Mercury Insurance 2008 Annual Report Download - page 57

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The Company has historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and
holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the
Company’s historical investment philosophy resulted in a portfolio with a moderate duration. Bond investments made by the
Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The increase
in municipal bond credit spreads in 2008 caused the overall market interest rate to increase, which resulted in the increase in the
duration of the Company’s portfolio. Consequently, the modified duration of the bond portfolio is 7.2 years at December 31, 2008
compared to 4.4 years and 4.0 years at December 31, 2007 and 2006, respectively. Given a hypothetical parallel increase of 100
basis or 200 basis points in interest rates, the fair value of the bond portfolio at December 31, 2008 would decrease by
approximately $179 million or $357 million, respectively.
Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on its $125 million
fixed 7.25% rate senior notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes.
Equity price risk
Equity price risk is the risk that the Company will incur losses due to adverse changes in the general levels of the equity
markets.
At December 31, 2008, the Company’s primary objective for common equity investments is current income. The fair
value of the equity investment consists of $236.8 million in common stocks and $10.6 million in non-sinking fund preferred
stocks. The common stock equity assets are typically valued for future economic prospects as perceived by the market.
The common equity portfolio represents approximately 8.1% of total investments at fair value. Beta is a measure of a
security’s systematic (non-diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in
the return of the market. The average Beta for the Company’s common stock holdings was 1.14. Based on a hypothetical 25% or
50% reduction in the overall value of the stock market, the fair value of the common stock portfolio would decrease by
approximately $67 million or $135 million, respectively.
Credit risk
Credit risk is risk due to uncertainty in a counterparty’s ability to meet its obligations. Credit risk is managed by
maintaining a minimum average fixed maturities portfolio credit quality rating of AA, unchanged from December 31,
2007. Historically, the ten-year default rate per Moody’s for AA-rated municipal bonds has been less than 1%. The Company’s
bond holdings are broadly diversified geographically, within the tax-exempt sector, representing approximately 88% of fixed
maturity securities at December 31, 2008 at fair value. Remaining fixed maturity securities in the taxable sector consist
principally of investment grade issues, of which approximately 59% represents U.S. government bonds and agencies, which were
rated at AAA at December 31, 2008. The Company believes that its conservative approach to credit risk has served it well in the
current economic climate, allowing for a competitive advantage over many insurers exposed to such risk.
Forward-looking statements
Certain statements in this report on Form 10-K or in other materials the Company has filed or will file with the SEC (as
well as information included in oral statements or other written statements made or to be made by us) contain or may contain
“forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of
the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the
Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results and
reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could
cause the Company’s actual business, prospects and results of operations to differ materially from the historical information
contained in this Form 10-K and from those that may be expressed or implied by the forward-looking statements contained in the
this Form 10-K and in other reports or public statements made by us.
Factors that could cause or contribute to such differences include, among others: the competition currently existing in the
California automobile insurance markets; the cyclical and general competitive nature of the property and casualty insurance
industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing
methodologies; a successful integration of the operations of AIS and the achievement of the synergies and revenue growth from
the acquisition of AIS; the Company’s success in managing its business in states outside of California; the impact of potential
third party “bad-faith” legislation, changes in laws or regulations, tax position challenges by the California Franchise Tax Board,
and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the
timing of the approval of premium rate changes for private passenger automobile policies issued in states where the Company
does business; the investment yields the Company is able to obtain with its investments in comparison to recent yields and the
general market risk associated with the Company’s investment portfolio, including the impact of the current liquidity crisis and
economic weakness on the Company’s market and investment portfolio; uncertainties related to assumptions and projections