Mercury Insurance 2008 Annual Report Download - page 47

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Fair Value of Financial Instruments
Certain financial assets and financial liabilities are recorded at fair value. The fair value of a financial instrument is the
price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at
the measurement date. The fair values of the Company’s financial instruments are generally based on, or derived from, executable
bid prices. In the case of financial instruments transacted on recognized exchanges, the observable prices represent quotations for
completed transactions from the exchange on which the financial instrument is principally traded.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued
by states and municipalities, certain corporate and other debt securities, corporate equity securities, and exchange traded
funds. Over 99% of the fair value of the financial instruments held at December 31, 2008 is based on observable market prices,
observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and
pricing parameters can vary across different financial instruments. Observable market prices and pricing parameters in a financial
instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
Certain financial instruments that the Company holds or may acquire may lack observable market prices or market
parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined
using techniques appropriate for each particular financial instrument. These techniques may involve some degree of
judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in
determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors,
including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the
marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing
parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a
higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have
diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be
reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of
market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise is
not actively quoted. For a further discussion, see Note 2 of Notes to Consolidated Financial Statements—Investments and
Investment Income—Fair Value of Investments in 2008.
Income Taxes
At December 31, 2008, the Company’s deferred income taxes were in a net asset position, compared to a net liability
position at December 31, 2007. The movement to net asset position is due primarily to a decrease in the market value of
investment securities. The Company assesses the likelihood that deferred tax assets will be realized and to the extent management
believes realization is not likely, a valuation allowance is established. Management’s recoverability assessment is based on
estimates of anticipated capital gains, available capital gains realized in prior years that could be utilized through carryback and
tax-planning strategies available to generate future taxable capital gains, which are expected to be sufficient to offset recorded
deferred tax assets.
Specifically, the Company has the ability and intention to generate realized capital gains, and minimize realized capital
losses for which no tax benefit will be derived, by employing a combination of prudent planning strategies. The Company expects
to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes
unrealized losses related to these debt securities, which represent a significant portion of the unrealized loss positions at year-end,
are not due to default risk. Thus, the principal amounts are believed to be fully realizable at maturity. The Company has a long-
term horizon for holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The
Company has prior years’ realized capital gains available to offset realized capital losses, via the filing of carryback refund
claims. The Company also has unrealized gains in its investment portfolio which could be realized through asset dispositions, at
management's discretion. Further, the Company has the capability to generate additional realized capital gains by entering into a
sale-leaseback transaction using one or more properties of its appreciated real estate holdings. Finally, the Company has an
established history of generating capital gain premiums earned through its common stock call option program. Based on the
continued existence of the options market, the substantial amount of capital committed to supporting the call option program, and
the Company's favorable track record in generating net capital gains from this program in both upward and downward markets,
management believes it will be able to generate sufficient amounts of option premium capital gains (more than sufficient to offset
any losses on the underlying stocks employed in the program) on a consistent, long term basis. By prudent utilization of some or
all of these actions, management believes that it has the ability and intent to generate capital gains, and minimize tax losses, in a
manner sufficient to avoid losing the benefits of its deferred tax assets.
Management's position is supported based on the Company's steady history of generating positive cash flow from
operations, as well as its reasonable expectation that its cash flow needs can be met in future periods without the forced sale of its
investments. This capability will enable management to use its discretion in controlling the timing and amount of realized losses
it generates during future periods. Thus, although realization is not assured, management believes it is more likely than not that
the Company's deferred tax assets will be realized.