capital appreciation. The fair value of the equity investment consists of $400.6 million in common stocks and $27.7 million in non-sinking fund
preferred stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market. The non-sinking
fund preferred stocks are typically valued using credit spreads to U.S. Treasury benchmarks. This causes them to be comparable to fixed income
securities in terms of interest rate risk.
At December 31, 2007, the duration on the Company’s non-sinking fund preferred stock portfolio was 11.8 years. This implies that an upward
parallel shift in the yield curve by 100 basis points would reduce the asset value at December 31, 2007 by approximately $2.7 million, with all
other factors remaining constant.
The common equity portfolio represents approximately 11% of total investments at fair value. Beta is a measure of a security’s systematic
(non-diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in the return of the market. The average
Beta for the Company’s common stock holdings was 1.10. Based on a hypothetical 20% reduction in the overall value of the stock market, the fair
value of the common stock portfolio would decrease by approximately $86 million.
Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on its $125 million fixed 7.25% rate senior
notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes.
FORWARD-LOOKING STATEMENTS
Certain statements in this report or in other materials the Company has filed or will file with the SEC (as well as information included in oral
statements or other written statements made or to be made by us) contain or may contain “forward-looking statements” within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking
statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position,
expenditures, financial results and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors
and events that could cause the Company’s actual business, prospects and results of operations to differ materially from the historical information
contained in this Annual Report and from those that may be expressed or implied by the forward-looking statements contained in this Annual
Report and in other reports or public statements made by us.
Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California automobile
insurance markets, the Company’s success in expanding its business in states outside of California, the impact of potential third party “bad-faith”
legislation, changes in laws or regulations, the outcome of tax position challenges by the California FTB, and decisions of courts, regulators
and governmental bodies, particularly in California, the Company’s ability to obtain and the timing of the approval of the California DOI for
premium rate changes for private passenger automobile policies issued in California and similar rate approvals in other states where the Company
does business, the level of investment yields the Company is able to obtain with its investments in comparison to recent yields and the market risk
associated with its investment portfolio, the cyclical and general competitive nature of the property and casualty insurance industry and general
uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies, uncertainties related
to assumptions and projections generally, inflation and changes in economic conditions, changes in driving patterns and loss trends, acts of war
and terrorist activities, court decisions and trends in litigation and health care and auto repair costs, and other uncertainties, and all of which are