Mercury Insurance 2009 Annual Report Download - page 68

At December 31, 2009, 77.4% of the Company’s total investment portfolio at fair value and 90.0% of its
total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity
holdings consist of perpetual preferred stocks and dividend-bearing common stocks on which dividend income is
partially tax-sheltered by the 70% corporate dividend exclusion. At December 31, 2009, 96.1% of short-term
investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The
Company does not have any material direct investment in subprime lenders.
During 2009, the Company recognized approximately $346.4 million in net realized investment gains,
which include approximately $255.2 million and $83.5 million related to fixed maturity securities and equity
securities, respectively. Included in the gains were $261.9 million and $133.6 million in gains due to changes in
the fair value of the Company’s fixed maturity portfolio and equity security portfolio, respectively, as a result of
electing the fair value option. Partially offsetting these gains were approximately $6.7 million and $50.1 million
in losses from the sale of fixed maturity securities and equity securities, respectively.
During 2008, the Company recognized approximately $550.5 million in net realized investment losses, of
which, approximately $274 million was related to fixed maturity securities and approximately $254 million was
related to equity securities. The losses were primarily due to extreme volatility in the capital markets and a
widening of credit spreads beyond historic norms in the third and fourth quarters of 2008. Included in this loss is
$531.1 million related to the change in fair value of the total investment portfolio. Losses were approximately
$6.4 million and $27.7 million from the sale of fixed maturity securities and equity securities, respectively.
Fixed Maturity Securities
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or
variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the
Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/
reward characteristics, liquidity needs, tax planning considerations or other economic factors. A primary
exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset
is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields,
the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The
nominal average maturities of the overall bond portfolio, including short-term bonds, were 12.2 years and 13.9
years at December 31, 2009 and 2008, respectively, which reflect a portfolio heavily weighted in investment
grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call
options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average
maturities of the overall bond portfolio, including short-term bonds, were approximately 6.8 years and 10.8 years
at December 31, 2009 and 2008, respectively, related to holdings which are heavily weighted with high coupon
issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio
reflecting anticipated early calls were 5.1 years and 7.2 years, including collateralized mortgage obligations with
modified durations of approximately 1.8 years and 1.7 years at December 31, 2009 and 2008, respectively, and
short-term bonds that carry no duration. Modified duration measures the length of time it takes, on average, to
receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it
measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in
interest rates; modified duration is considered a better indicator of price volatility than simple maturity alone.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a
weighted-average portfolio credit quality rating of AA-, compared to AA at December 31, 2008, with the decline
in rating due primarily to the downgrading of municipal bonds insurer ratings. To calculate the weighted-average
credit quality ratings as disclosed throughout this Form 10-K, individual securities were weighted based on fair
value and a credit quality numeric score that was assigned to each rating grade. Bond holdings are broadly
diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of
investment grade issues. At December 31, 2009, fixed maturity holdings rated below investment grade and non-
rated bonds totaled $92.0 million and $109.9 million, respectively, at fair value, and represented approximately
50