Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________
FORM 10-Q
_________________________
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 2012
Commission File No. 001-12257
 ______________________________
MERCURY GENERAL CORPORATION
(Exact name of registrant as specified in its charter)
 ________________________________
California
95-2211612
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
4484 Wilshire Boulevard, Los Angeles, California
90010
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (323) 937-1060
 _______________________________
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   ý     No   o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ý     No  o
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
 
ý
  
Accelerated filer
 
o
 
 
 
 
 
 
Non-accelerated filer
 
o   (Do not check if a smaller reporting company)
  
Smaller reporting company
 
o
Indicate by check mark whether the Registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act).    Yes  o     No   ý
At July 26, 2012 , the Registrant had issued and outstanding an aggregate of 54,911,377 shares of its Common Stock.
 




Table of Contents

MERCURY GENERAL CORPORATION
INDEX TO FORM 10-Q
 
 
 
 
 
 
Page
 
 
 
 
Item 1
 
 
 
 
 
Item 2
Item 3
Item 4
 
 
 
 
 
 
Item 1
Item 1A
Item 2
Item 3
Item 4
Item 5
Item 6
 
 

2

Table of Contents

PART I - FINANCIAL INFORMATION
 
Item 1. Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
June 30, 2012
 
December 31, 2011
 
(unaudited)
 
 
ASSETS
 
 
 
Investments, at fair value:
 
 
 
Fixed maturities trading (amortized cost $2,356,492; $2,345,620)
$
2,487,637

 
$
2,445,589

Equity securities trading (cost $459,672; $388,417)
446,167

 
380,388

Short-term investments (cost $179,799; $236,433)
179,326

 
236,444

Total investments
3,113,130

 
3,062,421

Cash
160,487

 
211,393

Receivables:
 
 
 
Premiums
317,438

 
288,799

Accrued investment income
32,828

 
32,541

Other
11,691

 
11,320

Total receivables
361,957

 
332,660

Deferred policy acquisition costs
179,115

 
171,430

Fixed assets, net
168,696

 
177,760

Current income taxes
21,440

 
0

Deferred income taxes
0

 
6,511

Goodwill
42,850

 
42,850

Other intangible assets, net
50,653

 
53,749

Other assets
22,105

 
11,232

Total assets
$
4,120,433

 
$
4,070,006

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Losses and loss adjustment expenses
$
978,321

 
$
985,279

Unearned premiums
882,441

 
843,427

Notes payable
140,000

 
140,000

Accounts payable and accrued expenses
100,158

 
94,743

Current income taxes
0

 
67

Deferred income taxes
1,002

 
0

Other liabilities
157,780

 
149,007

Total liabilities
2,259,702

 
2,212,523

Commitments and contingencies


 


Shareholders’ equity:
 
 
 
Common stock without par value or stated value:
Authorized 70,000 shares; issued and outstanding 54,911; 54,856
79,016

 
76,634

Additional paid-in capital
285

 
538

Retained earnings
1,781,430

 
1,780,311

Total shareholders’ equity
1,860,731

 
1,857,483

Total liabilities and shareholders’ equity
$
4,120,433

 
$
4,070,006

See accompanying Condensed Notes to Consolidated Financial Statements.

3

Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Three Months Ended June 30,
 
2012
 
2011
Revenues:
 
 
 
Net premiums earned
$
637,247

 
$
642,331

Net investment income
31,673

 
36,009

Net realized investment (losses) gains
(23,759
)
 
23,764

Other
2,544

 
4,443

Total revenues
647,705

 
706,547

Expenses:
 
 
 
Losses and loss adjustment expenses
497,251

 
451,338

Policy acquisition costs
117,726

 
122,829

Other operating expenses
51,203

 
55,098

Interest
378

 
1,669

Total expenses
666,558

 
630,934

(Loss) income before income taxes
(18,853
)
 
75,613

Income tax (benefit) expense
(13,589
)
 
18,362

Net (loss) income
$
(5,264
)
 
$
57,251

Net (loss) income per share:
 
 
 
Basic
$
(0.10
)
 
$
1.04

Diluted (1)
$
(0.10
)
 
$
1.04

Weighted average shares outstanding:
 
 
 
Basic
54,895

 
54,820

Diluted (1)
54,895

 
54,837

Dividends paid per share
$
0.61

 
$
0.60


(1) The dilutive impact of incremental shares for 2012 is excluded from loss position in accordance with U.S. generally accepted accounting principles (“GAAP”).
CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(in thousands)
(unaudited)
 
 
Three Months Ended June 30,
 
2012
 
2011
Net (loss) income
$
(5,264
)
 
$
57,251

Other comprehensive income, before tax:
 
 
 
Gains on hedging instrument
0

 
26

Other comprehensive income, before tax:
0

 
26

Income tax expense related to gains on hedging instrument
0

 
10

Other comprehensive income, net of tax:
0

 
16

Comprehensive (loss) income
$
(5,264
)
 
$
57,267

See accompanying Condensed Notes to Consolidated Financial Statements.

4

Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

 
Six Months Ended June 30,
 
2012
 
2011
Revenues:
 
 
 
Net premiums earned
$
1,273,059

 
$
1,280,818

Net investment income
63,159

 
71,105

Net realized investment gains
28,904

 
52,454

Other
5,258

 
7,713

Total revenues
1,370,380

 
1,412,090

Expenses:
 
 
 
Losses and loss adjustment expenses
947,167

 
897,799

Policy acquisition costs
235,156

 
244,633

Other operating expenses
104,128

 
113,770

Interest
788

 
3,364

Total expenses
1,287,239

 
1,259,566

Income before income taxes
83,141

 
152,524

Income tax expense
15,049

 
37,047

Net income
$
68,092

 
$
115,477

Net income per share:
 
 
 
Basic
$
1.24

 
$
2.11

Diluted
$
1.24

 
$
2.11

Weighted average shares outstanding:
 
 
 
Basic
54,886

 
54,814

Diluted
54,915

 
54,834

Dividends paid per share
$
1.22

 
$
1.20

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)

 
Six Months Ended June 30,
 
2012
 
2011
Net Income
$
68,092

 
$
115,477

Other comprehensive income, before tax:
 
 
 
Gains on hedging instrument
0

 
169

Other comprehensive income, before tax:
0

 
169

Income tax expense related to gains on hedging instrument
0

 
60

Other comprehensive income, net of tax:
0

 
109

Comprehensive income
$
68,092

 
$
115,586

See accompanying Condensed Notes to Consolidated Financial Statements.


5

Table of Contents

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Six Months Ended June 30,
 
2012
 
2011
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net income
$
68,092

 
$
115,477

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
18,700

 
20,574

Net realized investment gains
(28,904
)
 
(52,454
)
Bond amortization, net
3,981

 
2,704

Excess tax benefit from exercise of stock options
(116
)
 
(32
)
Increase in premiums receivables
(28,639
)
 
(6,026
)
Change in current and deferred income taxes
(13,878
)
 
45,546

Increase in deferred policy acquisition costs
(7,685
)
 
(973
)
Decrease in unpaid losses and loss adjustment expenses
(6,958
)
 
(53,221
)
Increase in unearned premiums
39,014

 
13,861

Increase in accounts payable and accrued expenses
6,343

 
5,021

Share-based compensation
(85
)
 
314

Increase in other payables
1,611

 
2,113

Other, net
(2,095
)
 
154

Net cash provided by operating activities
49,381

 
93,058

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Fixed maturities available-for-sale in nature:
 
 
 
Purchases
(260,626
)
 
(183,740
)
Sales
56,117

 
149,716

Calls or maturities
189,772

 
150,979

Equity securities available-for-sale in nature:
 
 
 
Purchases
(144,919
)
 
(230,301
)
Sales
75,024

 
191,342

Calls
923

 
0

Net (decrease) increase in payable for securities
(3,348
)
 
14,595

Net decrease in short-term investments
56,301

 
3,826

Purchase of fixed assets
(7,775
)
 
(9,584
)
Sale of fixed assets
1,393

 
2,453

Other, net
1,610

 
6,436

Net cash (used in) provided by investing activities
(35,528
)
 
95,722

CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Dividends paid to shareholders
(66,973
)
 
(65,784
)
Excess tax benefit from exercise of stock options
116

 
32

Proceeds from stock options exercised
2,098

 
641

Net cash used in financing activities
(64,759
)
 
(65,111
)
Net (decrease) increase in cash
(50,906
)
 
123,669

Cash:
 
 
 
Beginning of the year
211,393

 
181,388

End of period
$
160,487

 
$
305,057

SUPPLEMENTAL CASH FLOW DISCLOSURE
 
 
 
Interest paid
$
927

 
$
3,282

Income taxes paid (received)
$
28,927

 
$
(8,499
)
See accompanying Condensed Notes to Consolidated Financial Statements.

6


MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. General
Consolidation and Basis of Presentation
The condensed consolidated financial statements include the accounts of Mercury General Corporation and its subsidiaries (referred to herein collectively as the Company). For the list of the Company’s subsidiaries, see Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 .
The condensed consolidated financial statements have been prepared in conformity with GAAP, which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions and balances have been eliminated.
The financial data of the Company included herein has been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature have been made to present fairly the Company’s financial position at June 30, 2012 and the results of operations, comprehensive (loss) income, and cash flows for the periods presented. Operating results and cash flows for the six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012 .
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates (See Note 1 “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 ).
Earnings per Share
Potentially dilutive securities representing approximately 64,000 and 110,000 shares of common stock for the three months ended June 30, 2012 and 2011 , respectively, and 63,000 and 106,000 shares of common stock for the six months ended June 30, 2012 and 2011, respectively, were excluded from the computation of diluted earnings per common share for these periods because their effect would have been anti-dilutive.
Deferred Policy Acquisition Costs
In October 2010, the Financial Accounting Standards Board (“FASB”) issued a new standard to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The new standard defines acquisition costs as those related directly to the successful acquisition of new or renewal insurance contracts. Effective January 1, 2012, the Company adopted the new standard using the prospective method. Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses, and the servicing costs that will be incurred as premiums are earned. Under the new standard, the Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements. Deferred policy acquisition cost amortization was $117.7 million and $122.8 million for the three months ended June 30, 2012 and 2011 , respectively, and $235.2 million and $244.6 million for the six months ended June 30, 2012 and 2011 , respectively. The Company does not defer advertising expenses but expenses them as incurred. The Company recorded net advertising expenses of approximately $10 million and $11 million for the six months ended June 30, 2012 and 2011 , respectively.






7


2. Recently Issued Accounting Standards
In June 2011, the FASB issued a new standard which revises the manner in which entities present comprehensive income in their financial statements. The new standard removes the presentation options and requires entities to report components of comprehensive income in either a continuous statement of comprehensive income or two separate but consecutive statements. The new standard does not change the items that must be reported in other comprehensive income. The Company adopted the new standard which became effective for the interim period ended March 31, 2012. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements. In December 2011, the FASB issued a new standard which indefinitely defers certain provisions of this standard that revised the manner in which entities present comprehensive income in financial statements. One of this standard’s provisions required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. Accordingly, this requirement is indefinitely deferred and will be further deliberated by the FASB at a future date. The new standard was effective for the interim period ended March 31, 2012.
In May 2011, the FASB issued a new standard which develops a single and converged guidance on how to measure fair value and on required disclosures about fair value measurements. While the new standard is largely consistent with existing fair value measurement principles, it expands existing disclosure requirements for fair value measurements and makes other amendments. The Company adopted the new standard which became effective for the interim period ended March 31, 2012. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
3. Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured notes payable. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values and are classified as Level 3 in the fair value hierarchy as described in Note 5. The following table presents the estimated fair values of financial instruments at June 30, 2012 and December 31, 2011 .
 
 
June 30, 2012
 
December 31, 2011
 
(Amounts in thousands)
Assets
 
 
 
Investments
$
3,113,130

 
$
3,062,421

Liabilities
 
 
 
Interest rate swap agreements
$
399

 
$
670

Equity contracts
$
643

 
$
655

Secured notes payable
$
140,000

 
$
140,000

Methods and assumptions used in estimating fair values are as follows:
Investments
The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time an eligible item is first recognized. The cost of investments sold is determined on a first-in and first-out method and realized gains and losses are included in net realized investment (losses) gains. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5.
Interest rate swap agreements
The fair value of interest rate swap agreements reflects the estimated amounts that the Company would pay at June 30, 2012 and December 31, 2011 in order to terminate the contracts based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract. For additional disclosures regarding methods and assumptions used in estimating fair values of interest rate swap agreements, see Note 5.
Equity contracts
The fair value of equity contracts is based on quoted prices for identical instruments in active markets. For additional disclosures regarding methods and assumptions used in estimating fair values of equity contracts, see Note 5.


8


Secured notes payable
The fair value of the Company’s $120 million and $20 million secured notes, classified as Level 2 in the fair value hierarchy described in Note 5, is estimated based on assumptions and inputs, such as reset rates and the market value of underlying collateral, for similarly termed notes that are observable in the market.

4. Fair Value Option
Gains and losses due to changes in fair value for items measured at fair value pursuant to application of the fair value option are included in net realized investment (losses) gains in t he Company’s consolidated statements of operations, while interest and dividend income on investment holdings are recognized on an accrual basis on each measurement date and are included in net investment income in the Company’s consolidated statements of operations. The primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as expansion of use of fair value measurement consistent with the long-term measurement objectives of the FASB for accounting for financial instruments.
The following table presents gains and losses due to changes in fair value of investments that are measured at fair value pursuant to application of the fair value option:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2012
 
2011
 
2012
 
2011
 
(Amounts in thousands)
Fixed maturity securities
$
9,812

 
$
33,879

 
$
30,815

 
$
24,309

Equity securities
(33,972
)
 
(13,237
)
 
(5,476
)
 
17,151

Short-term investments
(628
)
 
(45
)
 
(784
)
 
(26
)
Total
$
(24,788
)
 
$
20,597

 
$
24,555

 
$
41,434


5. Fair Value Measurement
The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date using the exit price. Accordingly, when market observable data is not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value are categorized based on the level of judgment associated with inputs used to measure their fair value and the level of market price observability, as follows:
Level 1
Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.
 
 
Level 2
Pricing inputs are other than quoted prices in active markets, which are based on the following:
 
•     Quoted prices for similar assets or liabilities in active markets;
 
•     Quoted prices for identical or similar assets or liabilities in non-active markets; or
 
•     Either directly or indirectly observable inputs as of the reporting date.
 
Level 3
Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.
In certain cases, inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3). The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset or liability.
The Company uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3. The Company recognizes transfers between levels at either the actual date of the event or a change in circumstances that caused the transfer.

9


Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities
The Company’s fair value measurements are based on the market approach, which utilizes market transaction data for the same or similar instruments.
The Company obtained unadjusted fair values on approximately 97% of its portfolio from an independent pricing service. For approximately 3% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, less significantly, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of June 30, 2012 .
Level 1 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service, and are based on unadjusted quoted prices for identical assets or liabilities in active markets. Additional pricing services and closing exchange values are used as a comparison to ensure that reasonable fair values are used in pricing the investment portfolio.
U.S. government bonds and agencies : Valued using unadjusted quoted market prices for identical assets in active markets.
Common stock : Comprised of actively traded, exchange listed U.S. and international equity securities and valued based on unadjusted quoted prices for identical assets in active markets.
Money market instruments : Valued based on unadjusted quoted prices for identical assets.
Equity contracts : Comprised of free-standing exchange listed derivatives that are actively traded and valued based on quoted prices for identical instruments in active markets.
Level 2 Measurements - Fair values of financial assets and financial liabilities are obtained from an independent pricing service or outside brokers, and are based on prices for similar assets or liabilities in active markets or valuation models whose inputs are observable, directly or indirectly, for substantially the full term of the asset or liability. Additional pricing services are used as a comparison to ensure reliable fair values are used in pricing the investment portfolio.
Municipal securities : Valued based on models or matrices using inputs such as quoted prices for identical or similar assets in active markets.
Mortgage-backed securities : Comprised of securities that are collateralized by residential mortgage loans and valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. At June 30, 2012 and December 31, 2011 , the Company had no holdings in commercial mortgage-backed securities.
Corporate securities/Short-term bonds : Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.
Non-redeemable preferred stock : Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.
Interest rate swap agreements : Valued based on models using inputs, such as interest rate yield curves, observable for substantially the full term of the contract.
Level 3 Measurements - Fair values of financial assets are based on inputs that are both unobservable and significant to the overall fair value measurement, including any items in which the evaluated prices obtained elsewhere were deemed to be of a distressed trading level.
Collateralized debt obligations/Partnership interest in a private credit fund : Valued based on underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.
The Company’s total financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment gains in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011 , and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
 

10


 
June 30, 2012
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
12,553

 
$
0

 
$
0

 
$
12,553

Municipal securities
0

 
2,265,322

 
0

 
2,265,322

Mortgage-backed securities
0

 
30,887

 
0

 
30,887

Corporate securities
0

 
102,550

 
0

 
102,550

Collateralized debt obligations
0

 
0

 
76,325

 
76,325

Equity securities:
 
 
 
 
 
 
 
Common stock:
 
 
 
 
 
 
 
Public utilities
68,991

 
0

 
0

 
68,991

Banks, trusts and insurance companies
18,483

 
0

 
0

 
18,483

Energy and other
336,438

 
0

 
0

 
336,438

Non-redeemable preferred stock
0

 
11,225

 
0

 
11,225

Partnership interest in a private credit fund
0

 
0

 
11,030

 
11,030

Short-term bonds
0

 
40,792

 
0

 
40,792

Money market instruments
138,534

 
0

 
0

 
138,534

Total assets at fair value
$
574,999

 
$
2,450,776

 
$
87,355

 
$
3,113,130

Liabilities
 
 
 
 
 
 
 
Equity contracts
$
643

 
$
0

 
$
0

 
$
643

Interest rate swap agreements
0

 
399

 
0

 
399

Total liabilities at fair value
$
643

 
$
399

 
$
0

 
$
1,042

 
 
December 31, 2011
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
14,298

 
$
0

 
$
0

 
$
14,298

Municipal securities
0

 
2,271,275

 
0

 
2,271,275

Mortgage-backed securities
0

 
37,371

 
0

 
37,371

Corporate securities
0

 
75,142

 
0

 
75,142

Collateralized debt obligations
0

 
0

 
47,503

 
47,503

Equity securities:
 
 
 
 
 
 
 
Common stock:
 
 
 
 
 
 
 
Public utilities
26,342

 
0

 
0

 
26,342

Banks, trusts and insurance companies
16,027

 
0

 
0

 
16,027

Energy and other
316,592

 
0

 
0

 
316,592

Non-redeemable preferred stock
0

 
11,419

 
0

 
11,419

Partnership interest in a private credit fund
0

 
0

 
10,008

 
10,008

Short-term bonds
0

 
9,011

 
0

 
9,011

Money market instruments
227,433

 
0

 
0

 
227,433

Total assets at fair value
$
600,692

 
$
2,404,218

 
$
57,511

 
$
3,062,421

Liabilities
 
 
 
 
 
 
 
Equity contracts
$
655

 
$
0

 
$
0

 
$
655

Interest rate swap agreements
0

 
670

 
0

 
670

Total liabilities at fair value
$
655

 
$
670

 
$
0

 
$
1,325




11


The following tables present a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value at June 30, 2012 and 2011 .
 
 
Three Months Ended June 30,
 
2012
 
2011
 
Municipal
Securities
 
Collateralized
Debt Obligations
 
Partnership
Interest in a
Private Credit
Fund
 
Municipal
Securities
 
Collateralized
Debt Obligations
 
(Amounts in thousands)
Beginning Balance
$
0

 
$
52,983

 
$
10,510

 
$
0

 
$
58,408

     Realized (losses) gains included in earnings
0

 
(1,658
)
 
520

 
0

 
(2,684
)
     Purchase
0

 
25,000

 
0

 
0

 
0

Ending Balance
$
0

 
$
76,325

 
$
11,030

 
$
0

 
$
55,724

The amount of total (losses) gains for the period included in earnings attributable to assets still held at June 30
$
0

 
$
(1,658
)
 
$
520

 
$
0

 
$
(2,684
)
 
Six Months Ended June 30,
 
2012
 
2011
 
Municipal
Securities
 
Collateralized
Debt Obligations
 
Partnership
Interest in a
Private Credit
Fund
 
Municipal
Securities
 
Collateralized
Debt Obligations
 
(Amounts in thousands)
Beginning Balance
$
0

 
$
47,503

 
$
10,008

 
$
1,624

 
$
55,692

     Realized gains included in earnings
0

 
3,822

 
1,022

 
39

 
32

     Purchase
0

 
25,000

 
0

 
0

 
0

     Sales
0

 
0

 
0

 
(1,663
)
 
0

Ending Balance
$
0

 
$
76,325

 
$
11,030

 
$

 
$
55,724

The amount of total gains for the period included in earnings attributable to assets still held at June 30
$
0

 
$
3,822

 
$
1,022

 
$
0

 
$
32

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the six months ended June 30, 2012 and 2011 .
At June 30, 2012 , the Company did not have any nonrecurring measurements of nonfinancial assets or nonfinancial liabilities.
6. Derivative Financial Instruments
The Company is exposed to certain risks relating to its ongoing business operations. The primary risks managed by using derivative instruments are equity price risk and interest rate risk. Equity contracts on various equity securities are intended to manage the price risk associated with forecasted purchases or sales of such securities. Interest rate swaps are intended to manage the interest rate risk associated with the Company’s debts with fixed or floating rates.
On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on a $120 million credit facility for a fixed rate of 1.93% that matured on January 3, 2012 . The purpose of the swap was to offset the variability of cash flows resulting from the variable interest rate. The swap was not designated as a hedge and changes in the fair value were adjusted through the consolidated statement of operations in the period of change.
On March 3, 2008 , the Company entered into an interest rate swap of its floating LIBOR rate on the $18 million bank loan for a fixed rate of 4.25% . The swap was designated as a cash flow hedge and the fair market value of the interest rate swap was reported as a component of other comprehensive income and amortized into earnings over the term of the hedged transaction. On October 4, 2011 , the Company refinanced its Bank of America $18 million LIBOR plus 50 basis points loan that was scheduled to mature on March 1, 2013 with a Union Bank $20 million LIBOR plus 40 basis points loan that matures on January 2, 2015 . The related interest rate swap became ineffective and is no longer designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change. The fair market value of the interest rate swap was $0.4

12


million and $0.7 million as of June 30, 2012 and December 31, 2011 , respectively. The swap terminates on March 1, 2013 .
Fair value amounts, and gains and losses on derivative instruments
The following tables present the location and amounts of derivative fair values in the consolidated balance sheets and derivative gains and losses in the consolidated statements of operations:
 
 
Liability Derivatives
 
June 30, 2012
 
December 31, 2011
 
(Amount in thousands)
Non-hedging derivatives
 
 
 
Interest rate swap agreements - Other liabilities
$
399

 
$
670

Equity contracts - Short-term investments - Other liabilities
643

 
655

Total derivatives
$
1,042

 
$
1,325

The Effect of Derivative Instruments on the Consolidated Statements of Operations
 
 
Gain Recognized in Other
Comprehensive (Loss) Income
 
Three Months Ended June 30,
 
Six Months Ended June 30,
Derivatives Contracts for Cash Flow Hedges
2012
 
2011
 
2012
 
2011
 
(Amounts in thousands)
Interest rate swap agreements - Other comprehensive (loss) income
$
0

 
$
26

 
$
0

 
$
169

 
 
Gain Recognized in (Loss) Income
 
Three Months Ended June 30,
 
Six Months Ended June 30,
Derivatives Not Designated as Hedging Instruments
2012
 
2011
 
2012
 
2011
 
(Amounts in thousands)
Interest rate swap agreements - Other revenue
$
147

 
$
432

 
$
271

 
$
863

Equity contracts - Net realized investment (losses) gains
368

 
2,262

 
1,585

 
4,734

Total
$
515

 
$
2,694

 
$
1,856

 
$
5,597

Most equity contracts consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy that is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset diversification throughout various industries. For additional disclosures regarding equity contracts, see Note 5.
7. Goodwill and Other Intangible Assets
There were no changes in the carrying amount of goodwill for the six months ended June 30, 2012 . Goodwill is reviewed for impairment on an annual basis and more frequently if potential impairment indicators exist. No impairment indications were identified during any of the periods presented.

13


The following table presents the components of other intangible assets as of June 30, 2012 and December 31, 2011 .
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
 
Useful Lives
 
(Amounts in thousands)
 
(in years)
As of June 30, 2012:
 
 
 
 
 
 
 
Customer relationships
$
51,755

 
$
(17,130
)
 
$
34,625

 
11
Trade names
15,400

 
(2,246
)
 
13,154

 
24
Software
550

 
(550
)
 
0

 
2
Technology
4,300

 
(1,505
)
 
2,795

 
10
Favorable leases
1,725

 
(1,646
)
 
79

 
3
Total intangible assets, net
$
73,730

 
$
(23,077
)
 
$
50,653

 
 
As of December 31, 2011:
 
 
 
 
 
 
 
Customer relationships
$
51,755

 
$
(14,676
)
 
$
37,079

 
11
Trade names
15,400

 
(1,925
)
 
13,475

 
24
Software
550

 
(550
)
 
0

 
2
Technology
4,300

 
(1,290
)
 
3,010

 
10
Favorable leases
1,725

 
(1,540
)
 
185

 
3
Total intangible assets, net
$
73,730

 
$
(19,981
)
 
$
53,749

 
 
Intangible assets are amortized on a straight-line basis over their useful lives. Intangible assets amortization expense was $1.5 million and $1.6 million for the three months ended June 30, 2012 and 2011 , respectively, and $3.1 million and $3.3 million for the six months ended June 30, 2012 and 2011 , respectively. The following table presents the estimated future amortization expense related to intangible assets as of June 30, 2012 :
 
Year Ending
 
Amortization Expense
 
 
(Amounts in thousands)
Remainder of 2012
 
$
3,064

2013
 
5,986

2014
 
5,980

2015
 
5,980

2016
 
5,980

Thereafter
 
23,663

Total
 
$
50,653

8. Share-Based Compensation
The Company accounts for share-based compensation using the modified prospective transition method. Under this method, share-based compensation expense includes compensation expense for all share-based compensation awards granted prior to, but not yet vested as of January 1, 2006, and is based on the estimated grant-date fair value. Share-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the estimated grant-date fair value. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of four or five years for options granted prior to 2008 and four years for options granted subsequent to January 1, 2008, for only those shares expected to vest. The fair value of stock option awards is estimated using the Black-Scholes option pricing model with inputs for grant-date assumptions and weighted-average fair values.
Under its 2005 Equity Participation Plan (the “Plan”), the Compensation Committee of the Company’s Board of Directors granted performance vesting restricted stock units to the Company’s senior management and key employees as follows:
 
Grant Year
 
2012
 
2011
 
2010
Three-year performance period ending December 31,
2014

 
2013

 
2012

Vesting shares, target (1)
90,500

 
80,000

 
55,000

Vesting shares, maximum (1)
203,625

 
120,000

 
55,000

(1)
2010 grant includes 10,000 shares of restricted stock.

14


The restricted stock units vest at the end of a three -year performance period beginning with the year of the grant, and then only if, and to the extent that, the Company’s cumulative underwriting income, and with respect to the 2012 grants only, target level of growth in net premiums written, during such three-year period achieves the threshold performance levels established by the Compensation Committee.
The fair value of each restricted share grant is determined based on the market price on the grant date. Compensation cost is recognized based on management’s best estimate that performance goals will be achieved. If such goals are not met, no compensation cost is recognized and any recognized compensation cost would be reversed. For the 2011 and 2010 grants, the achievement of the performance condition set by the Compensation Committee was no longer considered probable, and previously recognized compensation costs were reversed as of June 30, 2012 and December 31, 2011, respectively.
9. Income Taxes
The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return once a “more-likely-than-not” threshold has been met. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement is recognized in the financial statements.
There were no material changes to the total amount of unrecognized tax benefits related to tax uncertainties during the six months ended June 30, 2012 . The Company does not expect any changes in such unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months.
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2005 through 2010 for federal taxes and 2003 through 2010 for California state taxes. Tax years 2005 through 2010 are currently under examination by the Internal Revenue Service. The Company is currently under examination by the California Franchise Tax Board (“FTB”) for tax years 2003 through 2010. The FTB has issued Notices of Proposed Assessments to the Company for tax years 2003 through 2006. The Company has filed protests with the FTB in response to these assessments and presented its case in a hearing before the FTB. No assessments have been received for tax years 2007 through 2010. Management believes that the resolution of these examinations and assessments will not have a material impact on the condensed consolidated financial statements.
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial reporting basis and the respective tax basis of the Company’s assets and liabilities, and expected benefits of utilizing net operating loss, capital loss, and tax-credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established.
At June 30, 2012 , the Company’s deferred income taxes were in a net liability position which included a combination of ordinary and capital deferred tax benefits. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generating sufficient taxable income of the appropriate nature within the carryback and carryforward periods available under the tax law. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to maximize the full benefits of its deferred tax assets. Although realization is not assured, management believes that it is more likely than not that the Company’s deferred tax assets will be realized.
10. Contingencies
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 .
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

15


In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statements
Certain statements in this Quarterly Report on Form 10-Q or in other materials the Company has filed or will file with the Securities and Exchange Commission (“SEC”) (as well as information included in oral statements or other written statements made or to be made by the Company) contain or may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results, and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause the Company’s actual business, prospects, and results of operations to differ materially from the historical information contained in this Quarterly Report on Form 10-Q and from those that may be expressed or implied by the forward-looking statements contained in this Quarterly Report on Form 10-Q and in other reports or public statements made by the Company.
Factors that could cause or contribute to such differences include, among others: the competition currently existing in the automobile insurance markets in California and the other states in which the Company operates; the cyclical and generally competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserves or other estimates; the accuracy and adequacy of the Company’s pricing methodologies; the Company’s success in managing its business in states outside of California; the impact of potential third party “bad-faith” legislation, changes in laws, regulations or new interpretation of existing laws and regulations, tax position challenges by the FTB, and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the timing of required regulatory approvals of premium rate changes for insurance policies issued in states where the Company operates; the Company’s reliance on independent agents to market and distribute its policies; the investment yields the Company is able to obtain with its investments in comparison to recent yields and the market risks associated with the Company’s investment portfolio; the effect government policies may have on market interest rates; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters in the markets served by the Company; the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives; the Company’s ability to realize current deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other uncertainties, all of which are difficult to predict and many of which are beyond the Company’s control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods.
The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report, or statement. Investors should also understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company’s forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements. Any forward-looking statements should also be considered in light of the information provided in “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 and in Item 1A. Risk Factors in Part II - Other Information of this Quarterly Report on Form 10-Q.

16

Table of Contents


OVERVIEW
A. General
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty insurance industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the Company’s ability to grow and retain business.
This section 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 condensed consolidated financial statements and notes thereto, and all other items contained within this Quarterly Report on Form 10-Q.

B. Business
The Company is primarily engaged in writing personal automobile insurance through 13 insurance subsidiaries (“Insurance Companies”). The Company also writes homeowners, commercial automobile and property, mechanical breakdown, fire, and umbrella insurance. These policies are mostly sold through independent agents who receive a commission for selling policies. The Company believes that it has thorough underwriting and claims handling processes that provide the Company with advantages over its competitors. The Company views its agent relationships and its underwriting and claims handling processes as its primary competitive advantages because they allow the Company to charge lower prices while realizing better margins than many competitors.
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, Illinois, Oklahoma, Texas, Florida, Virginia, New York, New Jersey, Arizona, Pennsylvania, Michigan, and Nevada. The direct premiums written during the six months ended June 30, 2012 and 2011 by state and line of business were:
Six Months Ended June 30, 2012
(Amounts in thousands)
 
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
823,903

 
$
124,759

 
$
20,091

 
$
31,529

 
$
1,000,282

 
76.1
%
Florida
82,569

 
(174
)
 
7,576

 
4,049

 
94,020

 
7.2
%
Texas
30,886

 
3,931

 
4,233

 
12,824

 
51,874

 
3.9
%
New Jersey
38,645

 
1,559

 
0

 
199

 
40,403

 
3.1
%
Other states
87,170

 
23,167

 
4,378

 
12,711

 
127,426

 
9.7
%
Total
$
1,063,173

 
$
153,242

 
$
36,278

 
$
61,312

 
$
1,314,005

 
100.0
%
 
80.9
%
 
11.7
%
 
2.7
%
 
4.7
%
 
100.0
%
 
 






17

Table of Contents

Six Months Ended June 30, 2011
(Amounts in thousands)
 
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
806,491

 
$
115,275

 
$
29,850

 
$
27,749

 
$
979,365

 
75.5
%
Florida
86,118

 
4,927

 
7,685

 
4,837

 
103,567

 
8.0
%
Texas
31,448

 
835

 
2,510

 
11,064

 
45,857

 
3.5
%
New Jersey
44,088

 
970

 
0

 
258

 
45,316

 
3.5
%
Other states
90,522

 
16,944

 
3,405

 
11,488

 
122,359

 
9.5
%
Total
$
1,058,667

 
$
138,951

 
$
43,450

 
$
55,396

 
$
1,296,464

 
100.0
%
 
81.7
%
 
10.7
%
 
3.3
%
 
4.3
%
 
100.0
%
 
 

C. Regulatory and Litigation Matters
The Department of Insurance (“DOI”) in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies 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 presents a summary of current financial and market conduct examinations:
 
State
  
Exam Type
  
Period Under Review
  
Status
OK
  
Financial
  
2008 to 2010
  
Received final report in June 2012.
IL
  
Market Conduct
  
Jul 2009 to Jun 2010
  
Received final report in May 2012.
GA
  
Financial
  
2007 to 2010
  
Received final report in April 2012.
NV
  
Market Conduct
  
Jan 2009 to Dec 2011
  
Fieldwork began in April 2012.
During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company and none of the findings reported to date is expected to be material to the Company’s financial position.
In April 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to Mercury Insurance Company (“MIC”), Mercury Casualty Company (“MCC”), and California Automobile Insurance Company (“CAIC”) based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI in February 2010. The 2010 NNC includes allegations of 35 instances of noncompliance with applicable California insurance law and seeks to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and may also seek monetary penalties. In April 2010, the Company submitted a Statement of Compliance and Notice of Defense to the 2010 NNC, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each allegation. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense does not establish to the satisfaction of the California DOI that the alleged noncompliance does not exist, and the matters described in the 2010 NNC are not otherwise able to be resolved informally with the California DOI. The California DOI has recently advised the Company that it is continuing to review this matter and it continues to question certain past practices. The Company denies the allegations in the 2010 NNC and believes that it has done nothing to warrant the penalties cited in the 2010 NNC.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) 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. 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 2004 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 2004 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. On January 31, 2012, the administrative law judge bifurcated the 2004 NNC, ordering separate hearings on (a) the California DOI’s order to show cause, in which the California DOI asserts false

18

Table of Contents

advertising allegations against the Company, and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI alleges that the Company used unlawful rates. On February 3, 2012, the administrative law judge submitted a proposed decision that dismissed the California DOI’s allegations that the Company used unlawful rates and recommended its adoption as the decision of the Insurance Commissioner. On March 30, 2012, the proposed decision was rejected by the Insurance Commissioner. The Company has challenged the rejection of the administrative law judge’s proposed decision in Los Angeles Superior Court. The hearing regarding the California DOI’s order to show cause and accusation has been scheduled on September 14, 2012.
In the 2004 and 2010 NNC matters, the Company believes that no monetary penalties are warranted and intends to defend the issues vigorously. The Company has been subject to fines and penalties by the California DOI in the past due to alleged violations of the California Insurance Code. The largest and most recent of these was settled in 2008 for $300,000. However, prior settlement amounts are not necessarily indicative of the potential results in the current Notice of Non-Compliance matters. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the 2004 and 2010 NNC matters will be material to the Company’s financial position. The Company has accrued a liability for the estimated cost to defend itself in the regulatory matters described above.
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 .
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies for which the Company is able to estimate its potential exposure and when the Company believes a loss is probable. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.
In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 .
D. Critical Accounting Policies and Estimates
Reserves
Preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves. 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 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 could be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company also engages an independent actuarial consultant 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 the actuarial consultant for GAAP reporting or periodic report disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count development, and average severity methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves 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 a single 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.

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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 provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. 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.
The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company uses this method for losses and loss adjustment expenses.

At June 30, 2012 , the Company recorded its point estimate of $978.3 million in losses and loss adjustment expenses liabilities which include $371.4 million of incurred but not reported (“IBNR”) loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to June 30, 2012 , and estimated future payments for reopened claims. Management believes that the liability for losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For the six months ended June 30, 2012 , the Company reported unfavorable development of approximately $29 million on the 2011 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2011 totaled approximately $1 billion . The unfavorable development in 2012 is largely the result of re-estimates of California bodily injury losses which have experienced both higher average severities and more late reported claims (claim count development) than originally estimated at December 31, 2011 . The Company also recognized approximately $8 million of pre-tax losses in the second quarter of 2012 as a result of wind and hail storms in the Midwest region.
For a further discussion of the Company’s reserving methods, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 .
Premiums
The Company’s insurance premiums are recognized as income ratably over the term of the policies and in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the consolidated balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs partially offset by investment income to related unearned premiums. To the extent that any of the Company’s lines of business become unprofitable, a premium deficiency reserve may be required.
Investments
The Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-redeemable preferred stocks, is actively traded on national exchanges or trading markets, and is valued at the last transaction price on the balance sheet dates.
Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include investments, receivables, interest rate swap agreements, accounts payable, equity contracts, and secured notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values. All investments are carried on the consolidated balance sheets at fair value, as disclosed in Note 3 of Condensed Notes to Consolidated Financial Statements.
The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange traded funds. Approximately 97% of the fair value of the financial instruments held at June 30, 2012 is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary across different financial instruments. Observable market prices and pricing parameters of a

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financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
The Company may hold or acquire financial instruments that lack observable market prices or market parameters currently or in future periods because they are less actively traded. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise is not actively quoted.
Income Taxes
At June 30, 2012 , the Company’s deferred income taxes were in a net liability position materially due to deferred tax liabilities attributable to tax basis differences in the Company’s investment portfolio. These liabilities were partially offset by deferred tax assets related to unearned premiums, expense accruals, loss reserve discounting, deferred capital losses, and tax credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established. Management’s recoverability assessment of its deferred tax assets which are ordinary in character takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities that represent sources of future ordinary taxable income.
Management’s recoverability assessment with regard to its capital deferred tax assets is based on estimates of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, both of which would contribute to the realization of deferred tax benefits. The Company expects to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a portion of the unrealized loss positions at period end, are fully realizable at maturity. The Company has a long-term time horizon for holding these securities, which management believes will allow avoidance of forced sales prior to maturity. The Company also has significant unrealized gains in its investment portfolio which could be realized through asset dispositions, at management’s discretion. Further, the Company has the capability to generate additional realized capital gains by entering into a sale-leaseback transaction using one or more of its appreciated real estate holdings.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations, as well as the reasonable expectation that its cash flow needs can be met in future periods without the forced sale of its investments. This capability assists management in controlling the timing and amount of realized losses it generates during future periods. By prudent utilization of some or all of these strategies, management believes that it has the ability and intent to generate capital gains, and minimize tax losses, in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.
The Company’s effective income tax rate for the year could be different from the effective tax rate for the six months ended June 30, 2012 and will be dependent on the Company’s profitability for the remainder of the year. The Company’s effective income tax rate can be affected by several factors. These generally include tax exempt investment income, other non-deductible expenses, investment gains and losses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate for the six months ended June 30, 2012 was 18.1%, compared to 24.3% for the same period in 2011. The decrease in the effective tax rate is mainly due to a decrease in taxable income relative to tax exempt investment income. The Company’s effective tax rate for the six months ended June 30, 2012 was lower than the statutory tax rate primarily as a result of tax exempt investment income earned. However, the effective tax rate for the entire year could differ from the rate for the six months.
Goodwill and Other Intangible Assets
Goodwill and other intangible assets arise from business acquisitions and consist of the excess of the cost of the acquisitions over the tangible and intangible assets acquired and liabilities assumed and identifiable intangible assets acquired. The Company annually evaluates goodwill and other intangible assets for impairment. The Company also reviews its goodwill and other intangible

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assets for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed its implied fair value. As of December 31, 2011 , the fair value of the Company’s reporting units exceeded their carrying value. There are no triggering events indicating the carrying amount of goodwill exceeds its implied fair value as of June 30, 2012 .
Contingent Liabilities
The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them and/or discloses them in the condensed notes to consolidated financial statements where required. The Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

RESULTS OF OPERATIONS

Three Months Ended June 30, 2012 compared to Three Months Ended June 30, 2011
Revenue
Net premiums written for the three months ended June 30, 2012 increased 2.7% from the corresponding period in 2011, while net premiums earned decreased by 0.8% from the corresponding period in 2011. The increase in net premiums written is primarily due to an increase in the number of policies written and slightly higher average premiums per policy written. The increase in average premiums per policy reflects a modest shift for the California personal automobile line from six-month policies to twelve-month policies. Premiums on twelve-month policies are typically twice that of six-month policies. For the three months ended June 30, 2012, fewer than 5% of California personal automobile policies were written on a twelve-month basis and more than 95% were written on a six-month basis compared to the corresponding period in 2011 where fewer than 1% of the California personal automobile policies were written on an annual basis and over 99% were written on a six-month basis. In addition, there was a small reduction in the rate of policy renewals caused by a revised California personal automobile rating plan implemented in December 2011. The revised rates caused dislocation by raising rates for some policyholders and decreasing rates for others. The Company estimates that the positive impact that annual policies had on net premiums written was largely offset by the negative impact of reduced policy renewals.
Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
 
 
Three Months Ended June 30,
 
2012
 
2011
 
(Amounts in thousands)
Net premiums written
$
653,633

 
$
636,294

Change in unearned premium
(16,386
)
 
6,037

Net premiums earned
$
637,247

 
$
642,331

Expenses
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies’ loss ratio, expense ratio, and combined ratio determined in accordance with GAAP:
 
 
Three Months Ended June 30,
 
2012
 
2011
Loss ratio
78.0
%
 
70.3
%
Expense ratio
26.5
%
 
27.7
%
Combined ratio
104.5
%
 
98.0
%
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The increase in the loss

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ratio for the three months ended June 30, 2012 compared to the same period in 2011 resulted primarily from increased loss severity, unfavorable development on 2011 and prior accident years reserves of $23 million, and catastrophic losses of approximately $8 million due to wind and hail storms in the Midwest region. The Company recognized approximately $3 million of catastrophic losses for the three months ended June 30, 2011.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The improvement in the expense ratio in 2012 was mainly due to ongoing cost reduction efforts.
Combined ratio is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results.
Income tax (benefit) expense was $ (13.6) million and $ 18.4 million for the three month periods ended June 30, 2012 and 2011 , respectively. The decrease resulted primarily from the decreased income before income taxes compared to the corresponding period in 2011.
Investments
The following table presents the investment results of the Company:
 
 
Three Months Ended June 30,
 
2012
 
2011
 
(Amounts in thousands)
Average invested assets at cost (1)
$
2,996,602

 
$
2,991,174

Net investment income (2)
 
 
 
Before income taxes
$
31,673

 
$
36,009

After income taxes
$
27,990

 
$
31,880

Average annual yield on investments (2)
 
 
 
Before income taxes
4.2
%
 
4.8
%
After income taxes
3.7
%
 
4.3
%
Net realized investment (losses) gains
$
(23,759
)
 
$
23,764

 
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.
(2)
Net investment income and average annual yield decreased primarily due to the maturity and replacement of higher yielding investments, purchased when market interest rates were higher, with lower yielding investments purchased during the current low interest rate environment.
Included in net (loss) income are net realized investment losses of $ 23.8 million and net realized investment gains of $ 23.8 million for the three months ended June 30, 2012 and 2011 , respectively. Net realized investment (losses) gains include losses of $ 24.8 million and gains of $ 20.6 million for the three months ended June 30, 2012 and 2011, respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net losses for the three months ended June 30, 2012 arose primarily from a $ 34.0 million decrease in the market value of the Company’s equity securities offset by a $ 9.8 million increase in the market value of the Company’s fixed maturity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for the three months ended June 30, 2012 . The primary cause of the losses on the Company’s equity securities was the decline in the market value of the Company’s large holdings of energy related stocks.
Net (Loss) Income
Net (loss) income was $ (5.3) million, or $ (0.10) per diluted share, and $ 57.3 million, or $ 1.04 per diluted share, in the three months ended June 30, 2012 and 2011 , respectively. Diluted per share results were based on a weighted average of 54.9  million and 54.8 million shares in the three months ended June 30, 2012 and 2011 , respectively. Basic per share results were $ (0.10) and $ 1.04 in the three months ended June 30, 2012 and 2011, respectively. Included in net (loss) income per share were net realized investment (losses) gains, net of income taxes, of $ (0.28) and $ 0.28 per share (basic and diluted) in the three months ended June 30, 2012 and 2011 , respectively.




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Six Months Ended June 30, 2012 compared to Six Months Ended June 30, 2011
Revenue
Net premiums written for the six months ended June 30, 2012 increased 1.3% from the corresponding period in 2011, while net premiums earned decreased by 0.6% from the corresponding period in 2011. The increase in net premiums written is primarily due to an increase in the number of policies written and slightly higher average premiums per policy written. The increase in average premiums per policy reflects a modest shift for the California personal automobile line from six-month policies to twelve-month policies. Premiums on twelve-month policies are typically twice that of six-month policies. For the six months ended June 30, 2012, fewer than 5% of California personal automobile policies were written on a twelve-month basis and more than 95% were written on a six-month basis compared to the corresponding period in 2011 where fewer than 1% of the California personal automobile policies were written on an annual basis and over 99% were written on a six-month basis. In addition, there was a small reduction in the rate of policy renewals caused by a revised California personal automobile rating plan implemented in December 2011. The revised rates caused dislocation by raising rates for some policyholders and decreasing rates for others. The Company estimates that the positive impact that annual policies had on net premiums written was largely offset by the negative impact of reduced policy renewals.
The following is a reconciliation of total net premiums written to net premiums earned:
 
 
Six Months Ended June 30,
 
2012
 
2011
 
(Amounts in thousands)
Net premiums written
$
1,311,920

 
$
1,294,511

Change in unearned premium
(38,861
)
 
(13,693
)
Net premiums earned
$
1,273,059

 
$
1,280,818

Expenses
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies’ loss ratio, expense ratio, and combined ratio determined in accordance with GAAP:
 
 
Six Months Ended June 30,
 
2012
 
2011
Loss ratio
74.4
%
 
70.1
%
Expense ratio
26.7
%
 
28.0
%
Combined ratio
101.1
%
 
98.1
%
The loss ratio was affected by unfavorable development of approximately $29 million and $10 million on prior accident years’ losses and loss adjustment expense reserves for the six months ended June 30, 2012 and 2011 , respectively. The unfavorable development in 2012 is largely the result of re-estimates of California bodily injury losses which have experienced both higher average severities and more late reported claims (claim count development) than originally estimated at December 31, 2011 . The Company also recognized approximately $8 million of pre-tax losses in the second quarter of 2012 as a result of wind and hail storms in the Midwest region. The Company recognized approximately $4 million of catastrophic losses for the six months ended June 30, 2011.
The improvement in the expense ratio in 2012 was mainly due to ongoing cost reduction efforts.
Income tax expense was $ 15.0 and $ 37.0 million for the six month periods ended June 30, 2012 and 2011 , respectively. The decrease resulted primarily from the decreased income before income taxes compared to the corresponding period in 2011.

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Investments
The following table presents the investment results of the Company:
 
 
Six Months Ended June 30,
 
2012
 
2011
 
(Amounts in thousands)
Average invested assets at cost (1)
$
2,992,590

 
$
3,021,760

Net investment income (2)
 
 
 
Before income taxes
$
63,159

 
$
71,105

After income taxes
$
56,028

 
$
63,094

Average annual yield on investments (2)
 
 
 
Before income taxes
4.2
%
 
4.7
%
After income taxes
3.7
%
 
4.2
%
Net realized investment gains
$
28,904

 
$
52,454

 
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.
(2)
Net investment income and average annual yield decreased primarily due to the maturity and replacement of higher yielding investments, purchased when market interest rates were higher, with lower yielding investments purchased during the current low interest rate environment.
Included in net income are net realized investment gains of $ 28.9 million and $ 52.5 million for the six months ended June 30, 2012 and 2011 , respectively. Net realized investment gains include gains of $ 24.6 million and $ 41.4 million for the six months ended June 30, 2012 and 2011 , respectively, due to changes in the fair value of total investments pursuant to application of the fair value accounting option. The net gains for the six months ended June 30, 2012 arose primarily from a $ 30.8 million increase in the market value of the Company’s fixed maturity securities offset by a $ 5.5 million decrease in the market value of the Company’s equity securities. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement for the six months ended June 30, 2012 . The primary cause of the losses on the Company’s equity securities was the decline in the market value of the Company’s large holdings of energy related stocks in the second quarter of 2012.
Net Income
Net income was $ 68.1 million , or $ 1.24 per diluted share, and $ 115.5 million , or $2.11 per diluted share, in the six months ended June 30, 2012 and 2011 , respectively. Diluted per share results were based on a weighted average of 54.9 million and 54.8 million shares in the six months ended June 30, 2012 and 2011 , respectively. Basic per share results were $ 1.24 and $ 2.11 in the six months ended June 30, 2012 and 2011 , respectively. Included in net income per share were net realized investment gains, net of income taxes, of $ 0.34 and $ 0.62 per share (basic and diluted) in the six months ended June 30, 2012 and 2011 , respectively.

LIQUIDITY AND CAPITAL RESOURCES
A. Cash Flows
The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company’s long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $ 339.8 million at June 30, 2012 , the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs or for future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.
Net cash provided by operating activities in the six months ended June 30, 2012 was $ 49.4 million , a decrease of $43.7 million compared to the corresponding period in 2011 . The decrease was primarily due to increased payment of income taxes. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders.

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The following table presents the estimated fair value of fixed maturity securities at June 30, 2012 by contractual maturity in the next five years:
 
 
Fixed Maturities
 
(Amounts in thousands)
Due in one year or less
$
105,072

Due after one year through two years
98,205

Due after two years through three years
53,686

Due after three years through four years
86,133

Due after four years through five years
64,351

 
$
407,447

B. Invested Assets
Portfolio Composition
An important component of the Company’s financial results is the return on its investment portfolio. The Company’s investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company continues to believe that this strategy maintains the optimal investment performance necessary to sustain investment income over time. The Company’s portfolio management approach utilizes a market risk and consistent asset allocation strategy as the primary basis for the allocation of interest sensitive, liquid and credit assets as well as for determining overall below investment grade exposure and diversification requirements. Within the ranges set by the asset allocation strategy, tactical investment decisions are made in consideration of prevailing market conditions.
The following table presents the composition of the total investment portfolio of the Company at June 30, 2012 :
 
 
Cost  (1)
 
Fair Value
 
(Amounts in thousands)
Fixed maturity securities:
 
 
 
U.S. government bonds and agencies
$
12,341

 
$
12,553

Municipal securities
2,153,336

 
2,265,322

Mortgage-backed securities
27,644

 
30,887

Corporate securities
98,924

 
102,550

Collateralized debt obligations
64,247

 
76,325

 
2,356,492

 
2,487,637

Equity securities:
 
 
 
Common stock:
 
 
 
Public utilities
63,986

 
68,991

Banks, trusts and insurance companies
17,609

 
18,483

Energy and other
357,182

 
336,438

Non-redeemable preferred stock
10,895

 
11,225

Partnership interest in a private credit fund
10,000

 
11,030

 
459,672

 
446,167

Short-term investments
179,799

 
179,326

Total investments
$
2,995,963

 
$
3,113,130

 
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.
At June 30, 2012 , 72.5% of the Company’s total investment portfolio at fair value and 90.8% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate

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dividend received deduction, and a partnership interest in a private credit fund. At June 30, 2012 , 77.3% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any direct equity investment in sub-prime lenders.
During the six months ended June 30, 2012 , the Company recognized $ 28.9 million in net realized investment gains, which mainly include gains of $31.3 million related to fixed maturity securities and losses of $3.2 million related to equity securities. Included in the gains and losses were $ 30.8 million in gains due to changes in the fair value of the Company’s fixed maturity security portfolio and $ 5.5 million in losses due to changes in the fair value of the Company’s equity security portfolio, as a result of applying the fair value option.
Fixed maturity securities and short-term investments
Fixed maturity securities include debt securities, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations or other economic factors. Short-term investments include money market accounts, options, and short-term bonds that are highly rated short duration securities and redeemable within one year.
A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company’s historical investment philosophy has resulted in a portfolio with a moderate duration. The nominal average maturity of the overall bond portfolio was 11.6 years (11.0 years including short-term instruments) at June 30, 2012 . The portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturity of the overall bond portfolio was 3.5 years (3.4 years including short-term instruments) at June 30, 2012 , 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 3.0 years (2.9 years including short-term instruments) at June 30, 2012 , including collateralized mortgage obligations with a modified duration of 2.5 years and short-term bonds 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. Modified duration measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rate, and is considered a better indicator of price volatility than simple maturity alone.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA-, at fair value, consistent with the average rating at December 31, 2011 . To calculate the weighted-average credit quality ratings disclosed throughout this Quarterly Report on Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Tax-exempt bond holdings are broadly diversified geographically. Taxable holdings consist principally of investment grade issues. Fixed maturity holdings rated below investment grade and non-rated bonds totaled $131.8 million and $113.0 million, at fair value, and represented 5.3% and 4.6% of total fixed maturity securities at June 30, 2012, and December 31, 2011 , respectively.
The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at June 30, 2012 at fair value. The Company’s estimated credit quality ratings are based on the average of ratings assigned by nationally recognized securities rating organizations. Credit ratings for the Company’s fixed maturity portfolio were stable during the three months ended June 30, 2012 , with 83.9% of fixed maturity securities at fair value experiencing no change in their overall rating. 14.7% of fixed maturity securities at fair value experienced upgrades during the period, partially offset by 1.4% in credit downgrades. The majority of the downgrades were slight and still within the investment grade portfolio, except for approximately $11.2 million at fair value that were downgraded to below investment grade during the quarter.

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June 30, 2012
 
(Amounts in thousands)
 
AAA
 
AA (1)
 
A (1)
 
BBB (1)
 
Non-Rated/Other
 
Total
Fair
Value
U.S. government bonds and agencies:
 
 
 
 
 
 
 
 
 
 
 
Treasuries
$
3,429

 
$
0

 
$
0

 
$
0

 
$
0

 
$
3,429

Government agency
9,124

 
0

 
0

 
0

 
0

 
9,124

Total
12,553

 
0

 
0

 
0

 
0

 
12,553

 
100.0
%
 
 
 
 
 
 
 
 
 
100.0
%
Municipal securities:
 
 
 
 
 
 
 
 
 
 
 
Insured
16,523

 
569,447

 
573,146

 
104,345

 
27,600

 
1,291,061

Uninsured
220,122

 
311,999

 
278,365

 
152,193

 
11,582

 
974,261

Total
236,645

 
881,446

 
851,511

 
256,538

 
39,182

 
2,265,322

 
10.4
%
 
38.9
%
 
37.6
%
 
11.3
%
 
1.8
%
 
100.0
%
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
Agencies
13,417

 
0

 
0

 
0

 
0

 
13,417

Non-agencies:
 
 
 
 
 
 
 
 
 
 
 
Prime
3,225

 
629

 
1,058

 
4

 
3,489

 
8,405

Alt-A
0

 
1,775

 
1,231

 
1,444

 
4,615

 
9,065

Total
16,642

 
2,404

 
2,289

 
1,448

 
8,104

 
30,887

 
53.9
%
 
7.8
%
 
7.4
%
 
4.7
%
 
26.2
%
 
100.0
%
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Communications
0

 
0

 
0

 
6,711

 
0

 
6,711

Consumer-cyclical
0

 
0

 
1,638

 
0

 
94

 
1,732

Consumer-non-cyclical
0

 
0

 
0

 
6,127

 
0

 
6,127

Industrial
0

 
0

 
0

 
189

 
0

 
189

Energy
0

 
0

 
0

 
19,041

 
0

 
19,041

Basic materials
0

 
0

 
0

 
4,681

 
0

 
4,681

Financial
0