Mercury Insurance 2012 Annual Report Download - page 70

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49
99.0% of municipal bond holdings are tax-exempt. The following table presents municipal bond holdings by state in descending
order of holdings at fair value at December 31, 2012:
States Fair Value Average Rating
(Amounts in thousands)
Texas $ 339,023 AA
California 285,554 A+
Florida 183,081 A+
Illinois 140,574 A+
Indiana 104,924 AA-
Other states 1,111,939 A+
Total $ 2,165,095
The portfolio is broadly diversified among the states and the largest holdings are in populous states such as Texas and
California. These holdings are further diversified primarily among cities, counties, schools, public works, hospitals and state
general obligations. The Company has no holdings in the three California municipalities that recently declared bankruptcy:
Stockton, Mammoth Lakes, and San Bernardino. The Company seeks to minimize overall credit risk and ensure diversification
by limiting exposure to any particular issuer.
Taxable fixed maturity securities represented 11.0% of the Company’s fixed maturity portfolio. 9.5% of the Company’s
taxable fixed maturity securities were comprised of U.S. government bonds and agencies and mortgage-backed securities
(agencies), which were rated AAA at December 31, 2012. 8.5% of the Company’s taxable fixed maturity securities, representing
0.9% of the total fixed maturity portfolio, were rated below investment grade. Below investment grade issues are considered
“watch list” items by the Company, and their status is evaluated within the context of the Company’s overall portfolio and its
investment policy on an aggregate risk management basis, as well as their ability to recover their investment on an individual issue
basis.
Equity price risk
Equity price risk is the risk that the Company will incur losses due to adverse changes in the equity markets.
At December 31, 2012, the Company’s primary objective for common equity investments was current income. The fair
value of the equity investments consists of $454.1 million in common stocks, $11.7 million in non-redeemable preferred stocks,
and $11.3 million in a partnership interest in a private credit fund. Common stock equity assets are typically valued for future
economic prospects as perceived by the market. The Company invests more of its portfolio in the energy and utility sector than
what is represented in the S&P 500 Index.
Common stocks represented 14.3% of total investments at fair value. Beta is a measure of a security’s systematic (non-
diversifiable) risk, which is the percentage change in an individual security’s return for a 1% change in the return of the market. The
average Beta for the Company’s common stock holdings was 1.06 at December 31, 2012. Based on a hypothetical 25% or 50%
reduction in the overall value of the stock market, the Company estimates that the fair value of the common stock portfolio would
decrease by $120.3 million or $240.6 million, respectively.
Interest rate risk
Interest rate risk is the risk that the Company will incur a loss due to adverse changes in interest rates relative to the interest
rate characteristics of interest bearing assets and liabilities. The Company faces interest rate risk, as it invests substantial funds in
interest sensitive assets and issues interest sensitive liabilities. Interest rate risk includes risks related to changes in U.S. Treasury
yields and other key benchmarks, as well as changes in interest rates resulting from the widening credit spreads and credit exposure
to collateralized securities.
The value of the fixed maturity portfolio, which represented 75.7% of total investment at fair value, is subject to interest
rate risk. As market interest rates decrease, the value of the portfolio increases and vice versa. A common measure of the interest
sensitivity of fixed maturity assets is modified duration, a calculation that utilizes maturity, coupon rate, yield and call terms to
calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest rate
fluctuations.
The Company has historically invested in fixed maturity investments with a goal of maximizing after-tax yields and holding
assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Company’s