Mercury Insurance 2013 Annual Report Download - page 52

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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, 2013, the Company’s deferred income taxes were in a net asset position materially due to deferred tax
assets resulting from unearned premiums, AMT and other tax credit carryforwards, loss reserve discounting, and expense accruals.
These deferred tax assets were substantially offset by deferred tax liabilities generated by deferred policy acquisition costs and
unrealized gains on securities held. 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 the Company's 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, each 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
significant portion of the unrealized loss positions at year-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 that 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.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash
flow from operations and believes that its cash flow needs can be met in future periods without the forced sale of its investments.
This capability assists management in controlling the timing and amount of realized losses generated during future periods. By
prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability to generate
capital gains and minimize tax losses in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management
will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management
believes it is more likely than not that the Company’s deferred tax assets will be realized.
The Company’s effective income tax rate can be affected by several factors. These generally include tax exempt investment
income, non-deductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related
to tax uncertainties. The effective tax rate was 15.1% for 2013, compared to 13.6% for 2012. The increase in the effective tax rate
is mainly due to an increase in taxable income relative to tax exempt investment income and an increase in the provision for the
Company's state income tax uncertainties. The Company’s effective tax rate for the year ended December 31, 2013 was lower
than the statutory tax rate primarily as a result of tax exempt investment income earned.
Contingent Liabilities
The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or
regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities
and accrues for them and/or discloses them in the notes to the consolidated financial statements where required. 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. See also “Regulatory
and Legal Matters” and Note 16 of Notes to Consolidated Financial Statements.
For a discussion of recently issued accounting standards, see Note 1 of Notes to Consolidated Financial Statements.
Premiums
The Company’s insurance premiums are recognized as income ratably over the term of the policies and in proportion to
the amount of insurance protection provided. Unearned premiums are carried as a liability on the consolidated balance sheets and
are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies
by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs partially offset by investment
income to related unearned premiums. To the extent that any of the Company’s lines of business become unprofitable, a premium
deficiency reserve may be required.