MERCURY GENERAL CORP (Form: 10-Q, Received: 11/03/2009 17:13:44)

Large accelerated filer

Accelerated filer

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended September 30, 2009

Commission File No. 001-12257

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

California

95-2211612

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)


4484 Wilshire Boulevard, Los Angeles, California		90010
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (323) 937-1060

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the Registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act). Yes ¨ No x

At October 31, 2009, the Registrant had issued and outstanding an aggregate of 54,770,238 shares of its Common Stock.

PART I - FINANCIAL INFORMATION

Item 1.

Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	September 30, 2009			December 31, 2008
	(unaudited)
ASSETS
Investments:
Fixed maturities trading, at fair value (amortized cost $2,692,117; $2,728,471)	$	2,728,815		$	2,481,673
Equity securities trading, at fair value (cost $321,911; $403,773)		287,720			247,391
Short-term investments, at fair value (cost $126,328; $208,278)		126,172			204,756

Total investments		3,142,707			2,933,820
Cash		204,194			35,396
Receivables:
Premiums receivable		267,684			268,227
Premium notes		23,357			25,699
Accrued investment income		38,168			36,540
Other		9,835			9,526

Total receivables		339,044			339,992
Deferred policy acquisition costs		182,237			200,005
Fixed assets, net		200,930			191,777
Current income taxes		—			43,378
Deferred income taxes		63,604			171,025
Goodwill		42,850			5,206
Other intangible assets		68,526			—
Other assets		29,755			29,596

Total assets	$	4,273,847		$	3,950,195


LIABILITIES AND SHAREHOLDERS’ EQUITY
Losses and loss adjustment expenses	$	1,055,887		$	1,133,508
Unearned premiums		871,698			879,651
Notes payable		272,690			158,625
Accounts payable and accrued expenses		133,954			93,864
Current income taxes		7,113			—
Other liabilities		163,892			190,496

Total liabilities		2,505,234			2,456,144

Commitments and contingencies
Shareholders’ equity:
Common stock without par value or stated value:
Authorized 70,000,000 shares; issued and outstanding 54,770,238 in 2009 and 54,763,713 shares in 2008		72,248			71,428
Accumulated other comprehensive loss		(672	)		(876	)
Retained earnings		1,697,037			1,423,499

Total shareholders’ equity		1,768,613			1,494,051

Total liabilities and shareholders’ equity	$	4,273,847		$	3,950,195

See accompanying Condensed Notes to Consolidated Financial Statements.

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)


	Three Months Ended September 30,
	2009		2008
Revenues:
Net premiums earned	$	653,758	$	696,605
Net investment income		35,208		38,086
Net realized investment gains (losses)		171,373		(276,973	)
Other		895		1,313

Total revenues		861,234		459,031

Expenses:
Losses and loss adjustment expenses		446,436		511,806
Policy acquisition costs		130,172		154,530
Other operating expenses		53,766		44,350
Interest		1,634		1,663

Total expenses		632,008		712,349

Income (loss) before income taxes		229,226		(253,318	)
Income tax expense (benefit)		71,489		(112,779	)

Net income (loss)	$	157,737	$	(140,539	)

Basic earnings per share (weighted average shares outstanding 54,769,799 in 2009 and 54,748,101 in 2008)	$	2.88	$	(2.57	)

Diluted earnings per share (weighted average shares 55,312,825 as adjusted by 543,026 for the dilutive effect of options in 2009 and 54,748,101 in 2008)	$	2.85	$	(2.57	)

Dividends declared per share	$	0.58	$	0.58

See accompanying Condensed Notes to Consolidated Financial Statements.

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)


	Nine Months Ended September 30,
	2009		2008
Revenues:
Net premiums earned	$	1,979,032	$	2,128,725
Net investment income		109,334		116,380
Net realized investment gains (losses)		352,549		(332,614	)
Other		3,256		3,809

Total revenues		2,444,171		1,916,300

Expenses:
Losses and loss adjustment expenses		1,336,191		1,484,824
Policy acquisition costs		414,062		472,112
Other operating expenses		158,616		131,834
Interest		5,059		3,659

Total expenses		1,913,928		2,092,429

Income (loss) before income taxes		530,243		(176,129	)
Income tax expense (benefit)		161,406		(102,355	)

Net income (loss)	$	368,837	$	(73,774	)

Basic earnings per share (weighted average shares outstanding 54,768,951 in 2009 and 54,737,337 in 2008)	$	6.73	$	(1.35	)

Diluted earnings per share (weighted average shares 55,080,542 as adjusted by 311,591 for the dilutive effect of options in 2009 and 54,737,337 in 2008)	$	6.70	$	(1.35	)

Dividends declared per share	$	1.74	$	1.74

See accompanying Condensed Notes to Consolidated Financial Statements.

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009		2008
Net income (loss)	$	157,737		$	(140,539	)	$	368,837	$	(73,774	)
Other comprehensive (loss) income, before tax:
(Losses) gains on hedging instrument		(187	)		(186	)		315		83

Other comprehensive (loss) income, before tax		(187	)		(186	)		315		83

Income tax (benefit) expense related to (losses) gains on hedging instrument		(65	)		(65	)		111		29

Comprehensive income (loss), net of tax	$	157,615		$	(140,660	)	$	369,041	$	(73,720	)

See accompanying Condensed Notes to Consolidated Financial Statements.

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Nine Months Ended September 30,
	2009			2008
Cash flows from operating activities:
Net income (loss)	$	368,837		$	(73,774	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		26,315			19,918
Net realized investment (gains) losses		(352,549	)		332,614
Bond amortization, net		4,760			5,711
Excess tax benefit from exercise of stock options		(5	)		(133	)
Decease in premiums receivable		543			10,098
Decrease (increase) in premiums notes receivable		2,342			(1,346	)
Decrease in deferred policy acquisition costs		17,768			4,037
Decrease in unpaid losses and loss adjustment expenses		(77,621	)		(54,674	)
Decrease in unearned premiums		(7,953	)		(20,229	)
Decrease (increase) in income taxes		157,806			(139,535	)
Increase in accounts payable and accrued expenses		37,751			3,477
Decrease in trading securities in nature, net of realized gains and losses		3,209			2,042
Share-based compensation		571			489
Decrease in other payables		(14,859	)		(11,867	)
Other, net		(10,455	)		(4,216	)

Net cash provided by operating activities		156,460			72,612
Cash flows from investing activities:
Fixed maturities available for sale in nature:
Purchases		(364,866	)		(521,102	)
Sales		226,184			423,031
Calls or maturities		165,159			184,913
Equity securities available for sale in nature:
Purchases		(218,038	)		(336,636	)
Sales		242,392			247,545
Net increase in payable for securities		1,713			2,973
Net decrease in short-term investments		78,756			19,818
Purchase of fixed assets		(30,215	)		(37,787	)
Sale and write off of fixed assets		345			1,115
Business acquisition, net of cash acquired		(115,488	)		—
Other, net		1,446			5,029

Net cash used in investing activities		(12,612	)		(11,101	)
Cash flows from financing activities:
Dividends paid to shareholders		(95,299	)		(95,248	)
Excess tax benefit from exercise of stock options		5			133
Proceeds from stock options exercised		244			1,120
Proceeds from bank loan		120,000			18,000

Net cash provided by (used in) financing activities		24,950			(75,995	)

Net increase (decrease) in cash		168,798			(14,484	)
Cash:
Beginning of the period		35,396			48,245

End of the period	$	204,194		$	33,761

Supplemental disclosures of cash flow information:
Interest paid during the period	$	6,077		$	5,595
Income taxes paid during the period	$	3,594		$	36,823
Net realized (losses) gains from sale of investments	$	(62,744	)	$	10,197

See accompanying Condensed Notes to Consolidated Financial Statements.

MERCURY GENERAL CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of Presentation

The condensed consolidated financial statements include the accounts of Mercury General Corporation (“Mercury General”) and its directly and indirectly wholly owned insurance and non-insurance subsidiaries (collectively, the “Company”). The insurance subsidiaries are: Mercury Casualty Company (“MCC”), Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Mercury Insurance Company of Illinois, Mercury Insurance Company of Georgia, Mercury Indemnity Company of Georgia, Mercury National Insurance Company, American Mercury Insurance Company, American Mercury Lloyds Insurance Company (“AML”), Mercury County Mutual Insurance Company (“MCM”), Mercury Insurance Company of Florida and Mercury Indemnity Company of America. The non-insurance subsidiaries are: Mercury Select Management Company, Inc. (“MSMC”), American Mercury MGA, Inc., Concord Insurance Services, Inc., Mercury Insurance Services, LLC, Mercury Group, Inc., AIS Management LLC, Auto Insurance Specialists, LLC (“AIS”) and PoliSeek AIS Insurance Solutions, Inc. (“PoliSeek”). AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact, MSMC. MCM is not owned by the Company, but is controlled through a management contract and therefore its results are included in the condensed consolidated financial statements. The condensed consolidated 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. All significant intercompany balances and transactions have been eliminated.

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 and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates and assumptions in the preparation of these condensed consolidated financial statements relate to losses and loss adjustment expenses and evaluation of the recoverability of deferred tax assets. Actual results could differ materially from those estimates (See Note 1 “Significant Accounting Policies” of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008).

The financial data of the Company included herein has been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature necessary to present fairly the Company’s financial position at September 30, 2009 and the results of operations, comprehensive income and cash flows for the periods presented have been made. Operating results and cash flows for the nine-month period ended September 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

Certain reclassifications have been made to the prior-period balances to conform to the current-period presentation.

2. Recently Adopted Accounting Standards

In June 2009, the Financial Accounting Standards Board (“FASB”) issued a new standard related to accounting standards codification and the hierarchy of generally accepted accounting principles. The new standard establishes the FASB Accounting Standards Codification ^TM as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the Securities and Exchange Commission under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. The new standard is effective for the interim reporting period ended September 30, 2009. The adoption of the new standard did not have a material impact on the Company’s condensed consolidated financial statements.

Effective January 1, 2009, the FASB issued a new accounting standard related to business combinations wherein an acquirer is required to use the acquisition method, previously referred to as the purchase method, for all business combinations and, further, for an acquirer to be identified for each business combination. This new standard significantly changes the accounting for business combinations in a number of areas including the treatment of contingent consideration, contingencies, and acquisition costs. It requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. Costs incurred to effect the acquisition are required to be recognized separately from the acquisition rather than included in the cost allocated to the assets acquired and liabilities assumed. The acquirer is required to recognize goodwill as of the acquisition date, measured as a residual, which in most types of business combinations will result in measuring goodwill as the excess of the consideration transferred plus the fair value of any noncontrolling interest in the acquiree at the acquisition date over the fair values of the identifiable net assets acquired. The standard also provides that changes in deferred tax asset valuation allowances and acquired income tax uncertainties that occur after the measurement period impact income tax expense.

Effective January 1, 2009, MCC acquired all of the membership interests of AIS Management LLC, a California limited liability company, which is the parent company of AIS and PoliSeek. The acquisition was accounted for in accordance with the new standard and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In March 2008, the FASB issued a new accounting standard to expand disclosures related to derivative instruments and hedging activities. The new standard requires increased qualitative disclosures such as how and why an entity is using a derivative instrument; how the entity is accounting for its derivative instrument and hedged item; and how the instrument affects the entity’s financial position, financial performance, and cash flows. Quantitative disclosures should include information about the fair value of the derivative instrument, including gains and losses, and should contain more detailed information about the location of the derivative instrument in the entity’s financial statements. Credit-risk disclosures should include information about the existence and nature of credit-risk-related contingent features included in derivative instruments. Credit-risk-related contingent features can be defined as those that require entities, upon the occurrence of a credit event such as a credit rating downgrade, to settle derivative instruments or post collateral. Existing financial accounting requirements for derivative instruments and hedging activities were not changed. The Company adopted the new standard on January 1, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In April 2008, the FASB issued a new accounting standard related to the determination of the useful life of intangible assets. This standard amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset and it is effective for fiscal years beginning after December 15, 2008. The Company adopted the new standard on January 1, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

In April 2009, the FASB issued a new accounting standard related to accounting for contingencies in a business combination. Under the new standard, an acquirer is required to recognize assets or liabilities arising from contingencies provided that the acquisition-date fair value of that asset or liability can be determined during the measurement period. The Company adopted the new standard effective January 1, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

The Company adopted the new FASB standard related to determining fair value when the volume and level of activity for an asset or liability have significantly decreased and identifying transactions that are not orderly. The new standard relates to selected transactions in disrupted markets and adopts guidelines related to a significant decrease in the volume and level of activity for an asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for an asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with earlier FASB standards related to fair value measurements. The new accounting standard became effective for the interim reporting period ended June 30, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

The Company adopted the new FASB standard related to interim disclosures about fair value of financial instruments which amends the earlier FASB standard related to such disclosures. The new standard requires disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies, in addition to disclosures previously required in annual financial statements. The new standard also amends the original standard related to interim financial reporting of fair value disclosures, and now requires related disclosures to be presented in a summarized form at interim reporting periods. The new accounting standard became effective for the interim reporting period ended June 30, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

The Company adopted the new FASB standard related to subsequent events. The new standard establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. It requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date. The new accounting standard became effective for the interim reporting period ended June 30, 2009 and its adoption did not have a material impact on the Company’s condensed consolidated financial statements.

3. Financial Instruments

The financial instruments recorded in the consolidated balance sheet include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured and unsecured notes payable. Due to their short-term maturity, the carrying amounts of receivables and accounts payable approximate their fair market values. The following table sets forth the carrying amounts and estimated fair values of other financial instruments at September 30, 2009 and December 31, 2008.


	September 30, 2009				December 31, 2008
	Carrying Value		Fair Value		Carrying Value		Fair Value
	(Amounts in thousands)
Assets
Investments	$	3,142,707	$	3,142,707	$	2,933,820	$	2,933,820
Interest rate swap agreements	$	9,776	$	9,776	$	14,394	$	14,394
Liabilities
Interest rate swap agreements	$	2,562	$	2,562	$	1,348	$	1,348
Equity contracts	$	2,126	$	2,126	$	2,803	$	2,803
Secured notes	$	138,000	$	137,315	$	—	$	—
Unsecured note	$	134,690	$	130,500	$	158,625	$	146,758

Methods and assumptions used in estimating fair values are as follows:

Investments

Effective January 1, 2008, the Company elected to apply the fair value option to all available-for-sale, fixed maturity and equity securities, and short-term investments existing at the time of adoption and similar securities acquired subsequently. The election included all hybrid securities held by the Company and similar securities acquired subsequently. Therefore, these securities are carried at fair value. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Interest rate swap agreements

The fair value of interest rate swap agreements reflects the estimated amounts that the Company would pay or receive at September 30, 2009 and December 31, 2008 in order to terminate the contracts based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract. For additional disclosures regarding methods and assumptions used in estimating fair values of interest rate swap agreements, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Equity contracts

The fair value of equity contracts is based on quoted prices for identical instruments in active markets. For additional disclosures regarding methods and assumptions used in estimating fair values of equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

Secured notes

The fair value of the Company’s $120 million and $18 million secured notes is estimated based on assumptions and inputs, such as reset rates, for similar termed notes that are observable in the market.

Unsecured note

The fair value of the Company’s publicly traded $125 million unsecured note is based on the unadjusted quoted price for similar notes in active markets.

4. Fair Value of Financial Instruments

Gains and losses due to changes in fair value for items measured at fair value pursuant to election of the fair value option are included in net realized investment gains (losses) in the Company’s consolidated statements of operations, while interest and dividend income on the investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as expansion of use of fair value measurement consistent with the long-term measurement objectives of the FASB for accounting for financial instruments. The following table reflects gains (losses) due to changes in fair value for items measured at fair value pursuant to election of the fair value option:


	Three Months ended September 30,						Nine Months ended September 30,
	2009			2008			2009			2008
	(Amounts in thousands)
Fixed maturity securities	$	136,062		$	(121,852	)	$	283,496		$	(191,709	)
Equity securities		55,281			(129,238	)		122,200			(129,781	)
Short-term investments		(84	)		(3,031	)		(87	)		(3,344	)

Total	$	191,259		$	(254,121	)	$	405,609		$	(324,834	)

5. Fair Value Measurement

The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price). Accordingly, when market observable data is not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Financial assets and financial liabilities recorded on the consolidated balance sheets at fair value are categorized based on the reliability of inputs to the valuation techniques as follows:

Level 1 Financial assets and financial liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in active markets that the Company can access.

Level 2 Financial assets and financial liabilities whose values are based on the following:

a) Quoted prices for similar assets or liabilities in active markets;

b) Quoted prices for identical or similar assets or liabilities in non-active markets; or

c) Valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability.

Level 3 Financial assets and financial liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect the Company’s estimates of the assumptions that market participants would use in valuing the financial assets and financial liabilities.

The availability of observable inputs varies by instrument. In situations where fair value is based on internally developed pricing models or inputs that are unobservable in the market, the determination of fair value requires more judgment. The degree of judgment exercised by the Company in determining fair value is typically greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The Company uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3.

Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities

The Company obtained unadjusted fair values on approximately 98% of its portfolio from an independent pricing service. For less than 2% of its portfolio, the Company obtained specific unadjusted broker quotes generally from one knowledgeable outside security broker to determine the fair value of each security. For approximately 0.1% of its portfolio, where the Company was not able to obtain fair values from the independent pricing service or outside security brokers, management performed discounted cash flow price modeling.

Level 1 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure realistic fair values are used in pricing the investment portfolio.

U.S. government bonds and agencies : Priced using unadjusted quoted market prices for identical assets in active markets.

Common stock; Other : Comprised of actively traded, exchange listed U.S. and international equity securities and valued based on unadjusted quoted prices for identical assets in active markets.

Money market instruments : Valued based on unadjusted quoted prices for identical assets.

Equity contracts : Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.

Level 2 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.

Municipal securities : Valued based on models or matrices using inputs including quoted prices for identical or similar assets in active markets.

Mortgage-backed securities : Comprised of securities that are collateralized by residential mortgage loans. Valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. At September 30, 2009 and December 31, 2008, the Company had no holdings in commercial mortgage-backed securities.

Corporate securities/Short-term bonds : Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.

Collateralized debt obligations : Valued based on observable inputs, such as underlying debt instruments and their appropriate benchmark spread, for identical or similar assets in active markets.

Redeemable and Non-redeemable preferred stock : Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.

Interest rate swap agreements : Valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.

Level 3 Measurements - Fair values of financial assets are based on discounted cash flow price modeling performed by management with inputs that are both unobservable and significant to the overall fair value measurement, including any items in which the evaluated prices obtained elsewhere were deemed to be of a distressed trading level.

Municipal securities : Comprised of certain distressed municipal securities for which valuation is based on models that are widely accepted in the financial services industry and require projections of future cash flows that are not market observable. Included in this category are $3.0 million of auction rate securities (“ARS”). ARS are valued based on a discounted cash flow model with certain inputs that are significant to the valuation, but are not market observable.

The Company’s total financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment gains (losses) in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.

Assets Measured at Fair Value

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2009 and December 31, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:


	September 30, 2009
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance as of September 30, 2009
	(Amounts in thousands)
Assets
Fixed maturity securities:
U.S. government bonds and agencies	$	9,128	$	—	$	—	$	9,128
Municipal securities		—		2,459,340		3,007		2,462,347
Mortgage-backed securities		—		125,773		—		125,773
Corporate securities		—		88,932		—		88,932
Collateralized debt obligations		—		42,185		—		42,185
Redeemable preferred stock		—		450		—		450
Equity securities:
Common stock:
Public utilities		33,715		—		—		33,715
Banks, trusts and insurance companies		14,396		—		—		14,396
Industrial and other		227,114		—		—		227,114
Non-redeemable preferred stock		—		12,495		—		12,495
Short-term bonds/Money market accounts		117,064		8,916		—		125,980
Equity contracts		192		—		—		192
Interest rate swap agreements		—		9,776		—		9,776

Total assets at fair value	$	401,609	$	2,747,867	$	3,007	$	3,152,483

Liabilities
Equity contracts	$	2,126	$	—	$	—	$	2,126
Interest rate swap agreements		—		2,562		—		2,562

Total liabilities at fair value	$	2,126	$	2,562	$	—	$	4,688


	December 31, 2008
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Balance as of December 31, 2008
	(Amounts in thousands)
Assets
Fixed maturity securities:
U.S. government bonds and agencies	$	9,898	$	—	$	—	$	9,898
Municipal securities		—		2,184,684		2,984		2,187,668
Mortgage-backed securities		—		202,326		—		202,326
Corporate securities		—		65,727		—		65,727
Collateralized debt obligations		—		13,120				13,120
Redeemable preferred stock		—		2,934		—		2,934
Equity securities:
Common stock:
Public utilities		39,148		—		—		39,148
Banks, trusts and insurance companies		11,328		—		—		11,328
Industrial and other		186,294		—		—		186,294
Non-redeemable preferred stock		—		10,621		—		10,621
Short-term bonds/Money market accounts		202,475		2,203		—		204,678
Equity contracts		78		—		—		78
Interest rate swap agreements		—		14,394		—		14,394

Total assets at fair value	$	449,221	$	2,496,009	$	2,984	$	2,948,214

Liabilities
Equity contracts	$	2,803	$	—	$	—	$	2,803
Interest rate swap agreements		—		1,348		—		1,348
Other		2,492		—		—		2,492

Total liabilities at fair value	$	5,295	$	1,348	$	—	$	6,643

When the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3).

The following table provides a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at September 30, 2009. There were no Level 3 financial assets and financial liabilities held at September 30, 2008.


	Three Months Ended September 30, 2009
	Fixed Maturities
	(Amounts in thousands)
Fair value at June 30, 2009	$	2,856
Realized gains included in net realized investment gains		151

Fair value at September 30, 2009	$	3,007

The amount of total gains for the period included in earnings attributable to assets held at September 30, 2009	$	151


	Nine Months Ended September 30, 2009
	Fixed Maturities
	(Amounts in thousands)
Fair value at December 31, 2008	$	2,984
Realized gains included in net realized investment gains		23

Fair value at September 30, 2009	$	3,007

The amount of total gains for the period included in earnings attributable to assets held at September 30, 2009	$	23

At September 30, 2009, the Company did not have any nonrecurring measurements of nonfinancial assets or nonfinancial liabilities.

6. Derivative Financial Instruments

The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts on various equity securities are entered into to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are entered into to manage interest rate risk associated with the Company’s loans with fixed or floating rates.

Fair value hedge

Effective January 2, 2002, the Company entered into an interest rate swap of a 7.25% fixed rate obligation on a $125 million senior note for a floating rate of LIBOR plus 107 basis points. The swap is designated as a fair value hedge and qualifies for the shortcut method wherein the gain or loss on the derivative, and the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in current earnings. The Company includes the gain or loss on the hedged item in the same line item, other revenue, as the offsetting loss or gain on the related interest rate swaps as follows:


	Three Months Ended September 30, 2009					Nine Months Ended September 30, 2009
Income Statement Classification	Gains/(Losses) on Swap			Gains/(Losses) on Loan		Gains/(Losses) on Swap			Gains/(Losses) on Loan
	(Amounts in thousands)
Other revenue	$	(747	)	$	747	$	(4,618	)	$	4,618

As of September 30, 2009, the total fair market value of the Company’s interest rate swap designated as a fair value hedge was $9.8 million.

Cash flow hedge

On March 3, 2008, the Company entered into an interest rate swap of a floating LIBOR rate on an $18 million bank loan for a fixed rate of 3.75%. The swap is designated as a cash flow hedge and qualifies for the shortcut method wherein the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings.

As of September 30, 2009, the total fair market value of the Company’s interest rate swap designated as a cash flow hedge was $(1.0) million.

Fair value amounts, and gains and losses on derivative instruments

The following tables provide the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains and losses in the consolidated statements of operations:

Fair Values of Derivative Instruments


	Asset Derivatives				Liability Derivatives
	September 30, 2009		December 31, 2008		September 30, 2009			December 31, 2008
Hedging derivatives
Interest rate contracts - Other assets (liabilities)	$	9,776	$	14,394	$	(1,034	)	$	(1,348	)


Non-hedging derivatives
Interest rate contracts - Other liabilities					$	(1,528	)
Equity contracts - Short-term investments (Other liabilities)	$	192	$	78		(2,126	)	$	(2,803	)

Total non-hedging derivatives	$	192	$	78	$	(3,654	)	$	(2,803	)

Total derivatives	$	9,968	$	14,472	$	(4,688	)	$	(4,151	)

The Effect of Derivative Instruments on the Statements of Operations

for Three Months and Nine Months Ended September 30, 2009 and 2008


	Gain or (Loss) Recognized in Income on Derivatives
	Three Months Ended September 30,						Nine Months Ended September 30,
Derivatives Contracts for Fair Value Hedges	2009			2008			2009			2008
	(Amounts in thousands)
Interest rate contracts - Interest expense	$	1,854		$	846		$	5,203		$	3,736

	Gain or (Loss) Recognized in OCI on Derivatives
	Three Months Ended September 30,						Nine Months Ended September 30,
Derivatives Contracts for Cash Flow Hedges	2009			2008			2009			2008
	(Amounts in thousands)
Interest rate contracts - Other comprehensive income	$	(187	)	$	(186	)	$	315		$	83

	Gain or (Loss) Recognized in Income on Derivatives
	Three Months Ended September 30,						Nine Months Ended September 30,
Derivatives Not Designated as Hedging Instruments	2009			2008			2009			2008
	(Amounts in thousands)
Interest rate contract - Other revenue	$	(866	)	$	—		$	(1,528	)	$	—
Equity contracts - Net realized investment gains		20			2,998			6,429			11,174

Total	$	(846	)	$	2,998		$	4,901		$	11,174

There were no gains or losses on derivative instruments designated as cash flow hedges reclassified from accumulated other comprehensive income into earnings during the three or nine month periods ended September 30, 2009.

The interest rate contract not designated as a hedging instrument is an interest rate swap entered into on February 6, 2009. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate of a $120 million credit facility which was used for the acquisition of AIS.

Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy. This is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset allocation throughout various industries.

For additional disclosures regarding equity contracts, see Note 5 of Condensed Notes to Consolidated Financial Statements.

7. Acquisition

Effective January 1, 2009, the Company acquired all of the membership interests of AIS Management LLC, a California limited liability company, which is the parent company of AIS and PoliSeek. AIS is a major producer of automobile insurance in the state of California and was the Company’s largest independent broker. This preexisting relationship did not require measurement at the date of acquisition as there was no settlement of executory contracts between the Company and AIS as part of the acquisition.

Goodwill of $37.6 million arising from the acquisition consists largely of the efficiencies and economies of scale expected from combining the operations of the Company and AIS, and is expected to be fully deductible for income tax purposes in 2009 and future years.

The Company recognized the assets acquired and the liabilities assumed at the acquisition date, measured at their fair values as of that date. The following table summarizes the consideration paid for AIS and the allocation of the purchase price.


	January 1, 2009
	(Amounts in thousands)
Consideration
Cash	$	120,000

Fair value of total consideration transferred	$	120,000


Acquisition-related costs	$	2,000


Recognized amounts of identifiable assets acquired and liabilities assumed
Financial assets	$	12,875
Property, plant, and equipment		2,915
Favorable leases		1,725
Trade names		15,400
Customer relationships		51,200
Software & technology		4,850
Liabilities assumed		(6,608	)

Total identifiable net assets		82,357

Goodwill		37,643

Total	$	120,000

The weighted-average amortization periods for intangible assets with definite lives, by asset class, are: 24 years for trade names, 11 years for customer relationships, 10 years for technology, 2 years for software, and 3 years for lease agreements.

A contingent consideration arrangement requires the Company to pay the former owner of AIS up to an undiscounted maximum amount of $34.7 million. The potential undiscounted amount of all future payments that the Company could be required to make under the contingent consideration arrangement is between $0 and $34.7 million. Based on the actual to date and the projected performance of the AIS business through December 31, 2010, the Company does not expect to pay the contingent consideration. That estimate of future performance is based on significant inputs that are not observable in the market, including management’s projections of future cash flows, which are considered Level 3 inputs. Key assumptions in determining the estimated contingent consideration include (a) a discount rate of 10.7% and (b) a decline in revenues ranging from 5.0% to 8.0%. As of November 3, 2009, the estimates for the contingent consideration arrangement, the range of outcomes, and the assumptions used to develop the estimates have not changed.

The fair value of the financial assets acquired includes cash, prepaid expenses and receivables from customers. The acquired receivables of $6.6 million at fair value were fully collected during the three-month period ended March 31, 2009. The fair value of the liabilities assumed includes accounts payable and other accrued liabilities.

The following table reflects the amount of revenue and net income of AIS, which are included in the Company’s consolidated statements of operations for the three-month and nine-month periods ended September 30, 2009, and the revenue of the combined entity for the three-month and nine-month periods ended September 30, 2008, had the acquisition date been January 1, 2008.


	Three Months ended September 30, 2008 (pro forma)		Nine Months ended September 30, 2008 (pro forma)
	(Amounts in thousands)
Combined entity
Revenues (1)	$	462,005	$	1,925,014
Net income (2)		N/A		N/A

	Three Months ended September 30, 2009		Nine Months ended September 30, 2009
	(Amounts in thousands)
AIS
Revenues (3)	$	3,110	$	9,066
Net income (3)	$	516	$	1,189

(1)

Includes net premiums earned, net investment income, net realized investment gains/losses and commission revenues.

(2)

2008 pro forma net income for the combined entity is not available as AIS was previously consolidated into its parent company and separate financial statements were not available.

(3)

Excludes intercompany transactions with the Company’s insurance subsidiaries.

8. Intangible Assets

The following table reflects the components of intangible assets as of September 30, 2009. There were no intangible assets as of December 31, 2008.


	September 30, 2009
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
	(Amounts in thousands)
Customer relationships	$	51,640	$	(3,649	)	$	47,991
Trade names		15,400		(481	)		14,919
Software and technology		4,850		(529	)		4,321
Favorable leases		1,725		(430	)		1,295

	$	73,615	$	(5,089	)	$	68,526

Intangible assets are amortized on a straight-line basis over their weighted average lives. Intangible assets amortization expense was $1.7 million for the three-month period ended September 30, 2009 and $5.1 million for the nine-month period ended September 30, 2009. The following table outlines the estimated future amortization expense related to intangible assets as of September 30, 2009:


Year Ending December 31,	(Amounts in thousands)
Remainder of 2009	$	1,703
2010		6,812
2011		6,358
2012		6,144
2013		5,969
Thereafter		41,540

Total	$	68,526

9. Goodwill

There were no changes in the carrying amount of goodwill for the three-month period ended September 30, 2009. The changes in the carrying amount of goodwill for the nine-month period ended September 30, 2009 are as follows:


	Nine Months Ended September 30, 2009
	(Amounts in thousands)
Balance as of January 1, 2009	$	41,557
Purchase price adjustments		1,293

Balance as of September 30, 2009	$	42,850

The purchase price adjustments are the result of additional information obtained in conjunction with the finalization of the purchase price allocation as of March 31, 2009. Goodwill is reviewed for impairment on an annual basis and between annual tests if potential impairment indicators exist. No impairment indications were identified during any of the periods presented.

10. Share-Based Compensation

The Company accounts for share-based compensation using the modified prospective transition method. Under this transition method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the estimated grant-date fair value. Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the estimated grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of four or five years, for only those shares expected to vest. The fair value of stock option awards is estimated using the Black-Scholes option pricing model.

11. Income Taxes

The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return once a “more-likely-than-not” threshold has been met. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement is recognized in the financial statements.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2006 through 2008 for federal taxes and 2001 through 2008 for California state taxes.

There were no material changes to the total amount of unrecognized tax benefits related to tax uncertainties during the nine months ended September 30, 2009. The Company does not expect any changes in such unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months. The Company recognizes interest and assessed penalties related to unrecognized tax benefits as part of income taxes.

The Company is currently under examination by the California Franchise Tax Board for tax years 2001 through 2005. The taxing authority has proposed significant adjustments to the Company’s California tax liabilities. Management does not believe that the ultimate outcome of this examination will have a material impact on the Company’s financial position. However, an unfavorable outcome may have a material impact on the Company’s results of operations in the period of such resolution.

Deferred tax assets and liabilities are recorded with respect to temporary differences in the accounting treatment of items for financial reporting purposes and for income tax purposes. Where, in management’s judgment and based on the weight of all available evidence, it is more likely than not that some amount of recorded deferred tax assets will not be realized, a valuation allowance is established for the portion that is not realizable.

At September 30, 2009, the Company’s deferred income taxes were in a net asset position partly as a result of the fair value declines in the investment portfolio originating in 2008, which resulted from extreme volatility in the capital markets and a widening of credit spreads beyond historic norms. Realization of deferred tax assets is dependent on generating sufficient taxable income of an appropriate nature to offset tax losses. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to avoid losing the full benefits of its deferred tax assets. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.

12. Contingencies

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages, which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations in the period of such ruling; however, none is expected to be material to the Company’s financial position. For a discussion of the Company’s pending material litigation, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

13. Recently Issued Accounting Standards

In April 2009, the FASB issued a new accounting standard related to the recognition and presentation of other-than-temporary impairments. The new standard amends the other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. Under the new accounting standard, the portion of other-than-temporary impairment on a debt security related to credit loss is recognized in current period earnings, and the remaining portion is recognized in other comprehensive income if the holder does not intend to sell the security and it is more likely than not that the holder will not be required to sell the security prior to recovery. If requirements related to intent and ability to hold the securities are not met, interest related impairment is recorded in current period earnings. As the Company elected to apply the fair value accounting option to all available for sale investments as of January 1, 2008, the new standard is not applicable to the Company.

In August 2009, the FASB issued a new accounting standard related to fair value measurements and disclosures for liabilities which amends the earlier FASB standard related to fair value measurements and disclosures. The new standard provides clarification in circumstances that a quoted price in an active market for an identical liability is not available, and a reporting entity is required to measure fair value using one or more valuation techniques. In addition, the new standard also addresses practice difficulties caused by the tension between fair value measurements based on the price that would be paid to transfer a liability to a new obligor and contractual or legal requirements that prevent such transfers from taking place. The new standard will be effective for the interim reporting period ending December 31, 2009. The adoption of the new standard is not expected to have a material impact on the Company’s consolidated financial statements.

In September 2009, the FASB issued a new accounting standard related to fair value measurements and disclosures. The standard expands the circumstances in which a practical expedient may be used to estimate fair value to include investments in foreign and other entities that have attributes of investment companies, report net asset value or its equivalent to their investors, and calculate net asset value or its equivalent consistent with the measurement principles of the AICPA Investment Companies Guide. The practical expedient cannot be used for investments that have a readily determinable fair value. The new standard sets forth disclosure requirements for investments within its scope. It also addresses whether the practical expedient, net asset value, can be used when it is probable the investor will sell the investment in a secondary market transaction, differences between the reporting date of the investor and investee, and determining the level of classification in the fair value hierarchy. The amendments are effective for interim and annual periods ending after December 15, 2009. The adoption of the new standard is not expected to have a material impact on the Company’s consolidated financial statements.

14. Subsequent Events

The Company evaluated subsequent events through November 3, 2009, the date the financial statements were issued, and noted no significant matters to be disclosed.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

I. Overview

A. General

The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, natural disasters, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates, and other factors such as changes in tax laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the ability of the Company to grow and retain business. Additionally, with the election of the fair value option, changes in the fair value of the investment portfolio are reflected in the consolidated statements of operations, which may result in volatility of earnings, particularly in times of high volatility in the capital markets.

The Company utilizes standard industry measures to report operating results that may not be presented in accordance with GAAP. Included within Management’s Discussion and Analysis of Financial Condition and Results of Operations is a non-GAAP financial measure, net premiums written, which represents the premiums charged on policies issued during a fiscal period less any reinsurance. The measure is not intended to replace, and should be read in conjunction with, the Company’s GAAP financial results and is reconciled to the most directly comparable GAAP measure, net premiums earned, below in Results of Operations.

B. Operations

The Company generates its revenues through the issuance of insurance policies, primarily covering personal automobiles and dwellings through 13 insurance subsidiaries (“Insurance Companies”). The Company also offers mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. These policies are mostly sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling policies. The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins than many competitors. The Company operates primarily in California, the only state in which it operated prior to 1990. The Company has since expanded its operations into the following states: Georgia and Illinois (1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001), New Jersey (2003), and Arizona, Pennsylvania, Michigan and Nevada (2004). Direct premiums written during the nine-month period ended September 30, 2009 by state and line of business were:


	Private Passenger Auto			Commercial Auto			Homeowners			Other Lines			Total
	(Amounts in thousands)
California	$	1,291,867		$	51,821		$	155,544		$	39,545		$	1,538,777		78.0	%
Florida		107,487			10,736			12,317			4,847			135,387		6.8	%
Texas		54,412			5,591			1,333			12,976			74,312		3.8	%
New Jersey		61,068			—			—			179			61,247		3.1	%
Other states		125,201			5,777			13,662			19,211			163,851		8.3	%

Total	$	1,640,035		$	73,925		$	182,856		$	76,758		$	1,973,574		100	%

		83.1	%		3.7	%		9.3	%		3.9	%		100	%

The Company also generates income from its investment portfolio. Approximately $109.3 million in pre-tax investment income was generated during the nine-month period ended September 30, 2009 on average investments of approximately $3.2 billion, at cost, compared to $116.4 million pre-tax investment income during the corresponding period in 2008 on average investments of approximately $3.5 billion, at cost. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.

The Company’s operating results have allowed it to consistently generate positive cash flow from operations, which was approximately $156.5 million and $72.6 million for the nine-month periods ended September 30, 2009 and 2008, respectively. Cash flow from operations has historically been used to pay shareholder dividends and to help support growth.

II. Results of Operations

Three Months Ended September 30, 2009 compared to Three Months Ended September 30, 2008

A. Revenue

Net premiums earned and net premiums written for the three-month period ended September 30, 2009 decreased approximately 6.2% and 4.7%, respectively, from the corresponding period in 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting continuing soft market conditions.

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total Company net premiums written to net premiums earned:


	Three Months Ended September 30,
	2009			2008
	(in thousands)
Net premiums written	$	662,756		$	695,142
(Increase) decrease in net unearned premiums		(8,998	)		1,463

Net premiums earned	$	653,758		$	696,605

B. Profitability

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table reflects the Insurance Companies’ loss ratio, expense ratio and combined ratio determined in accordance with GAAP:


	Three Months ended September 30,
	2009		2008
Loss ratio	68.3	%	73.5	%
Expense ratio	28.1	%	28.5	%

Combined ratio	96.4	%	102.0	%

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio for the three-month period ended September 30, 2009 is lower than the three-month period ended September 30, 2008 primarily as a result of positive reserve development in 2009 compared to adverse reserve development in 2008 coupled with lower loss frequency in 2009. Partially offsetting this are higher loss severities recorded in 2009 as well as lower average premiums earned per policy.

The combined ratio of losses and expenses is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results.

C. Investments

The following table summarizes the investment results of the Company:


	Three Months ended September 30,
	2009			2008
	(Amounts in thousands)
Average invested assets at cost (1)	$	3,169,577		$	3,442,190
Net investment income:
Before income taxes	$	35,208		$	38,086
After income taxes	$	32,006		$	33,390
Average annual yield on investments:
Before income taxes		4.4	%		4.4	%
After income taxes		4.0	%		3.9	%
Net realized investment gains (losses)	$	171,373		$	(276,973	)

(1)

Fixed maturities at amortized cost, and equities and short-term investments at cost.

Included in net income are net realized investment gains of $171.4 million for the three-month period ended September 30, 2009 compared with net realized investment loss of $277.0 million for the three-month period ended September 30, 2008. Net realized investment gains include gains of $191.3 million for the three-month period ended September 30, 2009 due to changes in the fair value of total investments pursuant to election of the fair value accounting option compared with losses $254.1 million for the three-month period ended September 30, 2008. The gains during the three-month period ended September 30, 2009 arise from the market value improvements on the Company’s fixed maturity and equity securities. During the three-month period ended September 30, 2009, the Company recorded approximately $136.1 million and $55.3 million in gains due to changes in the fair value of its fixed maturity portfolio and equity portfolio, respectively. The primary cause of the significant gains in fair value of equity securities was the overall improvement in the equity markets, which saw a growth of approximately 15.0% in the S&P 500 Index during the three-month period ended September 30, 2009.

The income tax expenses (benefit) for the three-month periods ended September 30, 2009 and 2008 were $71.5 million and $(112.8) million, respectively. The increase in expense resulted primarily from changes in the fair value of the investment portfolio.

Nine Months Ended September 30, 2009 compared to Nine Months Ended September, 2008

A. Revenue

Net premiums earned and net premiums written in the nine-month period ended September 30, 2009 decreased approximately 7.0% and 6.5%, respectively, from the corresponding period in 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.


	Nine Months Ended September 30,
	2009		2008
	(in thousands)
Net premiums written	$	1,971,053	$	2,108,585
Decrease in net unearned premiums		7,979		20,140

Net premiums earned	$	1,979,032	$	2,128,725

B. Profitability


	Nine Months ended September 30,
	2009		2008
Loss ratio	67.5	%	69.7	%
Expense ratio	29.0	%	28.4	%

Combined ratio	96.5	%	98.1	%

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio was affected by positive development of approximately $40 million and adverse development of approximately $46 million on prior periods’ loss reserves for the nine-month periods ended September 30, 2009 and 2008, respectively. Excluding the effect of prior accident years’ loss development, the loss ratio was 69.5% and 67.5% for the nine-month periods ended September 30, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years’ loss development is primarily due to increased loss severity and lower average premiums earned per policy, partially offset by lower loss frequency.

The expense ratio is determined by matching expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The expense ratio increased primarily due to an accrual for a reduction in workforce during the three-month period ended March 31, 2009 and the impact of the amortization of AIS deferred commissions, both of which are described below.

To improve profitability, during the three-month period ended March 31, 2009, the Company implemented several cost reduction programs, including a salary freeze, a suspension of the employee 401(k) matching program, and a workforce reduction of approximately 360 employees (7% of workforce) primarily located in California. As a result of the workforce reduction, an $8 million expense was recorded ($5 million to losses and loss adjustment expenses, $3 million to other operating expenses) during the three-month period ended March 31, 2009. The annualized cost savings from these cost reduction programs are expected to be over $20 million.

Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. As AIS is now a wholly-owned subsidiary, commissions paid are no longer deferrable. During the nine-month period ended September 30, 2009, the amortization of deferred commissions offset by corresponding deferred direct sales cost reduced pre-tax income on the statement of operations by $15 million.

C. Investments

The following table summarizes the investment results of the Company:


	Nine Months ended September 30,
	2009			2008
	(Amounts in thousands)
Average invested assets at cost (1)	$	3,211,524		$	3,468,969
Net investment income:
Before income taxes	$	109,334		$	116,380
After income taxes	$	97,976		$	102,195
Average annual yield on investments:
Before income taxes		4.5	%		4.5	%
After income taxes		4.1	%		3.9	%
Net realized investment gains (losses)	$	352,549		$	(332,614	)

(1)

Fixed maturities at amortized cost, and equities and short-term investments at cost.

Included in net income are net realized investment gains of $352.5 million for the nine-month period ended September 30, 2009 compared with net realized investment losses of $332.6 million for the nine-month period ended September 30, 2008. Net realized investment gains include gains of $405.6 million for the nine month period ended September 30, 2009 due to changes in the fair value of total investments pursuant to election of the fair value accounting option compared with losses of $324.8 million for the nine-month period ended September 30, 2008. The gains during the nine-month period ended September 30, 2009 arise from the market value improvements on the Company’s fixed maturity and equity securities. During the nine-month period ended September 30, 2009, the Company recorded approximately $283.5 million and $122.2 million in gains due to changes in the fair value of its fixed maturity portfolio and equity portfolio, respectively. The primary cause of the significant gains in the Company’s equity portfolio was due to the large allocation to energy related stocks. Energy related stocks experienced a significant growth in value, more than that of the overall stock market, which saw a growth of approximately 17% in the S&P 500 Index.

The income tax expenses (benefit) for the nine-month periods ended September 30, 2009 and 2008 were $161.4 million and $(102.4) million, respectively. The increase in expense resulted primarily from changes in the fair value of the investment portfolio.

III. Liquidity and Capital Resources

A. Cash Flows

The principal sources of funds for the Insurance Companies are premiums, sales and maturities of invested assets and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses, dividends to Mercury General and the purchase of investments.

The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $330.4 million at September 30, 2009, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

Net cash provided from operating activities in the nine-month period ended September 30, 2009 was $156.5 million, an increase of $83.8 million over the corresponding period in 2008. This increase was primarily due to additional operating cash flows from AIS, decrease in losses and loss adjustment expenses and tax expenses paid during the nine-month period ended September 30, 2009 compared with the corresponding period in 2008. The Company has utilized the cash provided from operating activities primarily for the development of information technology such as the NextGen and Mercury First computer systems and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $391.3 million were primarily reinvested by the Company in high grade fixed maturity securities.

The following table shows the estimated fair value of fixed maturity securities at September 30, 2009 by contractual maturity in the next five years:


	Fixed maturities
	(Amounts in thousands)
Due in one year or less	$	23,664
Due after one year through two years		28,066
Due after two years through three years		37,638
Due after three years through four years		92,406
Due after four years through five years		119,910

	$	301,684

Effective January 1, 2009, the Company acquired AIS for $120 million. The acquisition was financed by a $120 million credit facility that is secured by municipal bonds held as collateral. The credit facility calls for the collateral requirement to be greater than the loan amount. The collateral requirement is calculated as the fair market value of the municipal bonds held as collateral multiplied by the advance rates, which vary based on the credit quality and duration of the assets held and range between 75% and 100% of the fair value of each bond. The loan matures on January 1, 2012 with interest payable at a floating rate of LIBOR rate plus 125 basis points. In addition, the Company may be required to pay up to $34.7 million over the next two years as additional consideration for the AIS acquisition. The Company plans to fund that portion of the purchase price, if necessary, from cash on hand and cash flow from operations. On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on the loan for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is not designated as a hedge and changes in the fair value are adjusted through the consolidated statement of operations in the period of change.

B. Invested Assets

Portfolio Composition

An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company believes that this strategy maintains the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a recognized market risk and asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.

The following table sets forth the composition of the total investment portfolio of the Company at September 30, 2009 and December 31, 2008:


	September 30, 2009				December 31, 2008
	Cost (1)		Fair Value		Cost (1)		Fair Value
	(Amounts in thousands)
Fixed maturity securities:
U.S. government bonds and agencies	$	8,960	$	9,128	$	9,633	$	9,898
States, municipalities and political subdivisions		2,408,791		2,462,347		2,370,879		2,187,668
Mortgage-backed securities		137,134		125,773		216,483		202,326
Corporate securities		92,944		88,932		77,097		65,727
Collateralized debt obligations		43,838		42,185		48,929		13,120
Redeemable preferred stock		450		450		5,450		2,934

		2,692,117		2,728,815		2,728,471		2,481,673

Equity securities:
Common stock:
Public utilities		28,833		33,715		32,293		39,148
Banks, trusts and insurance companies		14,265		14,396		20,451		11,328
Industrial and other		264,074		227,114		330,030		186,294
Non-redeemable preferred stock		14,739		12,495		20,999		10,621

		321,911		287,720		403,773		247,391

Short-term investments		126,328		126,172		208,278		204,756

Total investments	$	3,140,356	$	3,142,707		3,340,522		2,933,820

(1)

Fixed maturities at amortized cost, and equities and short-term investments at cost.

At September 30, 2009, approximately 78.1% of the Company’s total investment portfolio at fair value and 90% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of perpetual preferred stocks and dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. At September 30, 2009, 92.8% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any material direct equity investment in subprime lenders.

During the nine-month period ended September 30, 2009, the Company recognized approximately $352.5 million in net realized investment gains, which include approximately $278.4 million and $67.9 million related to fixed maturity securities and equity securities, respectively. Included in the gains were $283.5 million and $122.2 million in gains due to changes in the fair value of the Company’s fixed maturity portfolio and equity security portfolio, respectively, as a result of electing the fair value option. Partially offsetting these gains were approximately $5.1 million and $54.6 million in loss from the sale of fixed maturity securities and equity securities, respectively.

Fixed maturity securities

Fixed maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy resulted in a portfolio with a moderate duration. The nominal average maturity of the overall bond portfolio, including short-term investments, was 12.5 years at September 30, 2009, which reflects a portfolio heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturity of the overall bond portfolio, including short-term investments, was approximately 6.6 years, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified duration of the overall bond portfolio reflecting anticipated early calls was 5.0 years at September 30, 2009, including collateralized mortgage obligations with modified durations of approximately 1.8 years and short-term investments that carry no duration. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in interest rates; modified duration is considered a better indicator of price volatility than simple maturity alone.

Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-. To calculate the weighted-average credit quality ratings as disclosed throughout this Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At September 30, 2009, bond holdings rated below investment grade and non rated bonds totaled $92.0 million and $85.3 million, respectively, at fair value, and represented approximately 3.4% and 3.1%, respectively, of total fixed maturity securities. At December 31, 2008, bond holdings of lower than investment grade and non rated