Mercury Insurance 2008 Annual Report Download - page 56

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46
Regulatory Capital Requirement
The NAIC utilizes a risk-based capital formula for casualty insurance companies which establishes recommended
minimum capital requirements that are compared to the Company’s actual capital level. The formula was designed to capture the
widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well
as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance
arrangements and a number of other factors. The Company has calculated the risk-based capital requirements of each of the
Insurance Companies as of December 31, 2008. The policyholders’ statutory surplus of each of the Insurance Companies
exceeded the highest level of minimum required capital.
Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written
to statutory policyholders’ surplus should not exceed 3.0 to 1. Based on the combined surplus of all the Insurance Companies of
$1,371.1 million at December 31, 2008, and net premiums written of $2,750.2 million, the ratio of premium writings to surplus
was 2.0 to 1.
Item 7A. Quantitative and Qualitative Disclosures about Market Risks
The Company is subject to various market risk exposures. Primary market risk exposures are to changes in interest rates,
equity prices and credit risk. Adverse changes to these rates and prices may occur due to changes in the liquidity of a market, or
to changes in market perceptions of credit worthiness and risk tolerance. The following disclosure reflects estimates of future
performance and economic conditions. Actual results may differ.
Overview
The Company’s investment policies define the overall framework for managing market and investment risks, including
accountability and controls over risk management activities, and specify the investment limits and strategies that are appropriate
given the liquidity, surplus, product profile and regulatory requirements of the subsidiary. Executive oversight of investment
activities is conducted primarily through the investment committee. The investment committee focuses on strategies to enhance
yields, mitigate market risks and optimize capital to improve profitability and returns.
The Company manages exposures to market risk through the use of asset allocation, duration, credit ratings, and value-at-
risk limits. Asset allocation limits place restrictions on the total funds that may be invested within an asset class. Duration limits
on the fixed maturities portfolio place restrictions on the amount of interest rate risk that may be taken. Value-at-risk limits are
intended to restrict the potential loss in fair value that could arise from adverse movements in the fixed maturities and equity
markets based on historical volatilities and correlations among market risk factors. Comprehensive day-to-day management of
market risk within defined tolerance ranges occurs as portfolio managers buy and sell within their respective markets based upon
the acceptable boundaries established by investment policies.
Interest rate risk
Interest rate risk is the risk that the Company will incur a loss due to adverse changes in interest rates relative to the
interest rate characteristics of interest bearing assets and liabilities. This risk arises from many of its primary activities, as the
Company invests substantial funds in interest sensitive assets and issues interest sensitive liabilities. Interest rate risk includes
risks related to changes in U.S. Treasury yields and other key benchmarks as well as changes in interest rates resulting from the
widening credit spreads and credit exposure to collateralized securities.
The Company invests its assets primarily in fixed maturity investments, which at December 31, 2008 comprised
approximately 85% of total investments at fair value. Tax-exempt bonds represent 88% of the fixed maturity investments with the
remaining amount consisting of sinking fund preferred stocks and taxable bonds. Equity securities account for approximately
8.4% of total investments at fair value. The remaining 6.6% 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.