Mapping out the Road Ahead 2008 Annual Report For nearly five decades, Mercury has proven itself to be a solid investment, committed to building the kind of financial strength that yields security for its policyholders and consistent returns for its shareholders. Total of $4.0 billion in4.0 assets Billion Mercury finished 2008 with 4,700 independent insurance agents and brokers in 13 states 4,700 Agents Total of $1.5 billion in Shareholders'1 Equity .5 Billion To Our Shareholders: Even as we embark on a new year and make our impact of SFAS No. 159, were $116 million, or $2.12 way into 2009, there is no denying the far-reaching per share, for 2008, compared to $4.09 per share for implications of the severe economic decline. It has 2007. This year over year reduction was primarily due impacted virtually every type of company, in every to an increase in our combined ratio, which I discuss industry, across every region of the country, and we in further detail below. are no exception. Although the insurance industry is The competitive environment for personal automo- somewhat less vulnerable during a recession, we bile insurance remained intense during 2008. are not immune to the unique challenges of the cur- Favorable underwriting results for the industry over rent environment. The rapid decline of the equity the past several years has extended the duration of and debt markets during the latter half of 2008 sig- the soft market. One of the primary drivers of this nificantly impacted our investment portfolio. In addi- trend has been lower loss frequency. However, we tion, increasing job losses, deteriorating credit mar- believe increases in claim severity will more than off- kets and the lack of consumer confidence all affect set the reduction in frequency going forward. our business as well. Although we may face addi- Consequently, we continue to expect rate increase tional challenges in the months ahead before things filings to outpace rate decrease filings during 2009, get better, history has taught us they will get better, continuing a trend we began to observe in late 2008. and we are positioning the Company to be ready Nevertheless, significant marketing expenditures and when the market improves. increased agent incentives by many of our competi- Turning to our Statement of Operations for 2008, tors made 2008 a very difficult environment in which the Company posted a net loss of $242 million, or to grow. $4.42 per share, in 2008. The net loss was due, pri- As a result, Company-wide premiums written marily, to declines in the value declined from 2007 by 7.8% to $2.8 billion in 2008. Although the insurance of our investment portfolio that In California, premiums written declined by 6.2% for industry is somewhat resulted from the extreme dis- the year to $2.2 billion, while our non-California oper- ruption in the capital markets ations premiums written declined by 13.1% to $589 less vulnerable during a during the second half of the million. As I discuss in more detail later in this letter, recession, we are not year. As a result of implement- we have many initiatives throughout the Company to immune from the unique ing Statement of Financial increase our premium volume. However, as we look challenges of the Accounting Standards No. ahead, we anticipate 2009 to be another challenging current environment. 159 (“SFAS No. 159”) in 2008, year, with expected declines in premium growth the total realized investment somewhere in the range of mid-single digits. loss of $551 million included As I referenced earlier, we experienced a $526 million of losses on investments that the Company-wide deterioration in our combined ratio, Company still holds. Approximately half that amount which increased to 101.8% in 2008, compared with comes from bonds, which we generally intend to 95.4% in 2007. In California, our combined ratio hold until they recover their value at maturity. increased from 92.6% in 2007 to 98.0% in 2008, Operating earnings, which exclude actual realized reflecting higher severity in our auto line, partially off- gains and losses from the sale of securities and the set by a reduction in frequency. In addition, we saw 1 an increase in adverse development, which reached cedures, made changes to our claims process for $57 million for 2008 compared to $26 million in PIP and Bodily Injury coverage and continue to work 2007. Lower average premiums in our California with our agents to improve results. We believe that homeowners and personal auto lines also contribut- claims process changes are having a positive impact ed to the combined ratio deterioration. In California, on our PIP costs for the we have filed for an approximate 2% rate increase in current accident year and In addition to operational our personal auto line in order to improve our results should begin to work efficiencies, growth and in this, our largest market. themselves into the finan- Our non-California operations produced a com- cial results in the future. profitability are also bined ratio of 115.7% in 2008 compared to 104.4% Our Company-wide necessary for Mercury’s in 2007—clearly unacceptable. This was primarily expense ratio grew from long-term success. due to our results in Florida and New Jersey, which 27.4% in 2007 to 28.5% in produced a combined underwriting loss of $71 mil- 2008. The increase was lion in 2008, compared with an underwriting loss of primarily due to three areas: technology-related $21.4 million in 2007. Included in the 2008 under- expenditures, the establishment of our new product writing loss was approximately $26 million in adverse management function and expenses related to the loss and loss adjustment expense development. This acquisition of Auto Insurance Specialists, Inc. (AIS). compares with $7 million of positive development In addition, fixed costs have not declined in propor- in 2007. tion to the decline in premiums. In Florida, our second largest state, improvements In an effort to improve our cost structure, we have in our claims handling have significantly reduced the taken a number of difficult but necessary steps that severity of our bodily injury claims, while expenses will help offset the increase in both our loss adjust- related to defending and containing bodily injury ment and underwriting expense ratios. Those steps indemnity costs have increased. Although we are include a salary freeze for all employees, a hiring pleased with the operational improvements made in freeze, except for certain positions, and a temporary Florida, we still have a ways to go to meet our profit- suspension of our 401(k) matching program. In addi- ability target and have filed for a 6% rate increase tion, in March 2009, we reduced our work force by that should go a long way towards getting us there. over 7%. This was a painful decision to make but, New Jersey is our most challenging state. The after careful consideration, it was deemed necessary laws governing Personal Injury Protection (PIP) cov- for the long-term benefit of the Company. The net erage led to a longer claims tail than in most other annual cost savings from these cost cutting mea- states and, with our short operating history, it has sures will be over $20 million. been difficult for us to estimate loss reserves. In addition to operational efficiencies, growth and Consequently, we experienced adverse loss devel- profitability are also necessary for Mercury’s long- opment in 2008 of $28 million and $8 million in 2007. term success. Consequently, we have identified the During 2008, we began relying less on industry data following key strategies to help grow our business, and more on internal Company data to estimate our improve our service and enhance our bottom line: reserves, however, it is still reasonable to expect reserve volatility in the future. • Implement improved pricing segmentation and overall rate adequacy. In New Jersey, we are taking various steps to • Continue to invest in our technology to make it improve our results. Effective January 1, 2009, we easier for our agents, customers and employees to put in place a new pricing plan, which improves our transact business with us, including the roll out of risk segmentation and increases overall rates by 5%. our new Web-based agent interface program, In addition, we have tightened our underwriting pro- Mercury First. 2 • Implement best practices and standardized proce- ratio of 2 to 1. In February 2009, Mercury’s Board of dures across all functions. Directors kept the dividend rate unchanged at $0.58 • Simplify our processes for greater efficiency and cents per share, providing a generous dividend yield improved customer service. based on the recent market price of our stock. We • Increase customer reach by leveraging the Internet will continue to evaluate our dividend quarterly based more effectively and increasing the number of rela- on our results and capital position. tionships with qualified agents. In January of 2009, we completed our purchase of • Continue our Service Excellence program, which AIS, a major producer of personal lines insurance in was rolled out in 2008. the state of California. AIS represented approximately Quite clearly, our investment results in 2008 were 15% of Mercury’s premium volume in 2008. We are significantly impacted by the decline in the capital pleased to report that the transition and integration markets as a result of the financial crisis and global efforts are going very smoothly and anticipate the recession. About half of Mercury’s losses came from purchase of AIS will be slightly accretive to earnings our municipal bond portfolio. Nevertheless, the port- in 2009.