Mercury Insurance 2013 Annual Report Download - page 64

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49
At December 31, 2013, the Company’s primary objective for common equity investments was current income. The fair
value of the equity investments consisted of $239.8 million in common stocks, $29.6 million in non-redeemable preferred stocks,
and $12.5 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 proportionately more in the energy and utility sector relative
to the S&P 500 Index.
Common stocks represented 7.6% of total investments at fair value. During the second half of 2013, the Company sold a
significant portion of its equity portfolio to improve the asset risk profile in its insurance subsidiaries and to lock in and realize
gains that resulted from the large stock market appreciation on that occurred during 2013. Beta is a measure of a security’s systematic
(non-diversifiable) risk, which is measured as the percentage change in an individual security’s return for a 1% change in the
return of the market. Based on hypothetical reductions in the overall value of the stock market, the following table illustrates
estimated reductions in the overall value of the Company's common stock portfolio at December 31, 2013 and 2012:
December 31,
2013 2012
(Amounts in thousands, except average Beta)
Average Beta 0.93 1.06
Hypothetical reduction in the overall value of the stock market of 25% $ 55,746 $ 120,332
Hypothetical reduction in the overall value of the stock market of 50% $ 111,492 $ 240,663
After reducing the size of the Company’s equity portfolio during 2013, the portfolio at December 31, 2013 had both a lower
Beta and a lower total amount invested in common stocks . Therefore, the impact that large market corrections could have on the
equity portfolio was lower at December 31, 2013 than at December 31, 2012.
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 81.1% 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 generated by such assets. 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 maturities tend to produce higher current yields, the Company’s historical
investment philosophy resulted in a portfolio with a moderate duration. Bond investments made by the Company typically have
call options attached, which further reduce the duration of the asset as interest rates decline. The increased investment in municipal
bonds with relatively longer duration in 2013 coupled with a rise in interest rates during the second quarter resulted in an increase
in the duration of the Company's portfolio. Consequently, the modified duration of the bond portfolio reflecting anticipated early
calls was 3.9 years at December 31, 2013 compared to 3.1 years and 3.7 years at December 31, 2012 and 2011, respectively. Given
a hypothetical parallel increase of 100 or 200 basis points in interest rates, the Company estimates that the fair value of its bond
portfolio at December 31, 2013 would decrease by $101.9 million or $203.8 million, respectively. Conversely, if interest rates
were to decrease, the fair value of the Company's bond portfolio would rise, and it may cause a higher number of the Company's
bonds to be called away. The proceeds from the called bonds would likely be reinvested at lower yields which would result in
lower overall investment income for the Company.