Mercury Insurance 2008 Annual Report Download - page 38

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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.
• Market Volatility - The prolonged and severe disruptions in the public debt and equity markets, including among other
things, widening of credit spreads, bankruptcies and government intervention in a number of large financial
institutions, have resulted in significant losses in the Company’s investment portfolio As a result, depending on
market conditions, the Company may incur substantial additional losses in future periods, which could have a material
adverse impact on its results of operations, equity, business and insurer financial strength and debt ratings.
• 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.
• 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,
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
alternating hard and soft market conditions. The Company has historically seen premium growth in excess of 20%
during hard markets. Premium growth rates in soft markets have been from slightly positive to negative and in 2008
they were negative 8%. 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 2008 and are now increasing rates. Rate increases generally indicate that the market is hardening.
Revenues, Income and Cash Generation
The Company generates its revenues through the sale of insurance policies, primarily covering personal automobiles and
homeowners. These policies are sold through independent agents and brokers who receive a commission averaging 17% of net
premiums written for selling and servicing policies.
During 2008, the Company continued its marketing efforts for name recognition and lead generation. The Company
believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation make the
Company very competitive in California and in other states. Net advertising expenditures were approximately $26 million and
$28 million during 2008 and 2007, respectively.
The Company believes that it has a thorough underwriting process that gives the Company an advantage over its
competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages
because it allows the Company to charge lower prices yet realize better margins than many competitors.
The Company also generated income from its investment portfolio. Approximately $151 million in pre-tax investment
income was generated during 2008 on a portfolio of approximately $2.9 billion at fair market value at December 31, 2008,
compared to $159 million pre-tax investment income during 2007 on a portfolio of approximately $3.6 billion at fair market value
at December 31, 2007. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and
limiting interest rate and credit risk.