Mercury Insurance 2011 Annual Report Download - page 65

involve some degree of judgment. The price transparency of the particular financial instrument will determine the
degree of judgment involved in determining the fair value of the Company’s financial instruments. Price
transparency is affected by a wide variety of factors, including, for example, the type of financial instrument,
whether it is a new financial instrument and not yet established in the marketplace, and the characteristics
particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are
available or for which fair value is derived from actively quoted prices or pricing parameters will generally have
a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will
generally have diminished price transparency. Even in normally active markets, the price transparency for
actively quoted instruments may be reduced from time to time during periods of market
dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and
sell a financial instrument provides a source of transparency for products that otherwise is not actively
quoted. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.
Income Taxes
At December 31, 2011, the Company’s deferred income taxes were in a net asset position materially due to
unearned premiums, expense accruals, loss reserve discounting, and tax credit carryforward. The Company
assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe
these assets are more likely than not to be realized, a valuation allowance is established.
Management’s recoverability assessment of its deferred tax assets which are ordinary in character takes into
consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation
that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to
recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the
Company has various deferred tax liabilities which represent sources of future ordinary taxable income.
Management’s recoverability assessment with regard to its capital deferred tax assets is based on estimates
of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of
which would contribute to the realization of deferred tax benefits. The Company expects to hold certain
quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes
unrealized losses related to a significant amount of these debt securities, which represent a portion of the
unrealized loss positions at period end, are fully realizable at maturity. The Company has a long-term horizon for
holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The
Company also has unrealized gains in its investment portfolio which could be realized through asset dispositions,
at management’s discretion. Further, the Company has the capability to generate additional realized capital gains
by entering into a sale-leaseback transaction using one or more of its appreciated real estate holdings. Finally, the
Company has an established history of generating capital gain premiums earned through its common stock call
option program. Based on the continued existence of the options market, the substantial amount of capital
committed to supporting the call option program, and the Company’s favorable track record in generating net
capital gains from this program in both upward and downward markets, management believes it will be able to
generate sufficient amounts of capital gains from this program, if necessary, to recover recorded capital deferred
tax assets.
The Company has the capability to implement tax planning strategies as it has a steady history of generating
positive cash flow from operations, as well as the reasonable expectation that its cash flow needs can be met in
future periods without the forced sale of its investments. This capability assists management in controlling the
timing and amount of realized losses it generates during future periods. By prudent utilization of some or all of
these actions, management believes that it has the ability and intent to generate capital gains, and minimize tax
losses, in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to
assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management
believes it is more likely than not that the Company’s deferred tax assets will be realized.
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