Mercury Insurance 2010 Annual Report Download - page 68

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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.
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, 2010, the Company’s primary objective for common equity investments is current
income. The fair value of the equity investments consists of $349.8 million in common stocks and $9.8 million in
non-redeemable preferred stocks. Common stock equity assets are typically valued for future economic prospects
as perceived by the market. The Company invests more in the energy and utility sector relative to the S&P 500
Index.
The common equity portfolio represents 11.1% 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
1.17 at December 31, 2010. 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 $102.3 million or $204.7
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 84.1% 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 narrowing in municipal bond credit spreads in 2010
caused the overall market interest rate to decrease, which resulted in a reduction in the duration of the
Company’s portfolio. Consequently, the modified duration of the bond portfolio reflecting anticipated early calls
was 4.7 years at December 31, 2010 compared to 5.1 years and 7.2 years at December 31, 2009 and 2008,
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, 2010 would decrease by $125.5 million or $251.0 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%. 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.
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