Mercury Insurance 2012 Annual Report Download - page 38

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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 consolidated 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, 2012, 67.4% of the Company’s total investment portfolio at fair value and 89.0% 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 Company’s investment portfolio, including the cash flows generated
by the investment portfolio is significantly dependent on the performance of municipal bonds. If the value of municipal bond
markets in general or any of the Company’s municipal bond holdings deteriorate, the performance of the Company’s investment
portfolio, financial condition, results of operations, and liquidity may be materially and adversely affected.
Adoption of proposed changes in the tax exemption available for municipal bond interest will have an adverse effect on
the value of the Company's municipal bond portfolio and the investment income generated by the Company.
Proposals have been made for the elimination or modification of the tax-exempt status or tax rates applicable to municipal
bonds as part of significant tax reform being considered, some of which would enact such changes retroactively. Because many
states adopt changes in the Internal Revenue Code as a part of the state taxation system, such changes to the federal income and/
or capital gains laws may result in changes to state tax laws, resulting in a loss of or reduction in the exemption of municipal bond
interest for state income tax purposes as well. Any changes in tax rates or the tax-exempt status applicable to municipal bonds
actually adopted could significantly affect the demand for and supply of liquidity and marketability of such municipal bond
obligations. Such changes would likely result in a decrease in the value of the Company's municipal bond portfolio and limit the
ability of the Company to acquire and dispose of municipal obligations at desirable yield and price levels. Such changes may also
materially reduce the after-tax income earned by the Company's investment securities.
If the Company’s loss reserves are inadequate, its business and financial position could be harmed.
The process of establishing property and liability loss reserves is inherently uncertain due to a number of factors, including
underwriting quality, the frequency and amount of covered losses, variations in claims settlement practices, the costs and uncertainty
of litigation, and expanding theories of liability. While the Company believes that its actuarial techniques and databases are
sufficient to estimate loss reserves, the Company’s approach may prove to be inadequate. If any of these contingencies, many of
which are beyond the Company’s control, results in loss reserves that are not sufficient to cover its actual losses, the Company’s
financial condition, results of operations, and liquidity may be materially adversely affected.
There is uncertainty involved in the availability of reinsurance and the collectability of reinsurance recoverable.
The Company reinsures a portion of its potential losses on the policies it issues to mitigate the volatility of the losses on its
financial condition and results of operations. The availability and cost of reinsurance is subject to market conditions, which are
outside of the Company’s control. From time to time, market conditions have limited, and in some cases prevented, insurers from