Mercury Insurance 2011 Annual Report Download - page 89

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MERCURY GENERAL CORPORATION AND SUBSIDIARIES
NOTES STATEMENTS TO CONSOLIDATED FINANCIAL—(Continued)
reporting period. These estimates require the Company to apply complex assumptions and judgments, and often
the Company must make estimates about effects of matters that are inherently uncertain and will likely change in
subsequent periods. The most significant assumptions in the preparation of these consolidated financial
statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those
estimates.
Investments
The Company applies the fair value option to all fixed maturities and equity securities and short-term
investments at the time the eligible item is first recognized. Gains and losses due to changes in fair value for
items measured at fair value pursuant to application of the fair value option are included in net realized
investment gains in the Company’s consolidated statements of operations, while interest and dividend income on
the investment holdings are recognized on an accrual basis on each measurement date and are included in net
investment income in the Company’s consolidated statements of operations. The cost of investments sold is
determined in accordance with first-in and first-out method and realized gains and losses are included in net
investment income. The primary reasons for electing the fair value option were simplification and cost-benefit
considerations as well as expansion of use of fair value measurement consistent with the long-term measurement
objectives of the FASB for accounting for financial instruments. See Note 2 for additional information regarding
the fair value option.
Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or
variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the
Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/
reward characteristics, liquidity needs, tax planning considerations, or other economic factors. Premiums and
discounts on fixed maturities are amortized using first call date and are adjusted for anticipated prepayments.
Premiums and discounts on mortgage-backed securities are adjusted for anticipated prepayment using the
retrospective method, with the exception of some beneficial interests in securitized financial assets, which are
accounted for using the prospective method.
Equity securities consist of non-redeemable preferred stocks, common stocks on which dividend income is
partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private
credit fund.
Short-term investments include money market accounts, options, and short-term bonds which are highly
rated short duration securities redeemable within one year.
The Company writes covered call options through listed and over-the-counter exchanges. When the
Company writes an option, an amount equal to the premium received by the Company is recorded as a liability
and is subsequently adjusted to the current fair value of the option written. Premiums received from writing
options that expire unexercised are treated by the Company on the expiration date as realized gains from
investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying
security or currency in determining whether the Company has realized a gain or loss. The Company, as writer of
an option, bears the market risk of an unfavorable change in the price of the security underlying the written
option. Liabilities for covered call options of $0.7 million and $2.8 million were included in other liabilities at
December 31, 2011 and 2010, respectively.
Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include investments, receivables,
interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. As
discussed above, all investments are carried at fair value on the consolidated balance sheets, including
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