Mercury Insurance 2011 Annual Report Download - page 39

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The Company’s valuation of financial instruments may include methodologies, estimations, and
assumptions that are subject to differing interpretations and could result in changes to valuations that may
materially adversely affect the Company’s financial condition or results of operations.
The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to
measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between market participants at the measurement date using
the exit price. Accordingly, when market observable data is not readily available, the Company’s own
assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or
liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value
are categorized based on the level of judgment associated with the input used to measure their fair value and the
level of market price observability.
During periods of market disruption, including periods of significantly changing interest rates, rapidly
widening credit spreads, inactivity or illiquidity, it may be difficult to value certain of the Company’s securities if
trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes in
historically active markets with significant observable data that become illiquid due to changes in the financial
environment. In such cases, the valuations associated with such securities may rely more on management
judgment and include inputs and assumptions that are less observable or require greater estimation as well as
valuation methods, which are more sophisticated or require greater estimation. The valuations generated by such
methods may be different from the value at which the investments ultimately may be sold. Further, rapidly
changing and unprecedented credit and equity market conditions could materially impact the valuation of
securities as reported within the Company’s financial statements, and the period-to-period changes in value could
vary significantly. Decreases in value may have a material adverse effect on the Company’s financial condition
or results of operations.
Changes in the financial strength ratings of financial guaranty insurers issuing policies on bonds held in
the Company’s investment portfolio may have an adverse effect on the Company’s investment results.
In an effort to enhance the bond rating applicable to certain bond issues, some bond issuers purchase
municipal bond insurance policies from private insurers. The insurance generally guarantees the payment of
principal and interest on a bond issue if the issuer defaults. By purchasing the insurance, the financial strength
ratings applicable to the bonds are based on the credit worthiness of the insurer as well as the underlying credit of
the bond issuer. Several financial guaranty insurers that have issued insurance policies covering bonds held by
the Company have experienced financial strength rating downgrades due to risk exposures on insurance policies
that guarantee mortgage debt and related structured products. These financial guaranty insurers are subject to
DOI oversight. As the financial strength ratings of these insurers are reduced, the ratings of the insured bond
issues correspondingly decrease. Although the Company has determined that the financial strength rating of the
underlying bond issues in its investment portfolio are within the Company’s investment policy without the
enhancement provided by the insurance policies, any further downgrades in the financial strength ratings of these
insurance companies or any defaults on the insurance policies written by these insurance companies may reduce
the fair value of the underlying bond issues and the Company’s investment portfolio or may reduce the
investment results generated by the Company’s investment portfolio, which could have a material adverse effect
on the Company’s financial condition, results of operations, and liquidity.
Deterioration of the municipal bond market in general or of specific municipal bonds held by the
Company may result in a material adverse effect on the Company’s financial condition, results of operations,
and liquidity.
At December 31, 2011, 74.0% of the Company’s total investment portfolio at fair value and 92.6% of its
total fixed maturity investments at fair value were invested in tax-exempt municipal bonds. With such a large
percentage of the Company’s investment portfolio invested in municipal bonds, the performance of the
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