Mercury Insurance 2009 Annual Report Download - page 75

Download and view the complete annual report

Please find page 75 of the 2009 Mercury Insurance annual report below. You can navigate through the pages in the report by either clicking on the pages listed below, or by using the keyword search tool below to find specific information within the annual report.

Page out of 132

  • 1
  • 2
  • 3
  • 4
  • 5
  • 6
  • 7
  • 8
  • 9
  • 10
  • 11
  • 12
  • 13
  • 14
  • 15
  • 16
  • 17
  • 18
  • 19
  • 20
  • 21
  • 22
  • 23
  • 24
  • 25
  • 26
  • 27
  • 28
  • 29
  • 30
  • 31
  • 32
  • 33
  • 34
  • 35
  • 36
  • 37
  • 38
  • 39
  • 40
  • 41
  • 42
  • 43
  • 44
  • 45
  • 46
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • 64
  • 65
  • 66
  • 67
  • 68
  • 69
  • 70
  • 71
  • 72
  • 73
  • 74
  • 75
  • 76
  • 77
  • 78
  • 79
  • 80
  • 81
  • 82
  • 83
  • 84
  • 85
  • 86
  • 87
  • 88
  • 89
  • 90
  • 91
  • 92
  • 93
  • 94
  • 95
  • 96
  • 97
  • 98
  • 99
  • 100
  • 101
  • 102
  • 103
  • 104
  • 105
  • 106
  • 107
  • 108
  • 109
  • 110
  • 111
  • 112
  • 113
  • 114
  • 115
  • 116
  • 117
  • 118
  • 119
  • 120
  • 121
  • 122
  • 123
  • 124
  • 125
  • 126
  • 127
  • 128
  • 129
  • 130
  • 131
  • 132

government programs designed to sustain the economy. The Company has also allocated more to the energy
sector relative to the S&P 500 Index to hedge against potential inflationary pressures on the equity markets
possible in a sudden economic recovery.
The common equity portfolio represents approximately 8.7% 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 1.19 at December 31, 2009. 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 $81.1 million or
$162.1 million, respectively.
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 value of the fixed maturity portfolio, which represents 85.9% of total investment at fair value, 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.
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 decrease in municipal bond credit spreads in 2009
caused the overall market interest rate to decrease, which resulted in the decrease in the duration of the
Company’s portfolio. Consequently, the modified duration of the bond portfolio, including short-term
investments, is 5.1 years at December 31, 2009 compared to 7.2 years and 4.4 years at December 31, 2008 and
2007, 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, 2009 would decrease by approximately $145.2 million or $290.5
million, respectively.
Interest rate swaps are used to manage interest rate risk associated with the Company’s loans with fixed or
floating rates. On February 6, 2009, the Company entered into an interest swap of its floating LIBOR rate on the
$120 million credit facility for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. On March 3, 2008,
the Company entered into an interest rate swap of a floating LIBOR rate on an $18 million bank loan for a fixed
rate of 3.75%, resulting in a total fixed rate of 4.25%. In addition, effective January 2, 2002, the Company
entered into an interest rate swap of a 7.25% fixed rate obligation on its $125 million senior note for a floating
rate of LIBOR plus 107 basis points.
57