Mercury Insurance 2007 Annual Report Download - page 70

68 MERCURYNOW 2007
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
labor rates can impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between
the occurrence of a loss and the payment or settlement of the 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 development, average severity and claim count development
methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves and industry
claims data as part of its reserve analysis. When deciding which method to use in estimating its reserves, the Company and its actuaries evaluate
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 these 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 provides 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 primarily
uses this method for loss adjustment expenses because specific case reserves are generally not established for loss adjustment expenses.
In states with little operating history where there are insufficient claims data to prepare a reserve analysis relying solely on Company historical
data, the Company generally projects ultimate losses using industry average loss data or expected loss ratios. As the Company develops an operating
history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development
methods. The Company analyzes catastrophe losses separately from non-catastrophe losses. For these 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 storms.
DEPRECIATION AND AMORTIZATION
Buildings are stated at the lower of cost or fair value and depreciated on a straight line basis over 30 years. Furniture and equipment and
purchased software are stated at cost and depreciated on a combination of straight-line and accelerated methods over 3 to 10 years. Automobiles
are depreciated over 5 years, using an accelerated method. Internally developed computer software is capitalized in accordance with Statement of
Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” and amortized on a straight-line method
over the estimated useful life of the software, not exceeding five years. Leasehold improvements are stated at cost and amortized over the life of
the associated lease.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company accounts for derivative financial instruments in accordance with SFAS No. 133, as amended by SFAS No. 138, “Accounting for
Certain Derivative Instruments and Hedging Activities,” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and
Hedging Activities.” The Company has entered into a hedge transaction that converts fixed rate debt to variable rate debt, effectively hedging the
change in fair value of the fixed rate debt resulting from fluctuations in interest rates. The carrying values of the derivative designated as a fair
value hedging instrument and the fixed rate debt are adjusted to fair values in accordance with SFAS No. 133, as amended, as discussed in Note
5 of Notes to Consolidated Financial Statements.