S&P Lowers Mercury’s Ratings to ‘AA-‘

May 14, 2007

Standard & Poor’s Ratings Services has lowered its counterparty credit and financial strength ratings on Mercury Casualty Co. (Mercury Casualty), Mercury Insurance Co. (Mercury Insurance), and its financial strength rating on Mercury Insurance Co. of Florida, to ‘AA-‘ from ‘AA.’

S&P also lowered its counterparty credit and senior debt ratings on Mercury General Corp. to ‘A-‘ from ‘A’. The outlook on all these ratings is stable.

However S&P noted that its has “affirmed its ‘A’ counterparty credit and financial strength ratings on California Automobile Insurance Co. and revised the outlook to stable from negative based on the recognition of California Auto as a strategically important entity to Mercury General and because of its substantially improved level of capitalization.”

S&P took the rating action, when, in its view, Mercury no longer showed the ability to maintain historical levels of profitability superior to the industry. Although its 2006 combined ratio was 94 percent, “it no longer exceeds its interactively rated peer group average to the same degree,” stated S&P credit analyst Tracy Dolin. “Contrary to our expectations, the company continues to be challenged in its efforts to expand outside California as demonstrated by moderating operating performance and declining premium growth.”

Mercury hasn’t been able to control its losses as effectively outside of its California market base. S&P does recognize the efforts the Company is making, but feels it will still take “several years for the group to collect internal loss experience data to implement tailored loss controls on a state-by-state basis.”

On an overall basis, S&P noted that Mercury has had only limited success with its diversification efforts. They are, however, considered a key factor in its efforts to build “sustainable earnings” outside of its home market.

S&P also considers Mercury to be “susceptible to regulatory, legal, and competitive environmental pressures in California due to its sizable book, constituting 74 percent of 2006 net GAAP premiums written,” even though it continues to perform well in California (GAAP combined ratio of 90.3 percent). Outside the state it’s another story as underwriting losses produced a GAAP combined ratio of 108.3 percent in 2006.

“Although we view Mercury’s diversification plan as a prudent long-term strategy, its ability to do so while maintaining historical standards of profitability remains in doubt,” S&P stressed.

Commenting on the effects from California’s Proposition 103, S&P said they haven’t “forced the magnitude of changes to Mercury’s business practice and competitive structure that was envisioned in 2006.” They do, however present “difficult regulatory, legal, and competitive pressures as it remains highly concentrated in California, potentially compromising its competitive position.”

S&P describes a “Catch-22” situation in California, with deregulatory controls that may invite increased competition as consumers shop for more favorable rates, while “more stringent regulatory rulings” may cause “California business writings to be unattractive.”

Mercury nonetheless retains a strong position in California with “extremely strong capitalization, superior operating performance, and local market presence as California’s largest independent agency auto,” said S&P. Its high concentration in the state along with its “increased underwriting leverage in recent years,” should be considered as partially offsetting factors.

S&P said it “believes that the company’s efforts to diversify will take some time to prove viable.” While Mercury’s risk management capabilities in California are proven, the company is in the process of phasing in and improving its risk controls outside of California. It’s focused on “establishing the same level of agency relationships in the newer states and understanding each state’s unique risk profile,” S&P notes. “Specifically, the company will sharpen its tools to ensure the adequacy of rates and the adequacy of reserves to be on par to its California system.”

Outside California S&P sees Mercury’s premium growth continuing to “decelerate in the intermediate term,” while homeowners insurance will constitute more than the 6 percent of premium it produces now.

“Capitalization is expected to remain extremely strong, but the capital adequacy ratio will probably decrease slightly because of the group’s expansion.”

S&P also expects Mercury’s net written premium growth to slow, even while it maintains a combined ratio in the mid 90 percent range, “reflecting anticipated continued softening in personal lines through year-end 2007. Debt-to-capital is expected to remain conservative at 15 percent or lower in 2007. Interest coverage is expected to remain above its current rating level at 10x or better.”

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