Mercury Insurance 2008 Annual Report Download - page 41

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The California Franchise Tax Board (“FTB”) has audited the 1997 through 2002 and 2004 tax returns and accepted the
1997 through 2000 returns to be correct as filed. The Company received a notice of examination for the 2003 tax return from the
FTB in January 2008. For the Company’ s 2001, 2002, and 2004 tax returns, the FTB has taken exception to the state
apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from Mercury
Insurance Services, LLC, a subsidiary of Mercury Casualty Company, that are excluded from the Mercury General California
Franchise tax return, should be included in the California apportionment factors. In addition, for the 2004 tax return, the FTB has
asserted that a portion of management fee expenses paid by Mercury Insurance Services, LLC should be disallowed. Based on
these assertions, the FTB has issued notices of proposed tax assessments for the 2001, 2002 and 2004 tax years totaling
approximately $5 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the
assessments before the California State Board of Equalization (“SBE”). An unfavorable ruling against the Company may have a
material impact on the Company’ s results of operations in the period of such ruling. Management believes that the issue will
ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail on this matter.
The Company is also involved in legal proceedings incidental to its insurance business. See Note 14 of Notes to
Consolidated Financial Statements—Commitments and Contingencies—Litigation.
Critical Accounting Estimates
Reserves
The preparation of the Company’ s consolidated financial statements requires judgment and estimates. The most
significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting and
Reporting by Insurance Enterprises” (“SFAS No. 60”), and Statement of Financial Accounting Standards No. 5, “Accounting for
Contingencies” (“SFAS No. 5”). Estimating loss reserves is a difficult process as many factors can ultimately affect the final
settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of
litigation, medical costs, the cost of repair materials and labor rates, among other factors, can all impact ultimate claim costs. In
addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the
payment or settlement of a claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as
property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company calculates a point estimate rather than a range of loss reserve estimates. There is inherent uncertainty with
estimates and this is particularly true with estimates for loss reserves. This uncertainty comes from many factors which may
include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over
inflation rates and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather
it considers them in establishing its reserve by looking at historical patterns and trends and projecting these out to current
reserves. The underlying factors and assumptions that serve as the basis for preparing the reserve estimate include paid and
incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other
relevant information.
The Company also engages independent actuarial consultants to review the Company’ s reserves and to provide the
annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on actuarial
consultants for GAAP reporting or periodic report disclosure purposes.
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 evaluates 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.