Mercury Insurance 2012 Annual Report Download - page 54

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The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance
business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of
business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see “Critical
Accounting Estimates” and Note 1 of Notes to Consolidated Financial Statements.
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies
for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss
contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate
of the possible loss, range of loss, or a statement that such an 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 16 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 an independent actuarial consultant 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 the actuarial consultant
for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the
incurred loss, claim count development, and average severity methods described below. The Company also uses the paid loss
development method to analyze loss adjustment expense reserves as part of its reserve analysis. When deciding among methods
to use, 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 a single 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 ultimate average cost per claim
can be estimated. The average severity method coupled with the claim count development method provide meaningful
information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. The
claim count development method analyzes historical claim count development to estimate future incurred claim count