Mercury General Corporation

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Mercury General Corporation (MCY) is a California-based insurance company primarily focused on providing automobile insurance, with some additional presence in homeowners, renters, and commercial auto insurance.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Mercury General’s business model revolves around assessing risks and pricing policies accordingly to generate premiums, then investing a portion of the premiums to generate additional profits.

Business Overview

Revenue Distribution: MCY’s revenue is largely derived from insurance premiums, primarily in the auto insurance sector. The company does offer insurance in other areas, including homeowners, renters, and commercial auto insurance, but the primary revenue driver comes from auto insurance in California, Florida, and Illinois.

  • The company’s geographical concentration (California, Florida, Texas and Illinois) leads to higher revenue and higher operating margins, as these states offer more profitable business.

Industry Trends: The insurance industry is undergoing significant changes. Technology, such as telematics and data analytics, is increasingly influencing how insurance companies assess risk and price premiums.

  • Consumers expect faster claims resolution, personalized pricing and convenience. Digital channels are also preferred by consumers for interacting with insurers.
  • Increased competition with both traditional insurers and new tech-focused companies is increasing.

Margins: MCY’s profitability is influenced by both its underwriting results and its investment performance. The combined ratio is a key metric to watch, as it indicates the profitability of insurance operations. A combined ratio below 100% indicates that the company is making an underwriting profit. The company needs to maintain its expense ratios at appropriate levels to maintain strong profitability.

  • The company has experienced some pressure in its auto insurance line as a result of higher claim severities, due to increased costs of vehicle repairs, parts and medical care.
  • The company’s operating expenses are mainly salaries and compensation for employees as well as IT.

Competitive Landscape: The insurance sector is highly competitive, with numerous players ranging from established giants to smaller regional companies and innovative insurtech startups.

  • The company competes mostly with other large, established regional or national insurance companies.
  • Pricing pressure from competitors, as they attempt to increase market share, is significant.
  • Insurtechs are using technology to offer better customer experiences and improve the efficiency of claims handling, providing additional competitive pressure.

What Makes MCY Different? While Mercury has a long history of operating in the personal insurance marketplace, its main strength lies in its distribution capabilities and geographical knowledge in its core regions of California, Texas, Illinois, and Florida. It has built long-term relationships with brokers in those states and is well-known by customers.

  • The company also has an investment portfolio with high-quality bonds which help offset risk from underwriting operations.
  • Unlike some of its peers, the company does not have any international operations, so it can focus all of its efforts in the domestic market.

Financial Analysis

Income Statement: The company’s income statement shows fluctuation. It’s net premiums earned has increased over the years, but the net income is inconsistent due to higher claims and higher loss ratios. Expenses (particularly general and administrative) has been fairly flat, which is a positive sign. Also, investment income, which constitutes a significant part of MCY’s business, fluctuates depending on market conditions.

Balance Sheet: MCY’s assets largely consist of investments, particularly in bonds, while its liabilities mainly comprise unearned premiums and claim reserves. Total assets have decreased over the past couple of years, and so has total debt.

  • The company’s solvency ratios are quite good (such as debt to capital and total liabilities to total assets).

Cash Flow Statement: MCY’s cash flow from operations is variable, depending on changes in premiums, claims, and the timing of settlements and investments. Generally, the company uses its cash flow from operations to make more investments and to pay off debt and obligations.

  • Given the volatile nature of its revenues, the cash flow is very sensitive to business cycles.

Moat Assessment:

MCY’s moat is rated as a 2/5. While it has a recognized brand in its operating markets, it is limited in scope and depth.

  • Intangible assets: While MCY has brand recognition in its operating markets, the insurance industry is characterized by commodified products that are often interchangeable. Hence, the brand value can only partially act as a moat.
  • Switching costs: Customers are not particularly locked in, since they may move from one company to another relatively easily, thus switching costs is considered as low.
  • Network effects: This is not applicable to the insurance industry.
  • Cost advantages: The company doesn’t have any significant cost advantage over its peers. Economies of scale could benefit larger insurers. Overall, this is one of the weaker parts of its competitive advantage.

Legitimate Risks:

  1. Catastrophic Events: Major events, such as earthquakes and hurricanes, could create substantial claims and sharply reduce financial results.
  2. Changes in Regulations: The regulatory landscape for insurance can change rapidly, imposing higher capital requirements or new forms of taxes. Such changes could impact profits and cash flows.
  3. Interest Rates and Investment Returns: Fluctuations in interest rates may affect a significant portion of the earnings generated by a company.
  4. Competitive Pressures: Aggressive pricing by competitors, new technological innovations from insurtech startups and an overall increase in competition are ongoing threats.
  5. Inflation: Rising claims costs, especially due to higher vehicle repair costs and higher costs of medical care, can reduce profitability by more than expected.
  6. Credit Risk: Significant credit losses can occur from defaults on fixed income securities or other investments held.

Business Resilience: MCY has some ability to recover from temporary setbacks through its investment portfolio and conservative financing policies. However, prolonged periods of low interest rates or high claim activity could severely damage the balance sheet and the returns it can generate to investors.

  • Management has mentioned that their primary focus is on long-term growth and stability, which allows it to more effectively navigate the business cycle.

Understandability Rating: 2 / 5

The business is relatively easy to understand. Understanding the basics of insurance operations is simple to grasp. However, it can be complex, since so many variables can affect its revenues, operating margins, and profitability. Also, understanding the regulatory and tax landscape may further increase the complexity of the business.

  • For most people, insurance companies are a difficult to understand. There are so many things to look at-that most people will never understand.

Balance Sheet Health Rating: 3 / 5

While MCY’s balance sheet isn’t excellent, it’s not poor either. The company can still withstand a major market event, although its debt levels are not great. But the company’s cash balances are more than enough to meet its short-term obligations. Also, the company does not pay a very high dividend compared to its peers, which allows the management to reinvest into operations.

  • The management seems to be quite conservative, since it maintains a solid portion of its assets in bonds.
  • The lack of high debt means that the company can react quicker in case of a market event and have more optionality.
  • The company may face some troubles because it has large holdings of municipal and local bonds. The market for this is notoriously illiquid.