Mercury's fourth-quarter and full-year results were slightly disappointing. Net earned premiums were up 2.8% to $754 million for the quarter, and net income was up 8.4% to $50 million. The combined ratio increased 50 basis points from the prior-year period, to 96.5%, but an increase in net investment income more than offset the difference.
For the year, net premiums earned were up 5.2% and net income fell 15% to $214 million. The main culprit in the income shortfall was a 260-basis-point increase in the combined ratio, to 95%.
As time goes on and more data comes in, an insurer has to revise estimates it made in the past regarding loss reserves. In 2005, favorable reserve development helped Mercury's bottom line to the tune of $45 million. In 2006, the company incurred some unfavorable reserve development, which was a $20 million hit to net income. The problem stemmed mainly from Mercury's expansion plans.
Most of Mercury's business (more than 70%) is written in California, but the company is expanding to other states. However, it takes awhile to build up the necessary experience and scale to expand, and in 2006 the company hit some speed bumps. Although non-California business was only 26% of Mercury's written premiums, it accounted for $35 million in adverse reserve development, compared with the California segment's $15 million in favorable reserve development.
The expansion plans are still a work in progress. In 2006, non-California operations posted a 108.3% combined ratio -- 18 points worse than the California segment's 90.3% combined ratio. In the earnings call, the company identified Florida and New Jersey as particularly tough markets. New Jersey recently opened up its market, and competitors like GEICO (a unit of Berkshire Hathaway
In the long term, Mercury General should be able to improve non-California results as it gets more experience and scale in other states (its long-term target is a 95% combined ratio), but the company cautioned that driving that improvement could take awhile.
It's not what the numbers are, it's what they mean. The silver lining to the current struggles is that the non-California segment's unprofitable status, if improvement can be expected over the next couple of years, temporarily and artificially depresses the company's earnings as it reinvests for the future. Hopefully, this will be a future catalyst for increased earnings power.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. Berkshire Hathaway is an Inside Value recommendation. The Motley Fool's disclosure policy is insured for a cool million.