SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-K/A
Amendment No. 1
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2008
Commission File No. 001-12257
MERCURY GENERAL CORPORATION
(Exact name of registrant as specified in its charter)

 
California
95-2211612
 
 
(State or other jurisdiction
(I.R.S. Employer
 
 
of incorporation or organization)
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
Securities registered pursuant to Section 12(b) of the Act:
 
 
Title of Class
Name of Exchange on Which Registered
 
 
Common Stock
New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
NONE

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   
Yes T No £
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   
Yes £ No T
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 T No £
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    T
 
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):
 
Large accelerated filer T
Accelerated filer £
 
 
Non-accelerated filer £
Smaller reporting company £
 
(Do not check if a smaller reporting company)
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).   Yes £ No T
 
The aggregate market value of the Registrant’s common equity held by non-affiliates of the Registrant at June 30, 2008 was approximately $1,245,000,000 (based upon the closing sales price on the New York Stock Exchange for such date, as reported by the Wall Street Journal).
 
At February 17, 2009, the Registrant had issued and outstanding an aggregate of 54,769,713 shares of its Common Stock.
Documents Incorporated by Reference
Portions of the definitive proxy statement for the Annual Meeting of Shareholders of the Registrant to be held on May 13, 2009 are incorporated herein by reference into Part III hereof.
 


 
 
 
 
Explanatory Note
 
        This Amendment No. 1 on Form 10-K/A amends the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2008, as filed on March 2, 2009 (the “Original Form 10-K”). The sole purpose of this amendment is to correct the date heading in the Registrant’s Consolidated Balance Sheets as of December 31, 2008 contained in Item 8. Financial Statements and Supplementary Data in the Original Form 10-K, which inadvertently only referenced 2008 rather than 2008 and 2007.  Except as described above, no changes have been made to the Original Form 10-K, and this amendment does not amend, update or change the substantive financial statements or any other items or disclosures in the Original Form 10-K.
 
2

 

PART I

Item 1.
Business

General

Mercury General Corporation (“Mercury General”) and its subsidiaries (collectively, the “Company”) are engaged primarily in writing automobile insurance in a number of states, principally California.  The Company also writes homeowners, mechanical breakdown, commercial and dwelling fire, and commercial property insurance.  The direct premiums written during 2008 by state and line of business were:

   
Year ended December 31, 2008
       
   
(Amounts in thousands)
       
   
Private Passenger Auto
   
Commercial Auto
   
Homeowners
   
Other Lines
   
Total
       
California
  $ 1,842,129     $ 72,050     $ 204,027     $ 52,993     $ 2,171,199       78.9 %
Florida
    145,952       16,272       15,892       8,921       187,037       6.8 %
New Jersey
    84,028       -       -       304       84,332       3.1 %
Texas
    74,690       9,995       1,473       17,368       103,526       3.8 %
Other states
    157,438       8,826       12,641       26,895       205,800       7.5 %
Total
  $ 2,304,237     $ 107,143     $ 234,033     $ 106,481     $ 2,751,894       100.0 %
      83.7 %     3.9 %     8.5 %     3.9 %     100.0 %        

The Company offers automobile policyholders the following types of coverage: bodily injury liability, underinsured and uninsured motorist, personal injury protection, property damage liability, comprehensive, collision and other hazards. The Company’s published maximum limits of liability for private passenger automobile insurance are, for bodily injury, $250,000 per person and $500,000 per accident and, for property damage, $250,000 per accident.  Subject to special underwriting approval, the combined policy limits may be as high as $1,000,000 for vehicles written under the Company’s commercial automobile program.  However, under the majority of the Company’s automobile policies, the limits of liability are equal to or less than $100,000 per person and $300,000 per accident for bodily injury and $50,000 per accident for property damage.

The principal executive offices of Mercury General are located in Los Angeles, California.  The home office of its California insurance subsidiaries and the Company’s computer and operations center is located in Brea, California.  The Company also owns office buildings in Rancho Cucamonga and Folsom, California, which are used to support the Company’s California operations and future expansion, and office buildings located in St. Petersburg, Florida and in Oklahoma City, Oklahoma, which house employees of the Company and several third party tenants.  The Company maintains branch offices in a number of locations in California as well as branch offices in Richmond, Virginia; Latham, New York; Bridgewater, New Jersey; Vernon Hills, Illinois; Atlanta, Georgia; and Austin, Houston and San Antonio, Texas.  The Company has approximately 5,000 employees.

Website Access to Information

The internet address for the Company’s website is www.mercuryinsurance.com.  The internet address provided in this Annual Report on Form 10-K is not intended to function as a hyperlink and the information on the Company’s website is not and should not be considered part of this report and is not incorporated by reference in this document.  The Company makes available on its website its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to such reports (the “SEC Reports”) filed with or furnished to the Securities and Exchange Commission (“SEC”) pursuant to Federal securities laws, as soon as reasonably practicable after each SEC Report is filed with or furnished to the SEC.  In addition, copies of the SEC Reports are available, without charge, upon written request to the Company’s Chief Financial Officer, Mercury General Corporation, 4484 Wilshire Boulevard, Los Angeles, California 90010.
 
3

Organization

Mercury General, an insurance holding company, is the parent of Mercury Casualty Company, a California automobile insurer founded in 1961 by George Joseph, the Company’s Chairman of the Board of Directors.  Including MCC, Mercury General has eighteen subsidiaries.  The Company’s insurance operations are conducted through the following insurance subsidiaries:

Insurance Companies
Date Formed or Acquired
 
A.M. Best Ratings
 
Primary States
Mercury Casualty Company ("MCC")
January 1961
   
A+
 
CA, AZ, FL, NV, NY, VA
Mercury Insurance Company ("MIC")
November 1972
   
A+
 
CA
California Automobile Insurance Company ("CAIC")
June 1975
   
A+
 
CA
California General Underwriters Insurance Company ("CGU")
April 1985
 
Non rated
 
CA
Mercury Insurance Company of Illinois ("MIC IL")
August 1989
   
A+
 
IL
Mercury Insurance Company of Georgia ("MIC GA")
March 1989
   
A+
 
GA
Mercury Indemnity Company of Georgia ("MID GA")
November 1991
   
A+
 
GA
Mercury National Insurance Company ("MNIC")
December 1991
   
A+
 
IL, MA
American Mercury Insurance Company ("AMI")
December 1996
   
A-
 
OK, FL, GA, TX
American Mercury Lloyds Insurance Company ("AML")
December 1996
   
A-
 
TX
Mercury County Mutual Insurance Company ("MCM")
September 2000
   
A-
 
TX
Mercury Insurance Company of Florida ("MIC FL")
August 2001
   
A+
 
FL, PA
Mercury Indemnity Company of America ("MIDAM")
August 2001
   
A+
 
NJ
             
Non-Insurance Companies
Date Formed or Acquired
 
Purpose
Mercury Select Management Company, Inc. ("MSMC")
August 1997
 
AML's attorney-in-fact
American Mercury MGA, Inc. ("AMMGA")
August 1997
 
General agent
Concord Insurance Services, Inc. ("Concord")
October 1999
 
Inactive insurance agent since 2006
Mercury Insurance Services, LLC ("MIS LLC")
November 2000
 
Management services to subsidiaries
Mercury Group, Inc. ("MGI")
July 2001
 
Inactive insurance agent since 2007

           Mercury General and its subsidiaries are referred to collectively as the “Company” unless the context indicates otherwise.  All of the subsidiaries as a group, excluding MSMC, AMMGA, Concord, MIS LLC and MGI, are referred to as the “Insurance Companies.” The term “California Companies” refers to MCC, MIC, CAIC and CGU.

On October 10, 2008, MCC entered into a Stock Purchase Agreement (the “Purchase Agreement”) with Aon Corporation, a Delaware corporation, and Aon Services Group, Inc., a Delaware corporation.  Pursuant to the terms of the Purchase Agreement effective January 1, 2009, MCC acquired all of the membership interest of AIS Management LLC, a California limited liability company, which is the parent company of Auto Insurance Specialists, LLC (“AIS”) and PoliSeek AIS Insurance Solutions, Inc.

4

Production and Servicing of Business

The Company sells its policies through approximately 4,700 independent agents and brokers, of which approximately 1,000 are located in each of California and Florida.  The remainder are located in Georgia, Illinois, Texas, Oklahoma, New York, New Jersey, Virginia, Pennsylvania, Arizona, Nevada and Michigan.  Over half of the agents in California have represented the Company for more than ten years.  The agents, most of whom also represent one or more competing insurance companies, are independent contractors selected and contracted by the Company.

No agent or broker accounted for more than 2% of direct premiums written except for AIS that produced approximately 15%, 14% and 13% during 2008, 2007, and 2006, respectively, of the Company’s direct premiums written.

The Company believes that it compensates its agents and brokers above the industry average.  During 2008, total commissions incurred were approximately 17% of net premiums written.

The Company’s advertising budget is allocated among television, newspaper, internet and direct mailing media to provide the best coverage available within targeted media markets.  While the majority of these advertising costs are borne by the Company, a portion of these costs are reimbursed by the Company’s independent agents based upon the number of account leads generated by the advertising. The Company believes that its advertising program is important to create brand awareness and to remain competitive in the current insurance climate.  During 2008, net advertising expenditures were $26 million.

Underwriting

The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Departments of Insurance (“DOI”) or similar governmental agencies of the applicable states.  Automobile insurance rates on voluntary business in California are subject to prior approval by the California DOI. The Company uses its own extensive database to establish rates and classifications.  Automobile liability insurers in California are also required to sell insurance to a proportionate number of drivers applying for placement as “assigned risks” based on the insurer’s share of the California automobile casualty insurance market. The California DOI has rating factor regulations in effect that influence the weight the Company ascribes to various classifications of data.  See “Regulation.”

At December 31, 2008, “good drivers” (as defined by the California Insurance Code) accounted for approximately 80% of all voluntary private passenger automobile policies in force in California, while higher risk categories accounted for approximately 20%.  The private passenger automobile renewal rate in California (the rate of acceptance of offers to renew) averages approximately 95%.  The Company also offers homeowners, commercial property and commercial automobile and mechanical breakdown insurance in California.

In states outside of California, the Company offers standard, non-standard and preferred private passenger automobile insurance.  Private passenger automobile policies in force for non-California operations represented approximately 20% of total private passenger automobile policies in force at December 31, 2008.  In addition, the Company offers mechanical breakdown insurance in many states outside of California and homeowners insurance in Florida, Illinois, Oklahoma, New York, Georgia, and Texas.

Claims

Claims operations are conducted by the Company.  The claims staff administers all claims and directs all legal and adjustment aspects of the claims process.  The Company adjusts most claims without the assistance of outside adjusters.

5

Loss and Loss Adjustment Expense Reserves and Reserve Development

The Company maintains reserves for the payment of losses and loss adjustment expenses for both reported and unreported claims.  Loss reserves are estimated based upon a case-by-case evaluation of the type of claim involved and the expected development of such claim.  The amount of loss reserves and loss adjustment expense reserves for unreported claims are determined on the basis of historical information by line of insurance.  Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

The Company’s ultimate liability may be greater or less than reported loss reserves.  Reserves are closely monitored and are analyzed quarterly by the Company’s actuarial consultants using current information on reported claims and a variety of statistical techniques.  The Company does not discount to a present value that portion of its loss reserves expected to be paid in future periods.  The Tax Reform Act of 1986, however, requires the Company to discount loss reserves for Federal income tax purposes.

For a reconciliation of beginning and ending reserves for losses and loss adjustment expenses, net of reinsurance deductions, as reflected on the Company’s consolidated financial statements for the periods indicated, see Note 7 of Notes to Consolidated Financial Statements.

During 2008, the Company experienced pre-tax losses of approximately $20 million in the fourth quarter from Southern California fire storms and approximately $6 million in the third quarter from Hurricane Ike in Texas.

The difference between the reserves reported in the Company’s consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and those reported in the statements filed with the DOI in accordance with statutory accounting principles (“SAP”) is shown in the following table:

   
December 31,
 
   
2008
   
2007
   
2006
 
   
(Amounts in thousands)
 
Reserves reported on a SAP basis
  $ 1,127,779     $ 1,099,458     $ 1,082,393  
Reinsurance recoverable
    5,729       4,457       6,429  
Reserves reported on a GAAP basis
  $ 1,133,508     $ 1,103,915     $ 1,088,822  

Under SAP, reserves are stated net of reinsurance recoverable whereas under GAAP, reserves are stated gross of reinsurance recoverable.

The following table presents the development of loss reserves for the period 1998 through 2008.  The top line of the table shows the reserves at the balance sheet date, net of reinsurance recoverable, for each of the indicated years.  This amount represents the estimated net losses and loss adjustment expenses for claims arising from the current and all prior years that are unpaid at the balance sheet date, including an estimate for losses that had been incurred but not yet reported to the Company.  The upper portion of the table shows the cumulative amounts paid as of successive years with respect to that reserve liability.  The middle portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year.  Estimates change as more information becomes known about the frequency and severity of claims for individual years. The bottom line shows the redundancy (deficiency) that exists when the original reserve estimates are greater (less) than the re-estimated reserves at December 31, 2008.
 
6

In evaluating the information in the table, it should be noted that each amount includes the effects of all changes in amounts for prior periods.  This table does not present accident or policy year development data.  Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future.  Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
   
December 31,
 
   
1998
   
1999
   
2000
   
2001
   
2002
   
2003
   
2004
   
2005
   
2006
   
2007
   
2008
 
   
(Amounts in thousands)
 
Net reserves for losses and
                                                                 
loss adjustment
                                                                 
expenses
  $ 385,816     $ 418,800     $ 463,803     $ 516,592     $ 664,889     $ 786,156     $ 886,607     $ 1,005,634     $ 1,082,393     $ 1,099,458     $ 1,127,779  
                                                                                         
Paid (cumulative) as of:
                                                                                       
One year later
    263,805       294,615       321,643       360,781       438,126       461,649       525,125       632,905       674,345       715,846          
Two years later
    366,908       403,378       431,498       491,243       591,054       628,280       748,255       891,928       975,086                  
Three years later
    395,574       429,787       462,391       528,052       637,555       714,763       851,590       1,027,781                          
Four years later
    402,000       439,351       476,072       538,276       655,169       740,534       893,436                                  
Five years later
    405,910       446,223       478,158       545,110       664,051       750,927                                          
Six years later
    409,853       445,892       481,775       549,593       667,277                                                  
Seven years later
    408,138       446,489       484,149       550,768                                                          
Eight years later
    408,321       446,777       485,600                                                                  
Nine years later
    408,567       447,654                                                                          
Ten years later
    408,672                                                                                  
Net reserves re-estimated as of:
                                                                                       
One year later
    393,603       442,437       480,732       542,775       668,954       728,213       840,090       1,026,923       1,101,917       1,188,100          
Two years later
    407,047       449,094       481,196       549,262       660,705       717,289       869,344       1,047,067       1,173,753                  
Three years later
    410,754       446,242       483,382       546,667       662,918       745,744       894,063       1,091,131                          
Four years later
    409,744       449,325       482,905       545,518       666,825       750,859       910,171                                  
Five years later
    410,982       448,813       480,740       550,123       668,318       755,970                                          
Six years later
    411,046       447,225       483,392       551,402       669,499                                                  
Seven years later
    408,857       447,362       485,328       551,745                                                          
Eight years later
    409,007       447,272       486,078                                                                  
Nine years later
    408,942       447,976                                                                          
Ten years later
    408,972                                                                                  
Net cumulative redundancy
                                                                                       
(deficiency)
   $ (23,156 )    $ (29,176 )    $ (22,275 )   (35,153 )   (4,610 )   30,186     (23,564 )   (85,497 )   (91,360 )   (88,642 )        
                                                                                         
Gross liability-end of year
  $ 405,976     $ 434,843     $ 492,220     $ 534,926     $ 679,271     $ 797,927     $ 900,744     $ 1,022,603     $ 1,088,822     $ 1,103,915     $ 1,133,508  
Reinsurance recoverable
    (20,160 )     (16,043 )     (28,417 )     (18,334 )     (14,382 )     (11,771 )     (14,137 )     (16,969 )     (6,429 )     (4,457 )     (5,729 )
Net liability-end of year
  $ 385,816     $ 418,800     $ 463,803     $ 516,592     $ 664,889     $ 786,156     $ 886,607     $ 1,005,634     $ 1,082,393     $ 1,099,458     $ 1,127,779  
                                                                                         
Gross re-estimated liability-latest
  $ 440,039     $ 474,642     $ 525,737     $ 581,501     $ 695,729     $ 785,216     $ 937,357     $ 1,120,245     $ 1,190,483     $ 1,199,836          
Re-estimated recoverable-latest
    (31,068 )     (26,666 )     (39,659 )     (29,756 )     (26,230 )     (29,246 )     (27,187 )     (29,114 )     (16,730 )     (11,735 )        
Net re-estimated liability-latest
  $ 408,972     $ 447,976     $ 486,078     $ 551,745     $ 669,499     $ 755,970     $ 910,171     $ 1,091,131     $ 1,173,753     $ 1,188,100          
                                                                                         
Gross cumulative
                                                                                       
redundancy (deficiency)
  $ (34,063 )   $ (39,799 )   $ (33,517 )   $ (46,575 )   $ (16,458 )   $ 12,711     $ (36,613 )   $ (97,642 )   $ (101,661 )   $ (95,921 )        
                                                                                         
 
7

 
For the years 2005 through 2007, the Company experienced negative development on loss reserves ranging from $85 million to $91 million.  The negative development from these years relates primarily to increases in loss severity estimates and defense and cost containment expense estimates for the California Bodily Injury coverage as well as increases in the provision for losses in New Jersey.  See “Critical Accounting Estimates-Reserves” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

For 2004, the negative development relates to an increase in the Company’s prior accident years’ loss estimates for personal automobile insurance in Florida and New Jersey.  In addition, an increase in estimates for loss severity for the 2004 accident year reserves for California and New Jersey automobile lines of business contributed to the deficiencies.

For 2003, loss redundancies largely relate to lower inflation than originally expected on the bodily injury coverage reserves for the California automobile insurance lines of business.  In addition, the Company experienced a reduction in expenditures to outside legal counsel for the defense of personal automobile claims in California. This led to a reduction in the ultimate expense amount expected to be paid out and therefore a redundancy in the reserves established at December 31, 2003. Partially offsetting these loss redundancies was adverse development in the Florida and New Jersey automobile lines of business.
 
For years 1998 through 2002, the Company’s previously estimated loss reserves produced deficiencies which were reflected in the subsequent years’ incurred losses.  The Company attributes a large portion of the deficiencies to increases in the ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated.  The increases in these losses relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs.

Operating Ratios

Loss and Expense Ratios

Loss and underwriting expense ratios are used to interpret the underwriting experience of property and casualty insurance companies.

Under SAP, losses and loss adjustment expenses are stated as a percentage of premiums earned because losses occur over the life of a policy.  Underwriting expenses on a statutory basis are stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period.  The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratios are less than 100%.  The Insurance Companies’ loss ratio, expense ratio and combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in the following table.  The Insurance Companies’ ratios include lines of insurance other than private passenger automobile.  Since these other lines represent only 16.3% of premiums written, the Company believes its ratios can be compared to the industry ratios included in the following table.

   
Year ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
Loss Ratio
    73.3 %     68.0 %     67.4 %     65.4 %     62.6 %
Expense Ratio
    28.5 %     27.1 %     27.1 %     26.5 %     26.4 %
Combined Ratio
    101.8 %     95.1 %     94.5 %     91.9 %     89.0 %
Industry combined ratio (all writers) (1)
    98.5 % (2)     98.3 %     95.5 %     95.1 %     94.4 %
Industry combined ratio (excluding direct writers) (1)
    N/A       96.2 %     94.7 %     94.5 %     93.9 %

(1)       Source: A.M. Best, Aggregates & Averages (2005 through 2008), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends).
(2)          Source:  A.M. Best, “2009 Special Report U.S. Property/Causality-Review & Preview, February 9, 2009”
(N/A)     Not available.
8

Under GAAP, the loss ratio is computed in the same manner as under statutory accounting, but the expense ratio is determined by matching underwriting expenses to the period over which net premiums were earned, rather than to the period that net premiums were written.  The following table sets forth the Insurance Companies’ loss ratio, expense ratio and combined ratio determined in accordance with GAAP for the last five years.

   
Year ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
Loss Ratio
    73.3 %     68.0 %     67.4 %     65.4 %     62.6 %
Expense Ratio
    28.5  %     27.4  %     27.6  %     27.0  %     26.6  %
Combined Ratio
    101.8 %     95.4 %     95.0 %     92.4 %     89.2 %

Premiums to Surplus Ratio

The following table reflects, for the periods indicated, the Insurance Companies’ statutory ratios of net premiums written to policyholders’ surplus.  Widely recognized guidelines established by the National Association of Insurance Commissioners (“NAIC”) indicate that this ratio should be no greater than 3 to 1.

   
Year ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
   
(Amounts in thousands, except ratios)
                   
Net premiums written
  $ 2,750,226     $ 2,982,024     $ 3,044,774     $ 2,950,523     $ 2,646,704  
Policyholders' surplus
  $ 1,371,095     $ 1,721,827     $ 1,579,248     $ 1,487,574     $ 1,361,072  
Ratio
 
2.0 to 1
   
1.7 to 1
   
1.9 to 1
   
2.0 to 1
   
1.9 to 1
 
 
Risk-Based Capital

The NAIC employs a risk-based capital formula for casualty insurance companies that establishes recommended minimum capital requirements for casualty companies.  The formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors.  Based on the formula adopted by the NAIC, the Company has calculated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2008.  As of such date, each of the Insurance Companies’ policyholders’ surplus exceeded the highest level of minimum required capital.
9

Statutory Accounting Principles

The Company’s results are reported in accordance with GAAP, which differ from amounts reported in accordance with SAP as prescribed by insurance regulatory authorities. Specifically, under GAAP:

 
• Policy acquisition costs such as commissions, premium taxes and other variable costs incurred in   connection with writing new and renewal business are capitalized and amortized on a pro rata basis over the period in which the related premiums are earned, rather than expensed as incurred, as required by SAP.

 
• Certain assets are included in the consolidated balance sheets whereas, under SAP, such assets are  designated as “nonadmitted assets,” and charged directly against statutory surplus. These assets consist primarily of premium receivables outstanding more than 90 days, federal deferred tax assets in excess of statutory limitations, state deferred taxes, furniture, equipment, leasehold improvements, capitalized software, and prepaid expenses.

 
• Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, respectively, as required by SAP.

 
• Fixed maturities securities are reported at fair value, rather than at amortized cost, or the lower of amortized cost or fair value, depending on the specific type of security, as required by SAP.

 
• The differing treatment of income and expense items results in a corresponding difference in federal income tax expense.  Changes in deferred income taxes are reflected as an item of income tax benefit or expense, rather than recorded directly to statutory surplus as regards policyholders, as required by SAP.  Admittance testing under SAP may result in a charge to unassigned surplus for non-admitted portions of deferred tax assets.  Under GAAP, a valuation allowance may be recorded against the deferred tax assets and reflected as an expense.

 
• Certain assessments paid to regulatory agencies that are recoverable from policy holders in future periods are expensed whereas these amounts are recorded as receivables under SAP.

Investments and Investment Results

General

The Company’s investments are directed by the Company’s Chief Investment Officer under the supervision of the Company’s Board of Directors.  The Company follows an investment policy that is regularly reviewed and revised.  The Company’s policy emphasizes investment grade, fixed income securities and maximization of after-tax yields and places certain restrictions to limit portfolio concentrations and market exposure.  Sales of securities are undertaken, with resulting gains or losses, in order to enhance after-tax yield and keep the portfolio in line with current market conditions.  Tax considerations, including the impact of the alternative minimum tax (“AMT”), are important in portfolio management.  Changes in loss experience, growth rates and profitability produce significant changes in the Company’s exposure to AMT liability, requiring appropriate shifts in the investment asset mix between taxable bonds, tax-exempt bonds and equities in order to maximize after-tax yield.  The Company closely monitors the timing and recognition of capital gains and losses to maximize the realization of any deferred tax assets arising from capital losses.  At December 31, 2008, the Company had available tax gains carried forward of approximately $43 million.

10

Investment Portfolio

The following table sets forth the composition of the Company’s investment portfolio:

   
December 31,
 
   
2008
   
2007
   
2006
 
   
Amortized Cost
   
Fair Value
   
Amortized Cost
   
Fair Value
   
Amortized Cost
   
Fair Value
 
   
(Amounts in thousands)
                         
Taxable bonds
  $ 313,218     $ 286,441     $ 440,028     $ 437,838     $ 583,602     $ 577,575  
Tax-exempt state and municipal bonds
    2,360,874       2,179,178       2,418,348       2,447,851       2,264,321       2,317,646  
Redeemable fund preferred stocks
    54,379       16,054       2,079       2,071       3,792       3,766  
Total fixed maturities
    2,728,471       2,481,673       2,860,455       2,887,760       2,851,715       2,898,987  
Equity investments including
                                               
non-redeemable preferred stocks
    403,773       247,391       330,995       428,237       258,310       318,449  
Short-term investments
    208,278       204,756       272,678       272,678       282,302       282,302  
Total investments
  $ 3,340,522     $ 2,933,820     $ 3,464,128     $ 3,588,675     $ 3,392,327     $ 3,499,738  
 
The Company continually evaluates the recoverability of its investment holdings.  Prior to the adoption of Statement of Financial Accounting Standard (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of Financial Accounting Standards Board (“FASB”) Statement No. 115” (“SFAS No. 159”), when a decline in value of fixed maturities or equity securities was considered other than temporary, the Company wrote the security down to fair value by recognizing a loss in the consolidated statement of operations. Declines in value considered to be temporary were charged as unrealized losses to shareholders’ equity as a reduction of accumulated other comprehensive income.  See “Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” and Note 2 of Notes to Consolidated Financial Statements.

At December 31, 2008, approximately 74% of the Company’s total investment portfolio at fair value and 88% of its total fixed maturity investments at fair value were invested in tax-exempt municipal bonds.  Shorter duration sinking fund preferred stocks and collateralized mortgage obligations together represented 7.5% of the Company’s total investment portfolio at fair value.  The weighted average Standard & Poor’s, Moody’s and Fitch’s rating of the Company’s bond holdings was AA at December 31, 2008.  Holdings of lower than investment grade bonds and non rated bonds constituted approximately 1.9% and 1.7%, respectively, of total invested assets at fair value.

The nominal average maturity of the overall bond portfolio, including collateralized mortgage obligations and short-term investments, was 13.9 years at December 31, 2008, which reflects a portfolio heavily weighted in investment grade tax-exempt municipal bonds.  The call-adjusted average maturity of the overall bond portfolio was approximately 10.8 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 7.2 years at December 31, 2008, including collateralized mortgage obligations with modified durations of approximately 1.7 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. Because 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.  The longer the duration, the greater the price volatility in relation to changes in interest rates.

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 year end, 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.

11

Investment Results

The following table summarizes the investment results of the Company for the most recent five years:

   
Year ended December 31,
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
   
(Amounts in thousands)
 
Average invested assets (includes short-term
                             
investments) (1)
  $ 3,452,803     $ 3,468,399     $ 3,325,435     $ 3,058,110     $ 2,662,224  
Net investment income:
                                       
Before income taxes
    151,280       158,911       151,099       122,582       109,681  
After income taxes
    133,721       137,777       127,741       105,724       95,897  
Average annual yield on investments:
                                       
Before income taxes
    4.4 %     4.6 %     4.5 %     4.0 %     4.1 %
After income taxes
    3.9 %     4.0 %     3.8 %     3.5 %     3.6 %
Net realized investment (losses) gains after
                                       
income taxes (2)
    (357,838 )     13,525       10,033       10,504       16,292  
Net increase (decrease) in unrealized gains/
                                       
losses on investments after income
                                       
taxes (3)
  $ -     $ 10,905     $ 3,103     $ (14,000 )   $ (4,284 )

(1) Fixed maturities at amortized cost, and equities and short-term investments at cost before write-downs.
(2) Includes investment impairment write-down, net of tax benefit, of $14.7 million in 2007, $1.3 million in 2006, $1.4 million in 2005 and $0.6 million in 2004.  2007 also includes $1.3 million gain, net of tax, and $0.9 million loss, net of tax benefit, related to the change in the fair value of trading securities and hybrid financial instruments, respectively.
(3) Effective January 1, 2008, the Company adopted SFAS No. 159.  The losses and gains due to changes in fair value for items measured at fair value pursuant to election of the fair value option were included in net realized investment losses and gains.
 
12

 
Competitive Conditions

The property and casualty insurance industry is highly competitive and consists of a large number of multi-state competitors offering automobile, homeowners, commercial property insurance, and other lines.  Many of the Company’s competitors have larger volumes of business and greater financial resources than those of the Company.  Based on the most recent regularly published statistical compilations of premiums written in 2007, the Company was the third largest writer of private passenger automobile insurance in California and the fourteenth largest in the United States.  Competitors with greater market share in California sell insurance through exclusive agents, rather than through independent agents and brokers.

The property and casualty insurance industry is highly cyclical, characterized by periods of high premium rates and shortages of underwriting capacity (“hard market”) followed by periods of severe price competition and excess capacity (“soft market”).  In management’s view, 2004 through 2007 was a period of very profitable results for companies underwriting automobile insurance. Many in the industry began experiencing declining profitability in 2007 and 2008.

Reputation for service and price are the principal means by which the Company competes with other automobile insurers.  The Company believes that it has a good reputation for service, and it has historically been among the lowest-priced insurers doing business in California according to surveys conducted by the California DOI.  In addition, the marketing efforts of independent agents and brokers can also provide a competitive advantage.

All rates charged by private passenger automobile insurers in California are subject to the prior approval of the California DOI.  See “Regulation—Department of Insurance Oversight.”

The Company encounters similar competition in each state outside California and line of business in which it operates.

Reinsurance

The Company has reinsurance through the Florida Hurricane Catastrophe Trust Fund (“FHCF”) that provides coverage equal to approximately 90 percent of $47 million in excess of $10 million per occurrence based on the latest information provided by FHCF.  The coverage is expected to change when new information is available later in 2009.

For California homeowners policies, the Company has reduced its catastrophe exposure from earthquakes by placing earthquake risks with the California Earthquake Authority (the “CEA”).  See “Regulation—Insurance Assessments.”  Although the Company’s catastrophe exposure to earthquakes has been reduced, the Company continues to have catastrophe exposure to fires following an earthquake.

The Company carries a commercial umbrella reinsurance treaty and seeks facultative arrangements for large property risks. In addition, the Company has other reinsurance in force that is not material to the consolidated financial statements. If any reinsurers are unable to perform their obligations under a reinsurance treaty, the Company will be required, as primary insurer, to discharge all obligations to its insured in their entirety.

Regulation

The Company is subject to significant regulation and supervision by the DOI of each state in which the Company operates.

13

Department of Insurance Oversight

The powers of the DOI in each state primarily include the prior approval of insurance rates and rating factors, the establishment of capital and surplus requirements and solvency standards, and restrictions on dividend payments and transactions with affiliates.  DOI regulations and supervision are designed principally to benefit policyholders rather than shareholders.

California Proposition 103 requires that property and casualty insurance rates be approved by the California DOI prior to their use and that no rate be approved which is excessive, inadequate, unfairly discriminatory or otherwise in violation of the provisions of the initiative.  The proposition specifies four statutory factors required to be applied in “decreasing order of importance” in determining rates for private passenger automobile insurance: (1) the insured’s driving safety record, (2) the number of miles the insured drives annually, (3) the number of years of driving experience of the insured and (4) whatever optional factors are determined by the California DOI to have a substantial relationship to risk of loss and are adopted by regulation.  The statute further provides that insurers are required to give at least a 20% discount to “good drivers,” as defined, from rates that would otherwise be charged to such drivers and that no insurer may refuse to insure a “good driver.”  The Company’s rate plan was approved by the California DOI and operates under these rating factor regulations.

Insurance rates in Georgia, New York, New Jersey, Pennsylvania and Nevada require prior approval from the state DOI, while insurance rates in Illinois, Texas, Virginia, Arizona and Michigan must only be filed with the respective DOI before they are implemented.  Oklahoma and Florida have a modified version of prior approval laws.  In all states, the insurance code provides that rates must not be excessive, inadequate or unfairly discriminatory.

The DOI in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of insurance companies domiciled in their states.

Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing and other practices.

The following table provides a summary of current financial and market conduct examinations:

State
Exam Type
Period Under Review
Status
CA
Financial
2004 to 2007
Report was issued in January 2009
CA
Rating & Underwriting
2004 to 2006
Field work has been completed. Awaiting final report.
NJ
Market Conduct
Sept 2007 to Aug 2008
Fieldwork began in November 2008
GA
Financial
2004 to 2006
Report was issued in October 2008
OK
Financial
2005 to 2007
Fieldwork began in October 2008
IL
Market Conduct
2007
Report was issued in August 2008

No material findings have been noted in any of these examinations.

For discussion of current regulatory matters in California, see “Regulatory and Legal Matters” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The operations of the Company are dependent on the laws of the states in which it does business and changes in those laws can materially affect the revenue and expenses of the Company.  The Company retains its own legislative advocates in California.  The Company made financial contributions of $354,450 and $463,985 to officeholders and candidates in 2008 and 2007, respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines to be appropriate.

14

Insurance Assessments

The California Insurance Guarantee Association (“CIGA”) was created to pay claims on behalf of insolvent property and casualty insurers.  Each year, these claims are estimated by CIGA and the Company is assessed for its pro-rata share based on prior year California premiums written in the particular line.  These assessments are limited to 2% of premiums written in the preceding year and are recouped through a mandated surcharge to policyholders the year after the assessment.  The Insurance Companies in other states are also subject to the provisions of similar insurance guaranty associations.

During 2008, the Company paid approximately $1.9 million in assessments to the New Jersey Unsatisfied Claim and Judgment Fund and the New Jersey Property-Liability Insurance Guaranty Association for assessments relating to its personal automobile line of business.  As permitted by state law, the New Jersey assessments paid during 2008 are recoupable through a surcharge to policyholders.  During 2008, the Company continued to recoup these assessments and will continue recouping them in 2009.  It is possible that there will be additional assessments in 2009.  Under GAAP, these recoverable assessments of $5.2 million have been expensed as other operating expenses in the consolidated statements of operations.

The CEA is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. The Company places all new and renewal earthquake coverage offered with its homeowners policy through the CEA.  The Company receives a small fee for placing business with the CEA, which was recorded as other income in the consolidated statements of operations.

Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses.  These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment.  Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 26, 2008, was approximately $74 million.

Holding Company Act

The California Companies are subject to California DOI regulation pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the “Holding Company Act”).  The California DOI may examine the affairs of each of the California Companies at any time.  The Holding Company Act requires disclosure of any material transactions among affiliates within a Holding Company System.  Certain transactions and dividends defined to be of an “extraordinary” type may not be affected if the California DOI disapproves the transaction within 30 days after notice.  Such transactions include, but are not limited to, extraordinary dividends; management agreements, service contracts, and cost-sharing arrangements; all guarantees that are not quantifiable; derivative transactions or series of derivative transactions; certain reinsurance transactions or modifications thereof in which the reinsurance premium or a change in the insurer’s liabilities equals or exceeds 5 percent of the insurer’s policyholders’ surplus as of the preceding December 31; sales, purchases, exchanges, loans and extensions of credit; and investments, in the net aggregate, involving more than the lesser of 3% of the respective California Company’s admitted assets or 25% of statutory surplus as regards policyholders as of the preceding December 31. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the preceding 12 months, exceeds the greater of 10% of the insurance company’s statutory policyholders’ surplus as of the preceding December 31 or the insurance company’s statutory net income for the preceding calendar year.  An insurance company is also required to notify the California DOI of any dividend after declaration, but prior to payment.  There are similar limitations imposed by other states on the Insurance Companies’ ability to pay dividends.  As of December 31, 2008, the Insurance Companies are permitted to pay, without extraordinary DOI approval, $136.7 million in dividends, of which $115.7 million is payable from the California Companies.

15

The Holding Company Act also provides that the acquisition or change of “control” of a California domiciled insurance company or of any person who controls such an insurance company cannot be consummated without the prior approval of the California DOI.  In general, a presumption of “control” arises from the ownership of voting securities and securities that are convertible into voting securities, which in the aggregate constitute 10% or more of the voting securities of a California insurance company or of a person that controls a California insurance company, such as Mercury General.  A person seeking to acquire “control,” directly or indirectly, of the Company must generally file with the California DOI   an application for change of control containing certain information required by statute and published regulations and provide a copy of the application to the Company.  The Holding Company Act also effectively restricts the Company from consummating certain reorganizations or mergers without prior regulatory approval.

Each of the Insurance Companies is subject to holding company regulations in the states in which it is domiciled; the provisions of which are substantially similar to those of the Holding Company Act.
 
Assigned Risks

Automobile liability insurers in California are required to sell bodily injury liability, property damage liability, medical expense and uninsured motorist coverage to a proportionate number (based on the insurer’s share of the California automobile casualty insurance market) of those drivers applying for placement as “assigned risks.”  Drivers seek placement as assigned risks because their driving records or other relevant characteristics, as defined by Proposition 103, make them difficult to insure in the voluntary market.  In 2008, assigned risks represented less than 0.1% of total automobile direct premiums written and less than 0.1% of total automobile direct premium earned.  The Company attributes the low level of assignments to the competitive voluntary market.  Many of the other states in which the Company conducts business offer programs similar to that of California.  These programs are not a significant contributor to the business written in those states.

16

EXECUTIVE OFFICERS OF THE COMPANY

The following table sets forth certain information concerning the executive officers of the Company as of February 15, 2009:

Name
 
Age
 
Position
George Joseph
   
87
 
Chairman of the Board
Gabriel Tirador
   
44
 
President and Chief Executive Officer
Allan Lubitz
   
50
 
Senior Vice President and Chief Information Officer
Joanna Y. Moore
   
53
 
Senior Vice President and Chief Claims Officer
Bruce E. Norman
   
60
 
Senior Vice President - Marketing
John Sutton
   
61
 
Senior Vice President - Customer Service
Ronald Deep
   
53
 
Vice President -South East Region
Christopher Graves
   
43
 
Vice President and Chief Investment Officer
Robert Houlihan
   
52
 
Vice President and Chief Product Officer
Kenneth G. Kitzmiller
   
62
 
Vice President - Underwriting
Theodore R. Stalick
   
45
 
Vice President and Chief Financial Officer
Charles Toney
   
47
 
Vice President and Chief Actuary
Judy A. Walters
   
62
 
Vice President - Corporate Affairs and Secretary

Mr. Joseph, Chairman of the Board of Directors, has served in this capacity since 1961. He held the position of Chief Executive Officer of the Company for 45 years from 1961 through December 2006.  Mr. Joseph has more than 50 years’ experience in the property and casualty insurance business.

Mr. Tirador, President and Chief Executive Officer, served as the Company’s assistant controller from 1994 to 1996.  In 1997 and 1998 he served as the Vice President and Controller of the Automobile Club of Southern California.  He rejoined the Company in 1998 as Vice President and Chief Financial Officer.  He was appointed President and Chief Operating Officer in October 2001 and Chief Executive Officer in January 2007.  Mr. Tirador has over 20 years experience in the property and casualty insurance industry and is a Certified Public Accountant.

Mr. Lubitz, Senior Vice President and Chief Information Officer, joined the Company in January 2008.  Prior to joining the Company, he served as Senior Vice President and Chief Information Officer of Option One Mortgage from 2003 to 2007 and President of ANR Consulting Group from 2000 to 2003. Prior to 2000, he held various management positions at First American Corporation over a 20 year period, most recently as Senior Vice President and Chief Information Officer.

Ms. Moore, Senior Vice President and Chief Claims Officer, joined the Company in the claims department in 1981.  She was named Vice President of Claims of Mercury General in 1991 and Vice President and Chief Claims Officer in 1995.  She was promoted to Senior Vice President and Chief Claims Officer on January 1, 2007.

Mr. Norman, Senior Vice President-Marketing, has been employed by the Company since 1971.  Mr. Norman was named to his current position in 1999, and has been a Vice President since 1985 and a Vice President of MCC since 1983.  Mr. Norman has supervised the selection and training of agents and managed relations between agents and the Company since 1977.

Mr. Sutton, Senior Vice President-Customer Service, joined the Company as Assistant to CEO in July 2000.  He was named Vice President in September 2007 and Senior Vice President in January 2008. Prior to joining the Company, he served as President and Chief Executive Officer of The Covenant Group from 1994 to 2000. Prior to 1994, he held various executive positions at Hanover Insurance Company.

Mr. Deep, Vice President-South East Region, joined the Company in September 2006 as State Administrator for the South East Region and was named Vice President of the South East Region in February 2007.  Prior to joining the Company, Mr. Deep was Executive Vice President of Shelby Insurance Company from 2004 to 2006 and an Assistant Vice President of USAA from 1994 to 2004.

Mr. Graves, Vice President and Chief Investment Officer, has been employed by the Company in the investment department since 1986.  Mr. Graves was appointed Chief Investment Officer in 1998, and named Vice President in April 2001.

Mr. Houlihan, Vice President and Chief Product Officer, joined the Company in December 2007.  Prior to joining the Company, he served as Senior Product Manager at Bristol West Insurance Group from 2005 to 2007 and Product Manager at Progressive Insurance Company from 1999 to 2005.

Mr. Kitzmiller, Vice President-Underwriting, has been employed by the Company in the underwriting department since 1972.  In 1991, he was appointed Vice President of Underwriting of Mercury General and has supervised the California underwriting activities of the Company since early 1996.

Mr. Stalick, Vice President and Chief Financial Officer, joined the Company as Corporate Controller in 1997.  In October 2000, he was named Chief Accounting Officer, a role he held until appointed to his current position in October 2001.  Mr. Stalick is a Certified Public Accountant.

Mr. Toney, Vice President and Chief Actuary, joined the Company in 1984 as a programmer/analyst.  In 1994 he earned his Fellowship in the Casualty Actuarial Society and was appointed to his current position.

Ms. Walters, Vice President-Corporate Affairs and Secretary, has been employed by the Company since 1967, and has served as its Secretary since 1982.  Ms. Walters was named Vice President - Corporate Affairs in 1998.
17

Item 1A.
Risk Factors

The Company’s business involves various risks and uncertainties, some of which are discussed in this section.  The information discussed below should be considered carefully with the other information contained in this Annual Report on Form 10-K and the other documents and materials filed by the Company with the SEC, as well as news releases and other information publicly disseminated by the Company from time to time.

The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties not presently known to the Company, or that it currently believes to be immaterial, may also adversely affect the Company’s business. Any of the following risks or uncertainties that develop into actual events could have a materially adverse effect on the Company’s business, financial condition or results of operations.

Risks Related to the Company and its Business

The Company is a holding company that relies on regulated subsidiaries for cash to satisfy its obligations.

As a holding company, the Company maintains no operations that generate revenue to pay operating expenses, shareholders’ dividends or principal or interest on its indebtedness. Consequently, the Company relies on the ability of its insurance subsidiaries, and particularly its California insurance subsidiaries, to pay dividends for the Company to meet its debt payment obligations and pay other expenses. The ability of the Company’s insurance subsidiaries to pay dividends is regulated by state insurance laws, which limit the amount of, and in certain circumstances may prohibit the payment of, cash dividends. Generally, these insurance regulations permit the payment of dividends only out of earned surplus in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. The inability of the Company’s insurance subsidiaries to pay dividends in an amount sufficient to enable the Company to meet its cash requirements at the holding company level could have a material adverse effect on the Company’s results of operations and its ability to pay dividends to its shareholders.

If the Company’s loss reserves are inadequate, its business and financial position could be harmed.

The process of establishing property and liability loss reserves is inherently uncertain due to a number of factors, including underwriting quality, the frequency and amount of covered losses, variations in claims settlement practices, the costs and uncertainty of litigation, and expanding theories of liability. While the Company believes that improved actuarial techniques and databases have assisted in estimating loss reserves, the Company’s methods may prove to be inadequate. If any of these contingencies, many of which are beyond the Company’s control, results in loss reserves that are not sufficient to cover its actual losses, its results of operations, liquidity and financial position may be materially adversely affected.

18

The Company’s success depends on its ability to accurately underwrite risks and to charge adequate premiums to policyholders.

The Company’s financial condition, liquidity and results of operations depend on the Company’s ability to underwrite and set premiums accurately for the risks it faces. Premium rate adequacy is necessary to generate sufficient premium to offset losses, loss adjustment expenses and underwriting expenses and to earn a profit. In order to price its products accurately, the Company must collect and properly analyze a substantial volume of data; develop, test and apply appropriate rating formulae; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. The Company’s ability to undertake these efforts successfully, and as a result, price accurately, is subject to a number of risks and uncertainties, including, without limitation:

 
• availability of sufficient reliable data;
 
•  incorrect or incomplete analysis of available data;
 
• uncertainties inherent in estimates and assumptions, generally;
 
• selection and application of appropriate rating formulae or other pricing methodologies;
 
• successful innovation of new pricing strategies;
 
• recognition of changes in trends and in the projected severity and frequency of losses;
 
• the Company’s ability to forecast renewals of existing policies accurately;
 
• unanticipated court decisions, legislation or regulatory action;
 
• ongoing changes in the Company’s claim settlement practices;
 
• changes in operating expenses;
 
• changing driving patterns;
 
• extra-contractual liability arising from bad faith claims;
 
• weather catastrophes;
 
• unexpected medical inflation; and
 
• unanticipated inflation in auto repair costs, auto parts prices and used car prices.

Such risks may result in the Company’s pricing being based on outdated, inadequate or inaccurate data or inappropriate analyses, assumptions or methodologies, and may cause the Company to estimate incorrectly future changes in the frequency or severity of claims. As a result, the Company could underprice risks, which would negatively affect the Company’s margins, or it could overprice risks, which could reduce the Company’s volume and competitiveness. In either event, the Company’s operating results, financial condition and cash flow could be materially adversely affected.
 
The effects of emerging claim and coverage issues on the Company’s business are uncertain and may have an adverse effect on the Company’s business.

As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect the Company’s business by either extending coverage beyond its underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after the Company has issued insurance policies that are affected by the changes. As a result, the full extent of liability under the Company’s insurance policies may not be known for many years after a policy is issued.

19

The Company’s private passenger insurance rates are subject to prior approval by the departments of insurance in most of the states in which the Company operates, and to political influences.

In most of the states in which the Company operates, it must obtain prior approval from the state department of insurance of the private passenger insurance rates charged to its customers, including any increases in those rates. If the Company is unable to receive approval of the rate increases it requests, the Company’s ability to operate its business in a profitable manner may be limited and its liquidity, financial condition and results of operations may be adversely affected.

From time to time, the private passenger auto insurance industry comes under pressure from state regulators, legislators and special interest groups to reduce, freeze or set rates at levels that do not correspond with underlying costs, in the opinion of the Company’s management. The homeowners insurance business faces similar pressure, particularly as regulators in catastrophe-prone states seek an acceptable methodology to price for catastrophe exposure. In addition, various insurance underwriting and pricing criteria regularly come under attack by regulators, legislators and special interest groups. The result could be legislation or regulations that would adversely affect the Company’s business, financial condition and results of operations.
 
The Company remains highly dependent upon California and several other key states to produce revenues and operating profits.

For the year ended December 31, 2008, the Company generated approximately 79.4% of its direct automobile insurance premiums written in California, 6.7% in Florida and 3.5% in New Jersey.  The Company’s financial results are therefore subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states and changes in any of these conditions could negatively impact the Company’s results of operations.

Acquired companies can be difficult to integrate, disrupt the Company’s business and adversely affect its operating results. The benefits anticipated in an acquisition may not be realized in the manner anticipated.

Effective January 1, 2009, the Company acquired all of the issued and outstanding membership interests of AIS Management, LLC, which is the parent company of Auto Insurance Specialists, LLC, and PoliSeek AIS Insurance Solutions, Inc. with the expectation that the acquisition would result in various benefits including, among other things, enhanced revenue and profits, greater market presence and development, and enhancements to the Company’s product portfolio and customer base.  These benefits may not be realized as rapidly as, or to the extent, anticipated by the Company.  Costs incurred in the integration of the AIS operations with the Company’s operations also could have an adverse effect on the Company’s business, financial condition and operating results. If these risks materialize, the Company’s stock price could be materially adversely affected. The acquisition of AIS, as with all acquisitions, involves numerous risks, including:

 
• difficulties in integrating AIS operations, technologies, services and personnel;
 
• potential loss of AIS customers;
 
• diversion of financial and management resources from existing operations;
 
• potential loss of key AIS employees;
 
• integrating personnel with diverse business and cultural backgrounds;
 
• preserving AIS’s important industry, marketing and customer relationships;
 
• assumption of liabilities held by AIS; and
 
• inability to generate sufficient revenue and cost savings to offset the cost of the acquisition.

The Company’s acquisition of AIS may also cause it to:

 
• assume and otherwise become subject to certain liabilities;
 
• incur additional debt, such as the $120 million debt incurred to fund the acquisition;
 
• make write-offs and incur restructuring and other related expenses; and
 
• create goodwill or other intangible assets that could result in significant impairment charges and/or amortization expense.

As a result, if the Company fails to properly evaluate, execute the acquisition of and integrate AIS, its business and prospects may be seriously harmed.
20

If the Company cannot maintain its A.M. Best ratings, it may not be able to maintain premium volume in its insurance operations sufficient to attain the Company’s financial performance goals.

The Company’s ability to retain its existing business or to attract new business in its insurance operations is affected by its rating by A.M. Best Company. A.M. Best Company currently rates all of the Company’s insurance subsidiaries with sufficient operating history to be rated as either A+ (Superior) or A- (Excellent).  If the Company is unable to maintain its A.M. Best ratings, the Company may not be able to grow its premium volume sufficiently to attain its financial performance goals, and if A.M. Best were to downgrade the Company’s rating, the Company could lose significant premium volume.

The Company’s ability to access capital markets, its financing arrangements, and its business operations are dependent on favorable evaluations and ratings by credit and other rating agencies.

Financial strength and claims-paying ability ratings issued by firms such as Standard & Poor’s, Fitch, and Moody’s have become an increasingly important factor in establishing the competitive position of insurance companies. The Company’s ability to attract and retain policies is affected by its ratings with these agencies. Rating agencies assign ratings based upon their evaluations of an insurance company’s ability to meet its financial obligations.  The Company’s financial strength ratings with Standard & Poor’s, Fitch, and Moody’s are AA-, AA-, and Aa3, respectively; its respective debt ratings are A-, A, and A3.  In February, 2009, the ratings were affirmed by Standard & Poor’s and Fitch, but the outlook for the ratings was changed from stable to negative while Moody’s maintained a stable outlook.  Since these ratings are subject to continuous review, the Company cannot guarantee the continuation of the favorable ratings. If the ratings were lowered significantly by any one of these agencies relative to those of the Company’s competitors, its ability to market products to new customers and to renew the policies of current customers could be harmed. A lowering of the ratings could also limit the Company’s access to the capital markets or adversely affect pricing of new debt sought in the capital markets. These events, in turn, could have a material adverse effect on the Company’s net income and liquidity.

The Company’s insurance subsidiaries are subject to minimum capital and surplus requirements, and any failure to meet these requirements could subject the Company’s insurance subsidiaries to regulatory action.

The Company’s insurance subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require the Company’s insurance subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. If any of the Company’s insurance subsidiaries fails to meet these standards and requirements, the Department of Insurance regulating such subsidiary may require specified actions by the subsidiary.

There is uncertainty involved in the availability of reinsurance and the collectibility of reinsurance recoverables.

The Company reinsures a portion of its potential losses on the policies it issues to mitigate the volatility of the losses on its financial condition and results of operations. The availability and cost of reinsurance is subject to market conditions, which are outside of the Company’s control. From time to time, market conditions have limited, and in some cases prevented, insurers from obtaining the types and amounts of reinsurance that they consider adequate for their business needs. As a result, the Company may not be able to successfully purchase reinsurance and transfer a portion of the Company’s risk through reinsurance arrangements. In addition, as is customary, the Company initially pays all claims and seeks to recover the reinsured losses from its reinsurers. Although the Company reports as assets the amount of claims paid which the Company expects to recover from reinsurers, no assurance can be given that the Company will be able to collect from its reinsurers. If the amounts actually recoverable under the Company’s reinsurance treaties are ultimately determined to be less than the amount it has reported as recoverable, the Company may incur a loss during the period in which that determination is made.

21

The Company depends on independent agents who may discontinue sales of its policies at any time.

The Company sells its insurance policies through approximately 4,700 independent agents and brokers.  The Company must compete with other insurance carriers for these agents’ and brokers’ business.  Some competitors offer a larger variety of products, lower prices for insurance coverage, higher commissions, or more attractive non-cash incentives.  To maintain its relationship with these independent agents, the Company must pay competitive commissions, be able to respond to their needs quickly and adequately, and create a consistently high level of customer satisfaction. If these independent agents find it preferable to do business with the Company’s competitors, it would be difficult to renew the Company’s existing business or attract new business. State regulations may also limit the manner in which the Company’s producers are compensated or incentivized. Such developments could negatively impact the Company’s relationship with these parties and ultimately reduce revenues.
 
Changes in market interest rates or defaults may have an adverse effect on the Company’s investment portfolio, which may adversely affect the Company’s financial results.

The Company’s results are affected, in part, by the performance of its investment portfolio. The Company’s investment portfolio contains interest rate sensitive-investments, such as municipal and corporate bonds. Increases in market interest rates may have an adverse impact on the value of the investment portfolio by decreasing unrealized capital gains on fixed income securities. Declining market interest rates could have an adverse impact on the Company’s investment income as it invests positive cash flows from operations and as it reinvests proceeds from maturing and called investments in new investments that could yield lower rates than the Company’s investments have historically generated. Defaults in the Company’s investment portfolio may produce operating losses and reduce the Company’s capital and surplus.

Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond the Company’s control. Although the Company takes measures to manage the risks of investing in a changing interest rate environment, it may not be able to mitigate interest rate sensitivity effectively. The Company’s mitigation efforts include maintaining a high quality portfolio and managing the duration of the portfolio to reduce the effect of interest rate changes on book value. Despite its mitigation efforts, a significant increase in interest rates could have a material adverse effect on the Company’s book value.

Changes in the financial strength ratings of financial guaranty insurers issuing policies on bonds held in the Company’s investment portfolio may have an adverse effect on the Company’s investment results.

In an effort to enhance the bond rating applicable to a certain bond issues, some bond issuers purchase municipal bond insurance policies from private insurers. The insurance generally guarantees the payment of principal and interest on a bond issue if the issuer defaults. By purchasing the insurance, the financial strength ratings applicable to the bonds are based on the credit worthiness of the insurer rather than the underlying credit of the bond issuer. Several financial guaranty insurers that have issued insurance policies covering bonds held by the Company are facing financial strength rating downgrades due to risk exposures on insurance policies that guarantee mortgage debt and related structured products.  These financial guaranty insurers are subject to DOI oversight.  As the financial strength ratings of these insurers are reduced, the ratings of the insured bond issues correspondingly decrease.  Although the Company has determined that the financial strength rating of the underlying bond issues in its investment portfolio are within the Company’s investment policy without the enhancement provided by the insurance policies, any further downgrades in the financial strength ratings of these insurance companies or any defaults on the insurance policies written by these insurance companies may reduce the fair value of the underlying bond issues and the Company’s investment portfolio or may reduce the investment results generated by the Company’s investment portfolio, which could have a material adverse effect on the Company’s financial condition, liquidity and results of operations.

22

The Company’s business is vulnerable to significant catastrophic property loss, which could have an adverse effect on its results of operations.

The Company faces a significant risk of loss in the ordinary course of its business for property damage resulting from natural disasters, man-made catastrophes and other catastrophic events, particularly hurricanes, earthquakes, hail storms, explosions, tropical storms, fires, war, acts of terrorism, severe winter weather and other natural and man-made disasters. Such events typically increase the frequency and severity of automobile and other property claims.  Because catastrophic loss events are by their nature unpredictable, historical results of operations may not be indicative of future results of operations, and the occurrence of claims from catastrophic events is likely to result in substantial volatility in the Company’s financial condition and results of operations from period to period. Although the Company attempts to manage its exposure to such events, the occurrence of one or more major catastrophes in any given period could have a material and adverse impact on the Company’s financial condition and results of operations and could result in substantial outflows of cash as losses are paid.
 
The Company’s expansion plans may adversely affect its future profitability.

The Company is currently expanding and intends to further expand its operations in several of the states in which the Company has operations and into states in which it has not yet begun operations. The intended expansion will necessitate increased expenditures. The Company expects to fund these expenditures out of cash flow from operations. The expansion may not occur, or if it does occur may not be successful in providing increased revenues or profitability. If the Company’s cash flow from operations is insufficient to cover the increased costs of the expansion, or if the expansion does not provide the benefits anticipated, the Company’s financial condition and results of operations and ability to grow its business may be harmed.

The Company may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

The Company’s future capital requirements depend on many factors, including its ability to write new business successfully, its ability to establish premium rates and reserves at levels sufficient to cover losses, the success of its current expansion plans and the performance of its investment portfolio. The Company may need to raise additional funds through equity or debt financing, sales of all or a portion of its investment portfolio or curtail its growth and reduce its assets. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company.  In the case of equity financing, the Company’s shareholders could experience dilution.  In addition, such securities may have rights, preferences and privileges that are senior to those of the Company’s current shareholders. If the Company cannot obtain adequate capital on favorable terms or at all, its business, operating results and financial condition could be adversely affected.
 
Any inability of the Company to realize its deferred tax assets may have a material adverse affect on the Company’s results of operations and its financial condition.

The Company recognizes deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits.  The Company evaluates its deferred tax assets for recoverability based on available evidence, including assumptions about future profitability and capital gain generation. Although management believes that it is more likely than not that that the deferred tax assets will be realized, some or all of the Company’s deferred tax assets could expire unused if the Company is unable to generate taxable capital gains in the future sufficient to utilize them or the Company enters into one or more transactions that limit its right to realize all of the deferred tax assets.

23

If the Company determines that it would not be able to realize all or a portion of its deferred tax assets in the future, the Company would reduce the deferred tax asset through a charge to earnings in the period in which the determination is made. This charge could have a material adverse affect on the Company’s results of operations and financial condition. In addition, the assumptions used to make this determination are subject to change from period to period based on changes in tax laws or variances between the Company’s future projected operating performance and actual results. As a result, significant management judgment is required in assessing the possible need for a deferred tax asset valuation allowance. For these reasons and because changes in these assumptions and estimates can materially affect the Company’s results of operations and financial condition, management has included the assessment of a deferred tax asset valuation allowance as a critical accounting estimate.
 
Continued deterioration of the municipal bond market in general or of specific municipal bonds held by the Company may result in a material adverse affect on the Company’s results of operations and its financial condition.

At December 31, 2008, approximately 74% of the Company’s total investment portfolio at fair value and 88% of its total fixed maturity investments at fair value were invested in tax-exempt municipal bonds.  Approximately 45% of the net losses held in the Company’s investment portfolio at December 31, 2008 related to the Company’s municipal bond holdings. With such a large percentage of the Company’s investment portfolio invested in municipal bonds, the performance of the Company’s investment portfolio, including the cash flows generated by the investment portfolio is significantly dependent on the performance of municipal bonds.  If the value of municipal bond markets in general or any of the Company’s municipal bond holdings continue to deteriorate, the performance of the Company’s investment portfolio, results of operations, financial position and cash flows may be materially and adversely affected.
 
The Company relies on its information technology systems to manage many aspects of its business, and any failure of these systems to function properly or any interruption in their operation could result in a material adverse effect on the Company’s business, financial condition and results of operations.

The Company depends on the accuracy, reliability and proper functioning of its information technology systems. The Company relies on these information technology systems to effectively manage many aspects of its business, including underwriting, policy acquisition, claims processing and handling, accounting, reserving and actuarial processes and policies, and to maintain its policyholder data.  The Company is developing and deploying new information technology systems that are designed to manage many of these functions across all of the states in which it operates and all of the lines of insurance it offers. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations-Technology.”  The failure of hardware or software that supports the Company’s information technology systems, the loss of data contained in the systems, or any delay or failure in the full deployment of the Company’s new information technology systems could disrupt its business and could result in decreased premiums, increased overhead costs and inaccurate reporting, all of which could have a material adverse effect on the Company’s business, financial condition and results of operations.

In addition, despite system redundancy, the implementation of security measures and the existence of a disaster recovery plan for the Company’s information technology systems, these systems are vulnerable to damage or interruption from:

 
• earthquake, fire, flood and other natural disasters;
 
• terrorist attacks and attacks by computer viruses or hackers;
 
• power loss;
 
• unauthorized access; and
 
• computer systems, Internet, telecommunications or data network failure.

It is possible that a system failure, accident or security breach could result in a material disruption to the Company’s business. In addition, substantial costs may be incurred to remedy the damages caused by these disruptions. Following implementation of its new information technology systems, the Company may from time to time install new or upgraded business management systems. To the extent that a critical system fails or is not properly implemented and the failure cannot be corrected in a timely manner, the Company may experience disruptions to the business that could have a material adverse effect on the Company’s results of operations.
 
24

Changes in accounting standards issued by the FASB or other standard-setting bodies may adversely affect the Company’s consolidated financial statements.

The Company’s consolidated financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, the Company is required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes the Company is required to adopt could change the current accounting treatment that the Company applies to its consolidated financial statements and that such changes could have a material adverse effect on the Company’s results and financial condition. See Note 1 of Notes to Consolidated Financial Statements.
 
The Company’s disclosure controls and procedures may not prevent or detect all acts of fraud.

The Company’s disclosure controls and procedures are designed to reasonably assure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act is accumulated and communicated to management and is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company’s management, including its Chief Executive Officer and Chief Financial Officer, believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, they cannot provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been prevented or detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by an unauthorized override of the controls. The design of any systems of controls also is based in part upon certain assumptions about the likelihood of future events, and the Company cannot assure that any design will succeed in achieving its stated goals under all potential future conditions. Accordingly, because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and not be detected.
 
Failure to maintain an effective system of internal control over financial reporting may have an adverse effect on the Company’s stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the SEC require the Company to include in its Form 10-K a report by its management regarding the effectiveness of the Company’s internal control over financial reporting. The report includes, among other things, an assessment of the effectiveness of the Company’s internal control over financial reporting as of the end of its fiscal year, including a statement as to whether or not the Company’s internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in the Company’s internal control over financial reporting identified by management. Areas of the Company’s internal control over financial reporting may require improvement from time to time. If management is unable to assert that the Company’s internal control over financial reporting is effective now or in any future period, or if the Company’s independent auditors are unable to express an opinion on the effectiveness of those internal controls, investors may lose confidence in the accuracy and completeness of the Company’s financial reports, which could have an adverse effect on its stock price.

The Company may be required to adopt International Financial Reporting Standards (IFRS). The ultimate adoption of such standards could negatively impact its business, financial condition or results of operations.

Although not yet required, the Company could be required to adopt IFRS, which is different than U.S. GAAP, for the Company’s accounting and reporting standards.  The implementation and adoption of new standards could favorably or unfavorably impact the Company’s business, financial condition or results of operations.

25

The ability of the Company to attract, develop and retain talented employees, managers and executives, and to maintain appropriate staffing levels, is critical to the Company’s success.

As the Company expands its operations, it must hire and train new employees, and retain current employees to handle the resulting increase in new inquiries, policies, customers and claims. The failure of the Company to successfully hire and retain a sufficient number of skilled employees could result in the Company having to slow the growth of its business in some jurisdictions. It could also affect the Company’s ability to develop and deploy information technology systems that are important to the success of the Company. In addition, the failure to adequately staff its claims and underwriting departments could result in decreased quality of the Company’s claims and underwriting operations.

The Company’s success also depends heavily upon the continued contributions of its executive officers, both individually and as a group. The Company’s future performance will be substantially dependent on its ability to retain and motivate its management team. The loss of the services of any of the Company’s executive officers could prevent the Company from successfully implementing its business strategy, which could have a material adverse effect on the Company’s business, financial condition and results of operations.
 
The insurance industry has been the target of litigation, and the Company faces litigation risks which, if decided adversely to the Company, could impact its financial results.

In recent years, insurance companies have been named as defendants in lawsuits including class actions, relating to pricing, sales practices and practices in claims handling, among other matters. A number of these lawsuits have resulted in substantial jury awards or settlements involving other insurers. Future litigation relating to these or other business practices may negatively affect the Company by requiring it to pay substantial awards or settlements, increasing the Company’s legal costs, diverting management attention from other business issues or harming the Company’s reputation with customers. Such litigation is inherently unpredictable.

The Company and its insurance subsidiaries are named as defendants in a number of lawsuits. These lawsuits are described more fully in “Item 3. Legal Proceedings.”  Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuits is uncertain and may, if these lawsuits are determined adversely to the Company, negatively impact the manner in which the Company conducts its business and its results of operations, which could materially increase the Company’s costs and expenses.

In addition, potential litigation involving new claim, coverage and business practice issues could adversely affect the Company’s business by changing the way policies are priced, extending coverage beyond its underwriting intent or increasing the size of claims. The effects of these and other unforeseen emerging claim, coverage and business practice issues could negatively impact the Company’s financial condition, revenues or its methods of doing business.
 
The failure of any of the loss limitation methods employed by the Company could have a material adverse effect on its financial condition or results of operations.

Various provisions of the Company’s policies, such as limitations or exclusions from coverage which are intended to limit the Company’s risks, may not be enforceable in the manner the Company intends.  In addition, the Company’s policies contain conditions requiring the prompt reporting of claims and the Company’s right to decline coverage in the event of a violation of that condition. While the Company’s insurance product exclusions and limitations reduce the Company’s loss exposure and help eliminate known exposures to certain risks, it is possible that a court or regulatory authority could nullify or void an exclusion or legislation could be enacted modifying or barring the use of such endorsements and limitations in a way that would adversely affect the Company’s loss experience, which could have a material adverse effect on its financial condition or results of operations.

26

General economic conditions may affect the Company’s revenue and profitability and harm its business.

Financial markets in the United States, Europe and Asia have experienced and continue to experience extreme disruption in recent months, and the United States and other countries are currently in a severe economic recession. Unfavorable changes in economic conditions, including continuing stock market declines, inflation, recession, declining consumer confidence or other changes, may reduce the Company’s premium volume through policy cancellations, modifications or non-renewals, may reduce cash flows from operations and investments, may harm the Company’s financial position and may reduce the Insurance Companies’ statutory surplus.  Challenging economic conditions also may impair the ability of the Company’s customers to pay premiums as they fall due, and as a result, the Company’s reserves and write-offs could increase. The significant losses in the Company’s investment portfolio could also continue if the losses in the financial markets in general continue.  The Company is unable to predict the duration and severity of the current disruption in financial markets and adverse economic conditions in the United States and other countries.  If economic conditions in the United States continue to deteriorate or do not show improvement, the adverse impact on the Company’s results of operations, financial position and cash flows may continue.
 
Continued deterioration in the public debt and equity markets could lead to additional investment losses and materially and adversely affect the Company’s business.

The prolonged and severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, bankruptcies and government intervention in a number of large financial institutions, have resulted in significant losses in the Company’s investment portfolio. For the year ended December 31, 2008, the Company incurred substantial realized investment losses, as described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I.  Continued deterioration in the financial markets could lead to additional investment losses.
 
Funding for the Company’s future growth may depend upon obtaining new financing, which may be difficult to obtain given prevalent economic conditions and the general credit crisis.

To accommodate the Company’s expected future growth, the Company may require funding in addition to cash provided from current operations.  The Company’s ability to obtain financing may be constrained by current economic conditions affecting global financial markets.  Specifically, the recent credit crisis and other related trends affecting the banking industry have caused significant operating losses and bankruptcies throughout the banking industry. Many lenders and institutional investors have ceased funding even the most credit-worthy borrowers. If the Company is unable to obtain necessary financing, it may be unable to take advantage of opportunities with potential business partners or new products or to otherwise expand its business as planned.
 
27

Risks Related to the Company’s Industry

The private passenger automobile insurance business is highly competitive, and the Company may not be able to compete effectively against larger, better-capitalized companies.

The Company competes with many property and casualty insurance companies selling private passenger automobile insurance in the states in which the Company operates, many of which are better capitalized than the Company and have higher A.M. Best ratings. The superior capitalization of many of the Company’s competitors may enable them to offer lower rates, to withstand larger losses, and to take advantage more effectively of new marketing opportunities. The Company’s competition may also become increasingly better capitalized in the future as the traditional barriers between insurance companies and banks and other financial institutions erode and as the property and casualty industry continues to consolidate. The Company’s ability to compete against these larger, better-capitalized competitors depends importantly on its ability to deliver superior service and its strong relationships with independent agents.

The Company may from time to time undertake strategic marketing and operating initiatives to improve its competitive position and drive growth. If the Company is unable to successfully implement new strategic initiatives or if the Company’s marketing campaigns do not attract new customers, the Company’s competitive position may be harmed, which could adversely affect the Company’s business and results of operations.
Additionally, in a highly competitive industry such as the automobile insurance industry, some of the Company’s competitors may fail from time to time. In the event of a failure of a major insurance company, the Company could be adversely affected, as the Company and other insurance companies would likely be required by state law to absorb the losses of the failed insurer, and as the Company would be faced with an unexpected surge in new business from the failed insurer’s former policyholders.

The Company may be adversely affected by changes in the personal automobile insurance business.

Approximately 83.7% of the Company’s direct written premiums for the year ended December 31, 2008 were generated from personal automobile insurance policies. Adverse developments in the market for personal automobile insurance, or the personal automobile insurance industry in general, whether related to changes in competition, pricing or regulations, could cause the Company’s results of operations to suffer. This industry is also exposed to the risks of severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes and, to a lesser degree, explosions, terrorist attacks and riots. The automobile insurance business is also affected by cost trends that impact profitability. Factors which negatively affect cost trends include inflation in automobile repair costs, automobile parts costs, used car prices and medical care. Increased litigation of claims, particularly those involving allegations of bad faith or seeking extra contractual and punitive damages, may also adversely affect loss costs.
 
28

The insurance industry is subject to extensive regulation, which may affect the Company’s ability to execute its business plan and grow its business.

The Company is subject to comprehensive regulation and supervision by government agencies in each of the states in which its insurance subsidiaries is domiciled, as well as in the states where its insurance subsidiaries sell insurance products, issue policies and handle claims. Some states impose restrictions or require prior regulatory approval of specific corporate actions, which may adversely affect the Company’s ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow its business profitably. These regulations provide safeguards for policyholders and are not intended to protect the interests of shareholders. The Company’s ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to its success. Some of these regulations include:

Required Licensing. The Company operates under licenses issued by the Departments of Insurance in the states in which the Company sells insurance. If a regulatory authority denies or delays granting a new license, the Company’s ability to enter that market quickly or offer new insurance products in that market may be substantially impaired. Also, if the Department of Insurance in any state in which the Company currently operates suspends, non-renews, or revokes an existing license, the Company would not be able to offer affected products in the state.
 
Transactions Between Insurance Companies and Their Affiliates. Transactions between the Company’s insurance subsidiaries and their affiliates (including the Company) generally must be disclosed to state regulators, and prior approval of the applicable regulator generally is required before any material or extraordinary transaction may be consummated. State regulators may refuse to approve or delay approval of some transactions, which may adversely affect the Company’s ability to innovate or operate efficiently.

Regulation of Insurance Rates and Approval of Policy Forms. The insurance laws of most states in which the Company conducts business require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. If, as permitted in some states, the Company begins using new rates before they are approved, it may be required to issue refunds or credits to the Company’s policyholders if the new rates are ultimately deemed excessive or unfair and disapproved by the applicable state regulator. Accordingly, the Company’s ability to respond to market developments or increased costs in that state can be adversely affected.

Restrictions on Cancellation, Non-Renewal or Withdrawal. Most of the states in which the Company operates have laws and regulations that limit its ability to exit a market. For example, these states may limit a private passenger auto insurer’s ability to cancel and non-renew policies or they may prohibit the Company from withdrawing one or more lines of insurance business from the state unless prior approval is received from the state insurance department. In some states, these regulations extend to significant reductions in the amount of insurance written, not just to a complete withdrawal. Laws and regulations that limit the Company’s ability to cancel and non-renew policies in some states or locations and that subject withdrawal plans to prior approval requirements may restrict the Company’s ability to exit unprofitable markets, which may harm its business and results of operations.

Other Regulations. The Company must also comply with regulations involving, among other things:

 
• the use of non-public consumer information and related privacy issues;
 
• the use of credit history in underwriting and rating;
 
• limitations on the ability to charge policy fees;
 
• limitations on types and amounts of investments;
 
• the payment of dividends;
 
• the acquisition or disposition of an insurance company or of any company controlling an insurance company;
 
• involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;
 
• reporting with respect to financial condition;
 
• periodic financial and market conduct examinations performed by state insurance department examiners; and
 
• the other regulations discussed in this Annual Report on Form 10-K.

29

Compliance with laws and regulations addressing these and other issues often will result in increased administrative costs. In addition, these laws and regulations may limit the Company’s ability to underwrite and price risks accurately, prevent it from obtaining timely rate increases necessary to cover increased costs and may restrict its ability to discontinue unprofitable relationships or exit unprofitable markets. These results, in turn, may adversely affect the Company’s profitability or its ability or desire to grow its business in certain jurisdictions, which could have an adverse effect on the market value of the Company’s common stock. The failure to comply with these laws and regulations may also result in actions by regulators, fines and penalties, and in extreme cases, revocation of the Company’s ability to do business in that jurisdiction. In addition, the Company may face individual and class action lawsuits by insureds and other parties for alleged violations of certain of these laws or regulations.
 
Regulation may become more extensive in the future, which may adversely affect the Company’s business and results of operations.

No assurance can be given that states will not make existing insurance-related laws and regulations more restrictive in the future or enact new restrictive laws. New or more restrictive regulation in any state in which the Company conducts business could make it more expensive for it to continue to conduct business in these states, restrict the premiums the Company is able to charge or otherwise change the way the Company does business. In such events, the Company may seek to reduce its writings in, or to withdraw entirely from, these states. In addition, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. The Company cannot predict whether and to what extent new laws and regulations that would affect its business will be adopted, the timing of any such adoption and what effects, if any, they may have on the Company’s operations, profitability and financial condition.

Assessments and other surcharges for guaranty funds, second-injury funds, catastrophe funds and other mandatory pooling arrangements may reduce the Company’s profitability.

Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insureds as the result of impaired or insolvent insurance companies. Many states also have laws that established second-injury funds to provide compensation to injured employees for aggravation of a prior condition or injury which are funded by either assessments based on paid losses or premium surcharge mechanisms. In addition, as a condition to the ability to conduct business in various states, the insurance subsidiaries must participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various types of insurance coverage to individuals or other entities that otherwise are unable to purchase that coverage from private insurers. The effect of these assessments and mandatory shared-market mechanisms or changes in them could reduce the Company’s profitability in any given period or limit its ability to grow its business.

Loss or significant restriction of the use of credit scoring in the pricing and underwriting of personal lines products could reduce the Company’s future profitability.

The Company uses credit scoring as a factor in pricing decisions where allowed by state law. Some consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against people with low incomes, minority groups and the elderly and are calling for the prohibition or restriction on the use of credit scoring in underwriting and pricing. Laws or regulations that significantly curtail the use of credit scoring, if enacted in a large number of states, could reduce the Company’s future profitability.

Risks Related to the Company’s Stock

The Company is controlled by a few large shareholders who will be able to exert significant influence over matters requiring shareholder approval, including change of control transactions.

George Joseph and Gloria Joseph collectively own more than 50% of the Company’s common stock. Accordingly, George Joseph and Gloria Joseph have the ability to exert significant influence on the actions the Company may take in the future, including change of control transactions. This concentration of ownership may conflict with the interests of the Company’s other shareholders and the holders of its debt securities.

30

Future sales of common stock may affect the market price of the Company’s common stock and the future exercise of options and warrants will result in dilution to the Company’s shareholders.

The Company may raise capital in the future through the issuance and sale of shares of its common stock. The Company cannot predict what effect, if any, such future sales will have on the market price of its common stock. Sales of substantial amounts of its common stock in the public market could adversely affect the market price of the Company’s outstanding common stock, and may make it more difficult for shareholders to sell common stock at a time and price that the shareholder deems appropriate. In addition, the Company has issued options to purchase shares of its common stock. In the event that any options to purchase common stock are exercised, shareholders will suffer dilution in their investment.
 
Applicable insurance laws may make it difficult to effect a change of control of the Company or the sale of any of its insurance subsidiaries.

Before a person can acquire control of a U.S. insurance company or any holding company of a U.S. insurance company, prior written approval must be obtained from the DOI of the state where the insurer is domiciled. Prior to granting approval of an application to acquire control of the insurer or holding company, the state DOI will consider a number of factors relating to the acquiror and the transaction. These laws and regulations may discourage potential acquisition proposals and may delay, deter or prevent a change of control of the Company or the sale by the Company of any of its insurance subsidiaries, including transactions that some or all of the Company’s shareholders might consider to be desirable.

Although the Company has consistently paid cash dividends in the past, it may not be able to pay cash dividends in the future.

The Company has paid cash dividends on a consistent basis since the public offering of its common stock in November 1985. However, future cash dividends will depend upon a variety of factors, including the Company’s profitability, financial condition, capital needs, future prospects and other factors deemed relevant by the Board of Directors.  The Company’s ability to pay dividends may also be limited by the ability of the Insurance Companies to make distributions to the Company, which may be restricted by financial, regulatory or tax constraints, and by the terms of the Company’s debt instruments.  In addition, there can be no assurance that the Company will continue to pay dividends even if the necessary financial and regulatory conditions are met and if sufficient cash is available for distribution.
 
Unresolved Staff Comments

None

31

Item 2.
Properties

The Company owns the following buildings:

Location
Purpose
 
Size in square feet
   
Percent occupied by Company at December 31, 2008
 
Brea, CA
Home office and I.T. facilities (2 buildings)
    236,000       100 %
Los Angeles, CA
Executive offices
    41,000       95 %
Rancho Cucamonga, CA
Administrative
    130,000       100 %
St. Petersburg, FL
Administrative
    157,000       79 %
Oklahoma, OK
Administrative
    100,000       87 %
Folsom, CA
Administrative and Data Center
    88,000       100 % *
 
* The building has been occupied by Company employees since January 2009.

The space owned and not occupied by the Company is leased to independent third party tenants.

In addition, the Company owns a 4.25 acre parcel of land in Brea, California, for future expansion.

The Company leases all of its other office space used for operations.  Office location is not crucial to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.
 
Item 3.
Legal Proceedings

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 cases where the Company is able to estimate its potential exposure and it is probable that the court will rule against the Company.  The Company vigorously defends actions against it, 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 results of operations in the period of such ruling, however, it is not expected to be material to the Company’s financial condition. For a detailed description of the pending lawsuits, see Note 14 of Notes to Consolidated Financial Statements—Litigation, which is incorporated herein by reference.

The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. See Note 6 of Notes to Consolidated Financial Statements, which is incorporated herein by reference.
 
Item 4.
Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders by the Company during the fourth quarter of the fiscal year covered by this report.

 
32

PART II

Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Price Range of Common Stock

The Company’s common stock is traded on the New York Stock Exchange (symbol: MCY). The following table shows the high and low sales price per share in each quarter during the past two years as reported in the consolidated transaction reporting system.

2008
 
High
   
Low
 
1st Quarter
  $ 50.06     $ 42.28  
2nd Quarter
  $ 52.64     $ 44.42  
3rd Quarter
  $ 62.00     $ 43.66  
4th Quarter
  $ 56.47     $ 36.11  
                 
2007
 
High
   
Low
 
1st Quarter
  $ 54.94     $ 50.48  
2nd Quarter
  $ 59.06     $ 52.78  
3rd Quarter
  $ 58.48     $ 50.57  
4th Quarter
  $ 56.30     $ 48.76  

The closing price of the Company’s common stock on February 17, 2009 was $31.24.

Dividends

Since the public offering of its common stock in November 1985, the Company has paid regular quarterly dividends on its common stock.  During 2008 and 2007, the Company paid dividends on its common stock of $2.32 and $2.08 per share, respectively.  On February 6, 2009, the Board of Directors declared a $0.58 quarterly dividend payable on March 31, 2009 to shareholders of record on March 16, 2009.

For financial statement purposes, the Company records dividends on the declaration date. The Company expects to continue the payment of quarterly dividends; however, the continued payment and amount of cash dividends will depend upon, among other factors, the Company’s operating results, overall financial condition, capital requirements and general business conditions.

For a discussion of certain restrictions on the payment of dividends to Mercury General by some of its insurance subsidiaries, see “Item 1. Business—Regulation—Holding Company Act” and Note 8 of Notes to Consolidated Financial Statements.
 
Shareholders of Record

The approximate number of holders of record of the Company’s common stock as of February 17, 2009 was 161.
 
33

Performance Graph

The graph below compares the cumulative total shareholder return on the shares of Common Stock of the Company (MCY) for the last five years with the cumulative total return on the Standard and Poor’s 500 Index and a peer group comprised of selected property and casualty insurance companies over the same period (assuming the investment of $100 in the Company’s Common Stock, the S&P 500 Index and the peer group at the closing price on December 31, 2003 and the reinvestment of all dividends).

Comparative Five-Year Cumulative Total Returns
Among Mercury General Corporation,
Peer Group Index and S&P 500 Index
 
 
GRAPHIC


   
2003
   
2004
   
2005
   
2006
   
2007
   
2008
 
Mercury General Corporation
  $ 100.00     $ 132.37     $ 132.54     $ 124.45     $ 122.25       118.55  
Peer Group
    100.00       108.84       119.70       140.28       148.13       106.31  
S&P 500 Composite Index
    100.00       110.88       116.33       134.70       142.10       89.53  

The peer group consists of Ace Limited, Alleghany Corporation, Allstate Corporation, American Financial Group, Berkshire Hathaway, Chubb Corporation, Cincinnati Financial Corporation, CNA Financial Corporation, Erie Indemnity Company, Hanover Insurance Group, HCC Insurance Holdings, Markel Corporation, Old Republic International, PMI Group, Inc., Progressive Corporation, RLI Corporation, Selective Insurance Group, Travelers Companies, Inc., W.R. Berkley Corporation and XL Capital, Ltd.

34

Item 6.
Selected Financial Data

     
Year Ended December 31,
 
     
2008
   
2007
   
2006
   
2005
   
2004
 
     
(Amounts in thousands, except per share data)
 
Income Data:
                             
Earned premiums
  $ 2,808,839     $ 2,993,877     $ 2,997,023     $ 2,847,733     $ 2,528,636  
Net investment income
    151,280       158,911       151,099       122,582       109,681  
Net realized investment (losses) gains
    (550,520 )     20,808       15,436       16,160       25,065  
Other
      4,597       5,154       5,185       5,438       4,775  
 
Total revenues
    2,414,196       3,178,750       3,168,743       2,991,913       2,668,157  
Losses and loss adjustment expenses
    2,060,409       2,036,644       2,021,646       1,862,936       1,582,254  
Policy acquisition costs
    624,854       659,671       648,945       618,915       562,553  
Other operating expenses
    174,828       158,810       176,563       150,201       111,285  
Interest
      4,966       8,589       9,180       7,222       4,222  
 
Total expenses
    2,865,057       2,863,714       2,856,334       2,639,274       2,260,314  
(Loss) Income before income taxes
    (450,861 )     315,036       312,409       352,639       407,843  
 
Income tax (benefit) expense
    (208,742 )     77,204       97,592       99,380       121,635  
Net (loss) income
  $ (242,119 )   $ 237,832     $ 214,817     $ 253,259     $ 286,208  
                                           
Per Share Data:
                                       
Basic earnings per share
  $ (4.42 )   $ 4.35     $ 3.93     $ 4.64     $ 5.25  
Diluted earnings per share
  $ (4.42 )   $ 4.34     $ 3.92     $ 4.63     $ 5.24  
Dividends paid
  $ 2.32     $ 2.08     $ 1.92     $ 1.72     $ 1.48  
                                           
     
December 31,
 
     
2008
   
2007
   
2006
   
2005
   
2004
 
     
(Amounts in thousands, except per share data)
 
Balance Sheet Data:
                                       
Total investments
  $ 2,933,820     $ 3,588,675     $ 3,499,738     $ 3,242,712     $ 2,921,042  
Total assets
    3,950,195       4,414,496       4,301,062       4,050,868       3,622,949  
Losses and loss adjustment expenses
    1,133,508       1,103,915       1,088,822       1,022,603       900,744  
Unearned premiums
    879,651       938,370       950,344       902,567       799,679  
Notes payable
    158,625       138,562       141,554       143,540       137,024  
Shareholders' equity
    1,494,051       1,861,998       1,724,130       1,607,837       1,459,548  
Book value per share
    27.28       34.02       31.54       29.44       26.77  

35

Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

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 on losses, 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 Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents and brokers in thirteen states.  The Company also offers homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile and commercial property insurance.  Private passenger automobile lines of insurance accounted for approximately 83.7% of the $2.8 billion of the Company’s direct premiums written in 2008.  Approximately 79.9% of the private passenger automobile premiums were written in California.  The Company operates primarily in the state of 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).

This overview discusses some of the relevant factors that management considers in evaluating the Company’s performance, prospects and risks.  It is not all-inclusive and is meant to be read in conjunction with the entirety of management’s discussion and analysis, the Company’s consolidated financial statements and notes thereto and all other items contained within this Annual Report on Form 10-K.

Economic and Industry Wide Factors

 
• Regulatory Uncertainty – The insurance industry is subject to strict state regulation and oversight and is governed by the laws of each state in which each insurance company operates.  State regulators generally have substantial power and authority over insurance companies including, in some states, approving rate changes and rating factors and establishing minimum capital and surplus requirements.  In many states, insurance commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners.  The Company has a successful track record of working with difficult regulations and new insurance commissioners.  However, there is no certainty that current or future regulations and the interpretation of those regulations by insurance commissioners and the courts will not have an adverse impact on the Company.

 
• Cost Uncertainty – Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned.  Consequently, significant assumptions are made when establishing insurance rates and loss reserves.  While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate.  Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analysis shows that they are needed.

 
• Market Volatility - The prolonged and severe disruptions in the public debt and equity markets, including among other things, widening of credit spreads, bankruptcies and government intervention in a number of large financial institutions, have resulted in significant losses in the Company’s investment portfolio  As a result, depending on market conditions, the Company may incur substantial additional losses in future periods, which could have a material adverse impact on its results of operations, equity, business and insurer financial strength and debt ratings.

 
• Inflation – The largest cost component for automobile insurers is losses, which include medical costs, replacement automobile parts and labor costs.  There can be significant variation in the overall increases in medical cost inflation and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty.  Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.

36

 
• Loss Frequency – Another component of overall loss costs is loss frequency, which is the number of claims per risks insured.  There has been a long-term trend of declining loss frequency in the personal automobile insurance industry, which has benefited the industry as a whole.  It is unknown if loss frequency in the future will decline, remain flat or increase.

 
• Underwriting Cycle and Competition – The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions.  The Company has historically seen premium growth in excess of 20% during hard markets.  Premium growth rates in soft markets have been from slightly positive to negative and in 2008 they were negative 8%.  In management’s view, 2004 through 2007 was a period of very profitable results for companies underwriting automobile insurance.  Many in the industry began experiencing declining profitability in 2007 and 2008 and are now increasing rates.  Rate increases generally indicate that the market is hardening.
 
Revenues, Income and Cash Generation

The Company generates its revenues through the sale of insurance policies, primarily covering personal automobiles and homeowners.  These policies are sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling and servicing policies.

During 2008, the Company continued its marketing efforts for name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation make the Company very competitive in California and in other states.  Net advertising expenditures were approximately $26 million and $28 million during 2008 and 2007, respectively.

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 also generated income from its investment portfolio.  Approximately $151 million in pre-tax investment income was generated during 2008 on a portfolio of approximately $2.9 billion at fair market value at December 31, 2008, compared to $159 million pre-tax investment income during 2007 on a portfolio of approximately $3.6 billion at fair market value at December 31, 2007.  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 and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $64 million and $216 million in 2008 and 2007, respectively.  Cash flow from operations has been used to pay shareholder dividends and to help support growth.

37

Opportunities, Challenges and Risks

The Company currently underwrites personal automobile insurance in thirteen states:  Arizona, California, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas and Virginia.  The Company expects to continue its growth by expanding into new states in future years with the objective of achieving greater geographic diversification.

There are, however, challenges and risks involved in entering each new state, including establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems and finding qualified agents to represent the Company. The Company does not expect to enter into any new states during 2009.

The Company is also subject to risks inherent in its business, which include but are not limited to the following (See also “Item 1A. Risk Factors.”):

 
• A catastrophe, such as a major wildfire, earthquake or hurricane, could cause a significant amount of loss to the Company in a very short period of time.
 
• A major regulatory change could make it more difficult for the Company to generate new business or reduce the profitability of the Company’s existing business.
 
• A sharp upward increase in market interest rates or a downturn in securities markets could cause a significant loss in the value of the Company’s investment portfolio.

To the extent it is within the Company’s control, the Company seeks to manage these risks in order to mitigate the effect that major events would have on the Company’s financial position.
 
Technology

In 2008, the Company launched its new internet agency portal, Mercury First, in New York.  The Mercury First rollout is continuing to all states through 2009.  Mercury First is a single entry point for agents and brokers that provides a broad suite of capabilities.  One of its most powerful tools is a Point of Sale (POS) system that allows agents and brokers to easily obtain and compare quotes and write new business.  The POS for Private Passenger Auto is already in use.  POS solutions for Commercial Auto and Homeowner are planned to be in use by agents in 2009.  Mercury First is also an easy-to-use agency portal that provides a customized work queue for each agency user showing new business leads, underwriting requests and other pertinent customer information in real time.  Agents can also assist customers with paying bills, reporting claims or updating their records.  The system enables quick access to documents and forms as well as empowering the agents with several self-service capabilities.

The Company began developing its NextGen computer system in 2002 to replace its legacy underwriting, billings, claims and commissions systems.  The NextGen system was designed to be a multi-state, multi-line system to enable the Company to enter new states more rapidly, as well as respond to legislative and regulatory changes more easily.  The Company completed rollout of NextGen for all underwriting, billing, claims and commission functions supporting Private Passenger Auto in seven states (Virginia, New York, Florida, California, Georgia, Illinois, and Texas).  The legacy Private Passenger Auto system has been retired.

As part of the Company’s commitment to service excellence, the Company launched an initiative in 2008 to improve its call center technologies.  The initiative’s goal is to enhance telephony infrastructure using Voice over Internet Protocol, centralized call recording, quality monitoring and workforce management software.  The technology has been integrated with the Company’s claim processing software and deployed to the centralized customer service call center. During 2009, this technology will be rolled out to other claims processing field offices.

38

Regulatory and Legal Matters

The process for implementing rate changes varies by state, with California, Georgia, New York, New Jersey, Pennsylvania and Nevada requiring prior approval from the DOI before a rate may be implemented.  Illinois, Texas, Virginia, Arizona and Michigan only require that rates be filed with the DOI, while Oklahoma and Florida have a modified version of prior approval laws.  In all states, the insurance code provides that rates must not be excessive, inadequate or unfairly discriminatory.  During 2008, the Company implemented automobile and homeowners insurance rate decreases in California that were initially filed in August 2006 and approved by the California DOI in January 2008 as part of the Company’s compliance with regulations proposed by the California DOI and approved in July 2006, as more fully described below.  In five other states, the Company implemented automobile rate increases.

The California DOI uses rating factor regulations requiring automobile insurance rates to be determined in decreasing order of importance by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) other factors as determined by the California DOI to have a substantial relationship to the risk of loss and adopted by regulation.

In April 2007, regulations became effective that generally tighten the existing Proposition 103 prior approval ratemaking regime primarily by establishing a maximum allowable rate of return (calculated by adding 6 percent plus the average of short, intermediate, and long-term T-bill rates) and a minimum allowable rate of return of negative 6 percent of surplus. However, the practical impact of these limitations is unclear because the new regulations allow for the California DOI to grant a number of variances based on loss prevention, business mix, service to underserved communities, and other factors. In October 2007, the California DOI invited comments from consumer groups and the insurance industry in an effort to set appropriate standards for granting or denying specific variances and to provide sufficient instruction regarding what information or data to submit when an insurer is applying for a specific variance.  The comment period ended on November 16, 2007. The California DOI then published proposed amendments to its regulations and held an informal workshop on them on April 7, 2008. On April 29, 2008, the Commissioner issued a new notice reflecting slight modifications to the proposed regulations and superseding the prior version.  The proposed changes were approved as emergency regulations by the Office of Administrative Law (“OAL”) on May 16, 2008 and became effective as of that date.
 
On July 14, 2006, the California OAL approved proposed regulations by the California DOI that effectively reduce the weight that insurers can place on a person’s residence when establishing automobile insurance rates.  Insurance companies in California are required to file rating plans with the California DOI that comply with the new regulations.  There is a two year phase-in period for insurers to fully implement those plans. The Company made a rate filing in August 2006 that reduced the territorial impact of its rates and requested a small overall rate increase. The California DOI approved the August 2006 filing in January 2008, which resulted in a small rate increase for two of the California insurance subsidiaries and a small decrease for a third, for a total net rate reduction of approximately 2.5%.  The newly approved rates went into effect in April 2008. In July 2008, the Company made an additional rate filing to bring its rates into full compliance with the new regulations.  However, the Company cannot predict whether the California DOI will determine that the Company’s rates are in full compliance with the new regulations as a result of this filing. In general, the Company expects that the regulations will cause rates for urban drivers to decrease and those for non-urban drivers to increase. These rate changes are likely to increase consumer shopping for insurance which could affect the volume and the retention rates of the Company’s business.  It is the Company’s intention to maintain its competitive position in the marketplace while complying with the new regulations.
 
39

In March 2006, the California DOI issued an Amended Notice of Non-Compliance (“NNC”) to the NNC originally issued in February 2004 alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. Through this action, the California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee, which the California DOI contends is the use of an unapproved rate, rating plan or rating system. Further, the California DOI seeks to impose a penalty for each and every date on which the Company allegedly used a misleading advertisement alleged in the NNC.  Finally, based upon the conduct alleged, the California DOI also contends that the Company acted fraudulently in violation of Section 704(a) of the California Insurance Code, which permits the California Commissioner of Insurance to suspend certificates of authority for a period of one year. The Company filed a Notice of Defense in response to the NNC. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company , denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. The matter is currently in discovery and a hearing before the administrative law judge is scheduled to start on March 16, 2009.  This matter has been the subject of five continuations since the original NNC was issued in 2004.
 
The Company is not able to determine the impact of any of the legal and regulatory matters described above. It is possible that the impact of some of the changes could adversely affect the Company and its operating results, however, the ultimate outcome is not expected to be material to the Company’s financial position.

The California Franchise Tax Board (“FTB”) has audited the 1997 through 2002 and 2004 tax returns and accepted the 1997 through 2000 returns to be correct as filed. The Company received a notice of examination for the 2003 tax return from the FTB in January 2008. For the Company’s 2001, 2002, and 2004 tax returns, the FTB has taken exception to the state apportionment factors used by the Company.  Specifically, the FTB has asserted that payroll and property factors from Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company, that are excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. In addition, for the 2004 tax return, the FTB has asserted that a portion of management fee expenses paid by Mercury Insurance Services, LLC should be disallowed. Based on these assertions, the FTB has issued notices of proposed tax assessments for the 2001, 2002 and 2004 tax years totaling approximately $5 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the California State Board of Equalization (“SBE”).  An unfavorable ruling against the Company may have a material impact on the Company’s results of operations in the period of such ruling. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail on this matter.

The Company is also involved in legal proceedings incidental to its insurance business. See Note 14 of Notes to Consolidated Financial Statements—Commitments and Contingencies—Litigation.

40

Critical Accounting Estimates

Reserves

The preparation of the Company’s consolidated financial statements requires judgment and estimates.  The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”), and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”).  Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the reserve that is required.  Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates, among other factors, can all impact ultimate claim costs.  In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount can be.  Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.

The Company calculates a point estimate rather than a range of loss reserve estimates.  There is inherent uncertainty with estimates and this is particularly true with estimates for loss reserves.  This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over inflation rates and uncertainty for unknown items.  The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its reserve by looking at historical patterns and trends and projecting these out to current reserves.  The underlying factors and assumptions that serve as the basis for preparing the reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information.

The Company also engages independent actuarial consultants to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on actuarial consultants for GAAP reporting or periodic report disclosure purposes.

The Company analyzes loss reserves quarterly primarily using the incurred loss development, average severity and claim count development methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves and industry claims data as part of its reserve analysis. When deciding which method to use in estimating its reserves, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on one method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.

 
• The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of business which have a long operating history.

 
• The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.

41

 
• The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves.

 
• The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company primarily uses this method for loss adjustment expenses because specific case reserves are generally not established for loss adjustment expenses.
 
In states with little operating history where there are insufficient claims data to prepare a reserve analysis relying solely on Company historical data, the Company generally projects ultimate losses using industry average loss data or expected loss ratios. As the Company develops an operating history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development methods. The Company analyzes catastrophe losses separately from non-catastrophe losses.  For catastrophe losses, the Company determines claim counts based on claims reported and development expectations from previous catastrophes and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous similar catastrophes.
 
There are many factors that can cause variability between the ultimate expected loss and the actual developed loss.  Because the actual loss for a particular accident period is unknown until all claims have settled for that period, the Company must estimate what it expects that loss to be.  While there are certainly other factors, the Company believes that the following items tend to create the most variability between expected losses and actual losses:

 
• Variability in inflation expectations – particularly on coverages that take longer to settle such as the California automobile bodily injury coverage.

 
• Variability in the number of claims reported subsequent to a period-end relating to that period – particularly on coverages that take longer to settle such as the California automobile bodily injury coverage.

 
• Variability between Company loss experience and industry averages for those lines of business that the Company is relying on industry averages to establish reserves.

 
• Unexpected large individual losses or groups of losses arising from older accident periods typically caused by an event that is not reflected in the historical company data used to establish reserves.

These items are discussed in detail:

42

 
1.     Inflation Variability – California automobile lines of business

For the Company’s California automobile lines of business, the bodily injury (BI) reserves comprise approximately 65% of the total reserve; material damage, including collision, comprehensive, and property damage (MD) reserves make up approximately 10% of the total reserve; and loss adjustment expense reserves make up approximately 25% of the total reserve. The BI reserves account for such a large portion of the total because BI claims tend to close much slower than MD claims. The majority of the loss adjustment expense reserves consist of estimated costs to defend BI claims, so those reserves also tend to close more slowly than MD claims. Loss development on MD reserves is generally insignificant because MD claims are closed quickly.

BI loss reserves are generally the most difficult to estimate because they take longer to close than most of the Company’s other coverages. The Company’s BI policy covers injuries sustained by any person other than the insured, except in the case of uninsured and underinsured motorist BI coverage, which covers damages to the insured for BI caused by uninsured or underinsured motorists. BI payments are primarily for medical costs and general damages.

The following table represents the typical closure patterns of BI claims in the California automobile insurance coverage:

 
% of Total
 
 
Claims closed
 
Dollars Paid
 
BI claims closed in the accident year reported
35% to 40%
    15 %
BI claims closed one year after the accident year reported
75% to 80%
    60 %
BI claims closed two years after the accident year reported
93% to 97%
    90 %
BI claims closed three years after the accident year reported
97% to 99%
    98 %
 
Claims that close during the initial accident year reported are generally the smaller, less complex claims that settle, on average, for approximately $2,000 to $2,500 whereas the average settlement, once all claims are closed in a particular accident year, is approximately $7,500 to $9,000. The Company creates incurred loss triangles to estimate ultimate losses utilizing historical reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity.  As a larger proportion of claims from an accident year are settled, there becomes a higher degree of certainty for the reserves established for that accident year.  Consequently, there is a decreasing likelihood of reserve development on any particular accident year, as those periods age.  The Company believes that the accident years that are most likely to develop are the 2006 through 2008 accident years; however it is also possible that older accident years could develop as well.
 
In general, when establishing reserves, the Company expects that historical trends will continue.  Furthermore, the Company believes that costs tend to increase, which is generally consistent with historical data, and therefore the Company believes that it is more reasonable to expect inflation than deflation.  Many potential factors can affect the BI inflation rate, including: changes in statutes and regulations, an increase or reduction in litigated files, general economic factors, more timely handling of claims, safer vehicles, changes in weather patterns, and gasoline prices; however, whether these are the factors that actually impacted the BI losses, and the magnitude of that impact is unknown.

43

The Company believes that it is reasonably possible that the California automobile BI inflation rate could vary from recorded amounts by as much as 7%, 5% and 4% for 2008, 2007 and 2006, respectively.  However, the variation could be more or less than these amounts.  As a comparison, at December 31, 2008 the actual variation for the amounts recorded at December 31, 2007 was 5.6%, 3.7% and 1.5% for the 2007, 2006 and 2005 accident years, respectively.  The following table shows the effects on the 2008, 2007 and 2006 accident year California BI loss reserves based on possible variations in the severity recorded:

California Bodily Injury Inflation Reserve Sensitivity Analysis

Accident Year
 
Number of Claims Expected (a)
   
Actual Recorded Severity at 12/31/08
   
Implied Inflation Rate Recorded
   
(A) Pro-forma severity if actual severity is lower by: 7% for 2008, 5% for 2007 and 4% for 2006
   
(B) Pro-forma severity if actual severity is higher by 7% for 2008, 5% for 2007 and 4% for 2006
   
Loss redundancy if actual severity is less than recorded (Column A)
   
Loss development if actual severity is more than recorded (Column B)
 
2008
    31,737     $ 8,831       12.4 %   $ 8,213     $ 9,449     $ 19,613,000     $ (19,613,000 )
2007
    35,716     $ 7,856       5.2 %   $ 7,463     $ 8,249     $ 14,036,000     $ (14,036,000 )
2006
    36,999     $ 7,465       3.6 %   $ 7,166     $ 7,764     $ 11,062,000     $ (11,062,000 )
2005
 
Not Applicable
    $ 7,204