Mercury Insurance 2011 Annual Report Download - page 74

The Company had $32.0 million, 1.3% of its fixed maturity portfolio, at fair value in U.S. government
bonds and agencies and mortgage-backed securities (agencies). In August 2011, Standard and Poor’s
downgraded the U.S. government’s long-term sovereign credit rating from AAA to AA+. This downgrade has
triggered significant volatility in prices for a variety of investments. While Moody’s and Fitch affirmed their
AAA ratings, they placed a negative outlook in November 2011 and warned of a potential downgrade if no long-
term deficit agreement was reached over the next two years. The negative outlook reflects these rating agencies’
declining confidence that timely fiscal measures will be forthcoming to place U.S. public finances on a
sustainable path and secure the AAA ratings. Standard and Poor’s affirmed the U.S. Treasury’s short-term credit
rating of AAA indicating that the short-term capacity of the U.S. to meet its financial commitment on its
outstanding obligations is strong. The Company understands that market participants continue to use rates of
return on U.S. government debt as a risk-free rate. In addition, in the period after the downgrade, market
participants continued to invest in U.S. Treasury securities and push the yield on U.S. Treasury securities even
lower than before the downgrade.
(1) Municipal Securities
The Company had $2.3 billion at fair value ($2.2 billion at amortized cost) in municipal bonds at
December 31, 2011, of which $1.3 billion were insured by bond insurers. For insured municipal bonds that have
underlying ratings, the average underlying rating was A+ at December 31, 2011.
At December 31, 2011, the bond insurers providing credit enhancement were Assured Guaranty Corporation
and National Public Finance Guarantee Corporation, which covered approximately 10% of the insured municipal
securities. The average rating of the Company’s insured municipal bonds by these bond insurers was A+, with an
underlying rating of A-. The remaining bond insurers’ credit ratings, which covered approximately 90% of the
insured municipal securities, are non-rated or below investment grade, and the Company does not believe that
these insurers provide credit enhancement to the municipal bonds that they insure.
The Company considers the strength of the underlying credit as a buffer against potential market value
declines which may result from future rating downgrades of the bond insurers. In addition, the Company has a
long-term time horizon for its municipal bond holdings which generally allows it to recover the full principal
amounts upon maturity and avoid forced sales prior to maturity of bonds that have declined in market value due
to the bond insurers’ rating downgrades. Based on the uncertainty surrounding the financial condition of these
insurers, it is possible that there will be additional downgrades to below investment grade ratings by the rating
agencies in the future, and such downgrades could impact the estimated fair value of municipal bonds.
Municipal securities included auction rate securities (“ARS”). The Company owned $0 and $1.6 million at
fair value of ARS at December 31, 2011 and 2010, respectively. ARS are valued based on a discounted cash flow
model with certain inputs that are not observable in the market and are considered Level 3 inputs.
(2) Mortgage-Backed Securities
The mortgage-backed securities portfolio is categorized as loans to “prime” borrowers except for $9.8
million and $11.5 million ($8.3 million and $10.7 million at amortized cost) of Alt-A mortgages at December 31,
2011 and 2010, respectively. Alt-A mortgage backed securities are at fixed or variable rates and include certain
securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles
than sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited
supporting documentation. At December 31, 2011, the Company had no holdings in commercial mortgage-
backed securities.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities was BB+ and the
weighted-average rating of the entire mortgage backed securities portfolio was A+ as of December 31, 2011.
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