Mercury Insurance 2011 Annual Report Download - page 59

estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of
the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate
resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have
a material adverse effect on its financial condition, results of operations, or cash flows.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a
discussion of legal matters, see Note 17 of Notes to Consolidated Financial Statements—Commitments and
Contingencies—Litigation.
C. Critical Accounting Estimates
Reserves
Preparation of the Company’s consolidated financial statements requires judgment and estimates. The most
significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can
ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the
regulatory and legal environment, results of litigation, medical costs, the cost of repair materials, and labor rates,
among other factors, can impact ultimate claim costs. In addition, time can be a critical part of reserving
determinations since the longer the span between the incidence of a loss and the payment or settlement of a
claim, the more variable the ultimate settlement amount could be. Accordingly, short-tail claims, such as
property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company calculates a point estimate rather than a range of loss reserve estimate. There is inherent
uncertainty with estimates and this is particularly true with estimates for loss reserves. This uncertainty comes
from many factors which may include changes in claims reporting and settlement patterns, changes in the
regulatory or legal environment, uncertainty over inflation rates and uncertainty for unknown items. The
Company does not make specific provisions for these uncertainties, rather it considers them in establishing its
reserve by looking at historical patterns and trends and projecting these out to current reserves. The underlying
factors and assumptions that serve as the basis for preparing the reserve estimate include paid and incurred loss
development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and
other relevant information.
The Company also engages independent actuarial consultants to review the Company’s reserves and to
provide the annual actuarial opinions required under state statutory accounting requirements. The Company does
not rely on actuarial consultants for GAAP reporting or periodic report disclosure purposes. The Company
analyzes loss reserves quarterly primarily using the incurred loss, claim count, and average severity methods
described below. The Company also uses the paid loss development method to analyze loss adjustment expenses
reserves as part of its reserve analysis. When deciding which method to use in estimating its reserves, the
Company evaluates the credibility of each method based on the maturity of the data available and the claims
settlement practices for each particular line of business or coverage within a line of business. When establishing
the reserve, the Company will generally analyze the results from all of the methods used rather than relying on
one method. While these methods are designed to determine the ultimate losses on claims under the Company’s
policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes.
The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
• The incurred loss development method analyzes historical incurred case loss (case reserves plus paid
losses) development to estimate ultimate losses. The Company applies development factors against
current case incurred losses by accident period to calculate ultimate expected losses. The Company
believes that the incurred loss development method provides a reasonable basis for evaluating ultimate
losses, particularly in the Company’s larger, more established lines of business which have a long
operating history.
• The average severity method analyzes historical loss payments and/or incurred losses divided by closed
claims and/or total claims to calculate an estimated average cost per claim. From this, the expected
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