Consolidation and Basis of Presentation
The interim consolidated financial statements include the accounts of Mercury General Corporation and its subsidiaries (referred to herein collectively as the “Company”). For the list of the Company’s subsidiaries, see Note 1. Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021. These interim financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from those filed in reports to insurance regulatory authorities. The financial data of the Company included herein are unaudited. In the opinion of management, all material adjustments of a normal recurring nature have been made to present fairly the Company’s financial position at September 30, 2022 and the results of operations and cash flows for the periods presented. All intercompany transactions and balances have been eliminated.
Certain financial information that is normally included in annual financial statements prepared in accordance with GAAP, but that is not required for interim reporting purposes, has been omitted from the accompanying interim consolidated financial statements and related notes. Readers are urged to review the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 for more complete descriptions and discussions. Operating results and cash flows for the nine months ended September 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022.
Certain prior period amounts have been reclassified to conform to the current period presentation.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about the effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to reserves for losses and loss adjustment expenses ("LAE"). Actual results could differ from those estimates. See Note 1. Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021.
Earnings (Loss) per Share
Potentially dilutive securities representing approximately 18,000 shares of common stock were excluded from the computation of diluted loss per share for the three months ended September 30, 2022, because their effect would have been anti-dilutive. For the nine months ended September 30, 2022, 1,294 incremental shares were excluded from the computation of diluted loss per share as the Company generated a net loss. There were no potentially dilutive securities with anti-dilutive effect for the three and nine months ended September 30, 2021.
Dividends per Share
The Company declared and paid a dividend per share of $0.3175 and $0.6325 during the three months ended September 30, 2022 and 2021, respectively, and dividends per share of $1.5875 and $1.8975 during the nine months ended September 30, 2022 and 2021, respectively.
Deferred Policy Acquisition Costs
Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses, and the servicing costs that will be incurred as premiums are earned. The Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. Deferred policy acquisition cost amortization was $168.9 million and $153.1 million for the three months ended September 30, 2022 and 2021, respectively, and $487.4 million and $468.6 million for the nine months
ended September 30, 2022 and 2021, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $2.3 million and $19.4 million for the three months ended September 30, 2022 and 2021, respectively, and $10.0 million and $40.7 million for the nine months ended September 30, 2022 and 2021, respectively.
Unearned premiums and loss and loss adjustment expense reserves are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. Unearned premiums and loss and loss adjustment expense reserves that are ceded to reinsurers are carried in other assets and reinsurance recoverables, respectively, in the Company's consolidated balance sheets. Earned premiums and losses and loss adjustment expenses are stated net of deductions for ceded reinsurance.
The Company is the assuming reinsurer under a Catastrophe Participation Reinsurance Contract (the "Contract") effective through December 31, 2022. The Company reimburses up to $25 million in losses for a proportional share of a portfolio of catastrophe losses under the Contract, to the extent the actual loss ratio exceeds the threshold loss ratio of 73.5%. If the actual loss ratio is less than the threshold loss ratio, the Company is eligible to receive a certain portion of the underwriting profit.
The Company is party to a Catastrophe Reinsurance Treaty (the "Treaty") covering a wide range of perils that is effective through June 30, 2023. The Treaty provides $936 million of coverage on a per occurrence basis after covered catastrophe losses exceed the $60 million Company retention limit. The Treaty specifically excludes coverage for any Florida business and for California earthquake losses on fixed property policies, such as homeowners, but does cover losses from fires following an earthquake. The Treaty provides for one full reinstatement of coverage limits with a minor exception at certain upper layers of coverage, and includes some additional minor territorial and coverage restrictions.
The effect of reinsurance on property and casualty premiums written and earned was as follows:
|Three Months Ended September 30,||Nine Months Ended September 30,|
| ||(Amounts in thousands)|
|Direct ||$||1,049,088 ||$||1,024,753 ||$||3,086,222 ||$||2,934,777 |
|Assumed||138 ||161 ||10,582 ||13,048 |
| Net||$||1,026,421 ||$||1,007,592 ||$||3,039,028 ||$||2,899,075 |
|Direct||$||1,009,829 ||$||947,458 ||$||2,974,651 ||$||2,800,357 |
|Assumed||2,684 ||3,322 ||8,142 ||9,912 |
| Net||$||989,688 ||$||933,605 ||$||2,925,410 ||$||2,761,934 |
The Company recognized ceded premiums earned of approximately $23 million and $17 million for the three months ended September 30, 2022 and 2021, respectively, and $57 million and $48 million for the nine months ended September 30, 2022 and 2021, respectively, which are included in net premiums earned in its consolidated statements of operations. The Company recognized ceded losses and loss adjustment expenses of approximately $(2) million and $(1) million for the three months ended September 30, 2022 and 2021, respectively, and $(15) million and $(4) million for the nine months ended September 30, 2022 and 2021, respectively, which are included in losses and loss adjustment expenses in its consolidated statements of operations. The negative ceded losses and loss adjustment expenses for the three and nine months ended September 30, 2022 and 2021 were primarily the result of favorable development on prior years' catastrophe losses that had been ceded to the Company's reinsurers.
The Company's insurance subsidiaries, as primary insurers, are required to pay losses to the extent reinsurers are unable to discharge their obligations under the reinsurance agreements.
Revenue from Contracts with Customers (Topic 606)
The Company's revenue from contracts with customers is commission income earned from third-party insurers by its
100% owned insurance agencies, which amounted to approximately $4.5 million and $4.6 million, with related expenses of $2.5 million and $3.0 million, for the three months ended September 30, 2022 and 2021, respectively, and $13.5 million and $15.9 million, with related expenses of $8.0 million and $9.9 million, for the nine months ended September 30, 2022 and 2021, respectively. All of the commission income, net of related expenses, is included in other revenues in the Company's consolidated statements of operations, and in other income of the Property and Casualty business segment in the Company's segment reporting (see Note 13. Segment Information).
As of September 30, 2022 and December 31, 2021, the Company had no contract assets and contract liabilities, and no remaining performance obligations associated with unrecognized revenues.
Allowance for Credit Losses
Financial Instruments - Credit Losses (Topic 326) uses the "expected loss" methodology for recognizing credit losses for financial assets that are not accounted for at fair value through net income. The Company's investment portfolio, which does not include accrued investment income, is not subject to Topic 326 as it applies the fair value option to all of its investments (see Note 4. Fair Value Option). The estimated allowance amounts for credit losses at September 30, 2022 and December 31, 2021 related to premiums receivable.
The majority of the Company's premiums receivable are short-term in nature and are due within a year, consistent with the policy term of its insurance policies sold. Generally, premiums are collected prior to providing risk coverage, minimizing the Company's exposure to credit risk. In estimating an allowance for uncollectible premiums receivable, the Company assesses customer balances and write-offs by state, line of business, and the year the premiums were written. The estimated allowance is based on historical write-off percentages adjusted for the effects of current trends and reasonable and supportable forecasts, as well as expected recoveries of amounts written off.
The improving economy and declining unemployment rate contributed to the reduction in allowance for credit losses for the nine months ended September 30, 2021. However, the rising inflation and interest rates had negative impacts on the allowance for credit losses for the nine months ended September 30, 2022, mostly offsetting the positive impacts of some improvements in the economy.
The following table presents a summary of changes in allowance for credit losses on premiums receivable:
| ||Three Months Ended September 30,||Nine Months Ended September 30,|
| ||(Amounts in thousands)|
|Beginning balance||$||6,000 ||$||6,000 ||$||6,000 ||$||10,000 |
| Provision during the period for expected credit losses ||1,153 ||694 ||3,330 ||(1,837)|
|Write-off amounts during the period||(1,311)||(838)||(3,798)||(2,610)|
|Recoveries during the period of amounts previously written off ||158 ||144 ||468 ||447 |
|Ending balance ||$||6,000 ||$||6,000 ||$||6,000 ||$||6,000 |
Accrued Interest ReceivablesThe Company made certain accounting policy elections for its accrued interest receivables allowed under Topic 326: a) an election to present accrued interest receivable balances separately from the associated financial assets on the balance sheet, and b) an election not to measure an allowance for credit losses on accrued interest receivable amounts and instead write off uncollectible accrued interest amounts in a timely manner by reversing interest income. The Company's accrued interest receivable balances are included in accrued investment income receivable in its consolidated balance sheets. There were no accrued interest receivable amounts considered uncollectible or written off during the three and nine months ended September 30, 2022 and 2021.