Mercury Insurance 2012 Annual Report Download - page 80

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59
Investments
The Company applies the fair value option to all fixed maturities and equity securities and short-term investments at the
time an eligible item is first recognized. The cost of investments sold is determined on a first-in and first-out method and realized
gains and losses are included in net realized investment gains. 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 primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as fair value
measurement use 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, which may have fixed or variable principal payment schedules 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 and 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 $0.2 million and $0.7 million were included in other liabilities at December 31, 2012 and
2011, 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 notes payable. As discussed above, all investments are carried at fair
value on the consolidated balance sheets, including $42.8 million and $11.3 million of fixed maturities and equity securities,
respectively, which are valued based on broker quotes for underlying debt and credit instruments and an estimated benchmark
spread for similar assets in active markets. The fair value of the Company’s $120 million and $20 million secured notes, classified
as Level 2 in the fair value hierarchy described in Note 3, is estimated based on assumptions and inputs, such as reset rates and
the market value for underlying collateral, for similarly termed notes that are observable in the market. See Note 3 for methods
and assumptions used in estimating fair values of interest rate swap agreements and equity contracts. Due to their short-term
maturity, the carrying values of receivables and accounts payable approximate their fair market values. The following table presents
estimated fair values of financial instruments at December 31, 2012 and 2011.
December 31,
2012 2011
(Amounts in thousands)
Assets
Investments $ 3,180,095 $ 3,062,421
Liabilities
Interest rate swap agreements $ 103 $ 670
Equity contracts $ 175 $ 655
Secured notes $ 140,000 $ 140,000