Mercury Insurance 2009 Annual Report Download - page 74

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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
subsidiaries. Executive oversight of investment activities is conducted primarily through the Company’s
investment committee. The investment committee focuses on strategies to enhance after-tax 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, and credit
ratings. 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. 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.
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 weighted-average fixed maturities 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. Historically, the ten-year default rate per Moody’s for AA rated municipal bonds has been less
than 1%. The Company’s municipal bond holdings, which represent 90.3% of its fixed maturity portfolio at
December 31, 2009 at fair value, are broadly diversified geographically. Approximately 99.7% of municipal
bond holdings are in the tax-exempt sector. The largest holdings are in populous states such as Texas
(15.2%) and California (12.7%); however, such holdings are further diversified primarily between cities,
counties, schools, public works, hospitals and state general obligations. In California, the Company owns
approximately $8.0 million at fair value of general obligations of the state at December 31, 2009. Credit risk is
addressed by limiting exposure to any particular issuer to ensure diversification. Taxable fixed maturity securities
represent 10.0% of the Company’s fixed maturity portfolio. Approximately 35.7% of the Company’s taxable
fixed maturity securities were comprised of U.S. government bonds and agencies, which were rated AAA at
December 31, 2009. Approximately 12.9% of the Company’s taxable fixed maturity securities were rated below
investment grade. Below investment grade issues are considered “watch list” items by the Company, and their
status is evaluated within the context of the Company’s overall portfolio and its investment policy on an
aggregate risk management basis, as well as their ability to recover their investment on an individual issue basis.
Credit ratings for the Company’s fixed maturity portfolio were slightly lower during 2009, with 69% of the
fixed maturity portfolio at fair value experiencing no change in overall rating, approximately 26% experienced
downgrades during the period, and approximately 5.0% in credit upgrades. The majority of the downgrades were
due to continued downgrading of the monoline insurance carried on much of the municipal holdings. The
majority of the downgrades was slight and still within the investment grade portfolio and only approximately $27
million at fair value was downgraded to below investment grade, allowing the Company to maintain a high
overall credit rating on its fixed maturity securities.
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, 2009, the Company’s primary objective for common equity investments is current
income. The fair value of the equity investment consists of $272.5 million in common stocks and $13.7 million
in non-redeemable preferred stocks. The common stock equity assets are typically valued for future economic
prospects as perceived by the market. The current market expectation is cautiously optimistic following
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