Mercury Insurance 2012 Annual Report Download - page 58

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Investments
The Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required when
applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated
statements of operations. The majority of equity holdings, including non-redeemable fund preferred stocks, is actively traded on
national exchanges or trading markets, and is valued at the last transaction price on the balance sheet dates.
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 notes payable. The fair value of a financial instrument is the price
that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their
fair market values. All investments are carried on the consolidated balance sheets at fair value, as disclosed in Note 1 of Notes to
Consolidated Financial Statements.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued
by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange
traded funds. Approximately 98% of the fair value of the financial instruments held at December 31, 2012 is based on observable
market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market
prices and pricing parameters can vary by financial instrument. Observable market prices and pricing parameters of a financial
instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
The Company may hold or acquire financial instruments that lack observable market prices or market parameters currently
or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques
appropriate for each particular financial instrument. These techniques may 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 are otherwise not actively quoted. For a further discussion,
see Note 3 of Notes to Consolidated Financial Statements.
Income Taxes
At December 31, 2012, the Company’s deferred income taxes were in a net liability position materially due to deferred tax
liabilities generated by deferred acquisition costs and unrealized gains on securities held. These deferred tax liabilities were
substantially offset by deferred tax assets resulting from unearned premiums, expense accruals, loss reserve discounting, and AMT
and other tax credit carryforwards. 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 these debt securities, which represent a portion
of the unrealized loss positions at period end, are fully realizable at maturity. Management believes its long-term time horizon for
holding these securities allows it to avoid any 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.