Mercury Insurance 2013 Annual Report Download - page 73

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58
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 (losses) 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 (losses) gains,
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. The primary reasons for electing the fair value option were simplification and cost-benefit
considerations as well as the expansion of the use of fair value measurement by the Company consistent with the long-term
measurement objectives of the Financial Accounting Standards Board (“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, may be
held for indefinite periods of time, 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 that 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 $0.1 million and $0.2 million were included in other liabilities at December 31, 2013 and
2012, respectively.
Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include investments, receivables, a total return swap,
interest rate swaps, accounts payable, equity contracts, and secured and unsecured notes payable. As discussed above, all
investments are carried at fair value on the consolidated balance sheets, including $4.3 million and $12.5 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 the market value of underlying collateral and reset rates, for similarly termed notes that are observable in the market. The
fair value of the Company's $50 million unsecured note, classified as Level 2 in the fair value hierarchy described in Note 3, is
based on the unadjusted quoted price for similar notes in active markets. See Note 3 for methods and assumptions used in estimating
fair values of the total return swap, interest rate swaps, 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, 2013 and 2012.