Attached files

file filename
EX-31.1 - CERTIFICATION OF REGISTRANT'S CEO PURSUANT TO SECTION 302 - MERCURY GENERAL CORPmcy-2015930x10qxexhibit311.htm
EX-15.2 - AWARENESS LETTER OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - MERCURY GENERAL CORPmcy-2015930x10qxexhibit152.htm
EX-31.2 - CERTIFICATION OF REGISTRANT'S CFO PURSUANT TO SECTION 302 - MERCURY GENERAL CORPmcy-2015930x10qxexhibit312.htm
EX-15.1 - REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - MERCURY GENERAL CORPmcy-2015930x10qxexhibit151.htm
EX-32.1 - CERTIFICATION OF REGISTRANT'S CEO PURSUANT TO SECTION 906 - MERCURY GENERAL CORPmcy-2015930x10qxexhibit321.htm
EX-32.2 - CERTIFICATION OF REGISTRANT'S CFO PURSUANT TO SECTION 906 - MERCURY GENERAL CORPmcy-2015930x10qxexhibit322.htm

 
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 September 30, 2015
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 October 29, 2015, the Registrant had issued and outstanding an aggregate of 55,164,462 shares of its Common Stock.
 





MERCURY GENERAL CORPORATION
INDEX TO FORM 10-Q
 
 
 
 
 
 
Page
 
 
 
 
Item 1
 
Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014
 
Consolidated Statements of Operations and Consolidated Statements of Comprehensive Income for the Three Months Ended September 30, 2015 and 2014
 
Consolidated Statements of Operations and Consolidated Statements of Comprehensive Income for the Nine Months Ended September 30, 2015 and 2014
 
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014
 
Item 2
Item 3
Item 4
 
 
 
 
 
 
Item 1
Item 1A
Item 2
Item 3
Item 4
Item 5
Item 6
 
 

2


PART I - FINANCIAL INFORMATION
 
Item 1. Financial Statements

MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
 
 
September 30, 2015
 
December 31, 2014
 
(unaudited)
 
 
ASSETS
 
 
 
Investments, at fair value:
 
 
 
Fixed maturity securities (amortized cost $2,802,441; $2,503,494)
$
2,886,864

 
$
2,618,400

Equity securities (cost $307,893; $387,851)
298,687

 
412,880

Short-term investments (cost $162,834; $373,180)
162,835

 
372,542

Total investments
3,348,386

 
3,403,822

Cash
295,184

 
289,907

Receivables:
 
 
 
Premiums
442,061

 
390,009

Accrued investment income
41,383

 
38,737

Other
21,114

 
21,202

Total receivables
504,558

 
449,948

Deferred policy acquisition costs
205,245

 
197,202

Fixed assets, net
157,605

 
158,976

Current income taxes
11,915

 
503

Deferred income taxes
20,971

 
0

Goodwill
42,796

 
42,796

Other intangible assets, net
32,538

 
35,623

Other assets
27,381

 
21,512

Total assets
$
4,646,579

 
$
4,600,289

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Losses and loss adjustment expenses
$
1,131,553

 
$
1,091,797

Unearned premiums
1,063,323

 
999,798

Notes payable
290,000

 
290,000

Accounts payable and accrued expenses
139,345

 
130,887

Deferred income taxes

 
5,333

Other liabilities
192,859

 
207,028

Total liabilities
2,817,080

 
2,724,843

Commitments and contingencies


 


Shareholders’ equity:
 
 
 
Common stock without par value or stated value:
       Authorized 70,000 shares; issued and outstanding 55,164; 55,121
91,028

 
88,705

Additional paid-in capital
6,644

 
3,804

Retained earnings
1,731,827

 
1,782,937

Total shareholders’ equity
1,829,499

 
1,875,446

Total liabilities and shareholders’ equity
$
4,646,579

 
$
4,600,289

See accompanying Condensed Notes to Consolidated Financial Statements.

3


MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Three Months Ended September 30,
 
2015
 
2014
Revenues:
 
 
 
Net premiums earned
$
745,520

 
$
705,237

Net investment income
30,898

 
32,564

Net realized investment losses
(26,286
)
 
(20,089
)
Other
2,281

 
2,275

Total revenues
752,413

 
719,987

Expenses:
 
 
 
Losses and loss adjustment expenses
545,692

 
492,525

Policy acquisition costs
132,881

 
131,090

Other operating expenses
60,788

 
58,545

Interest
785

 
707

Total expenses
740,146

 
682,867

Income before income taxes
12,267

 
37,120

Income tax (benefit) expense
(3,003
)
 
5,824

Net income
$
15,270

 
$
31,296

Net income per share:
 
 
 
Basic
$
0.28

 
$
0.57

Diluted
$
0.28

 
$
0.57

Weighted average shares outstanding:
 
 
 
Basic
55,164

 
55,002

Diluted
55,178

 
55,014

Dividends paid per share
$
0.6175

 
$
0.6150



CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)
 
 
Three Months Ended September 30,
 
2015
 
2014
Net income
$
15,270

 
$
31,296

Other comprehensive income, before tax:
 
 
 
Gains on hedging instrument

 

Other comprehensive income, before tax:

 

Income tax expense related to gains on hedging instrument

 

Other comprehensive income, net of tax:

 

Comprehensive income
$
15,270

 
$
31,296

See accompanying Condensed Notes to Consolidated Financial Statements.

4


MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
 
 
Nine Months Ended September 30,
 
2015
 
2014
Revenues:
 
 
 
Net premiums earned
$
2,197,803

 
$
2,086,827

Net investment income
94,101

 
93,656

Net realized investment (losses) gains
(75,595
)
 
102,813

Other
6,823

 
6,666

Total revenues
2,223,132

 
2,289,962

Expenses:
 
 
 
Losses and loss adjustment expenses
1,581,306

 
1,452,171

Policy acquisition costs
401,868

 
393,964

Other operating expenses
191,017

 
166,341

Interest
2,304

 
1,900

Total expenses
2,176,495

 
2,014,376

Income before income taxes
46,637

 
275,586

Income tax (benefit) expense
(4,437
)
 
76,681

Net income
$
51,074

 
$
198,905

Net income per share:
 
 
 
Basic
$
0.93

 
$
3.62

Diluted
$
0.93

 
$
3.62

Weighted average shares outstanding:
 
 
 
Basic
55,154

 
54,986

Diluted
55,172

 
54,995

Dividends paid per share
$
1.8525

 
$
1.8450


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
(unaudited)
 
 
Nine Months Ended September 30,
 
2015
 
2014
Net income
$
51,074

 
$
198,905

Other comprehensive income, before tax:
 
 
 
Gains on hedging instrument

 

Other comprehensive income, before tax:

 

Income tax expense related to gains on hedging instrument

 

Other comprehensive income, net of tax:

 

Comprehensive income
$
51,074

 
$
198,905

See accompanying Condensed Notes to Consolidated Financial Statements.


5



MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Nine Months Ended September 30,
 
2015
 
2014
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net income
$
51,074

 
$
198,905

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
19,967

 
20,145

Net realized investment losses (gains)
75,595

 
(102,813
)
Bond amortization, net
17,279

 
14,650

Excess tax benefit from exercise of stock options
(106
)
 
(169
)
Increase in premiums receivables
(46,952
)
 
(29,613
)
Change in current and deferred income taxes
(35,822
)
 
16,632

Increase in deferred policy acquisition costs
(8,043
)
 
(6,972
)
Increase in unpaid losses and loss adjustment expenses
21,079

 
23,929

Increase in unearned premiums
56,562

 
59,092

(Decrease) increase in accounts payable and accrued expenses
(17,509
)
 
15,968

Share-based compensation
2,946

 
2,741

Changes in other payables
10,255

 
(14,643
)
Other, net
2,382

 
1,645

Net cash provided by operating activities
148,707

 
199,497

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Fixed maturities available-for-sale in nature:
 
 
 
Purchases
(807,150
)
 
(393,208
)
Sales
211,724

 
175,919

Calls or maturities
283,311

 
213,865

Equity securities available-for-sale in nature:
 
 
 
Purchases
(573,011
)
 
(706,461
)
Sales
641,854

 
522,662

Calls or maturities
2,378

 

Changes in securities payable and receivable
(6,658
)
 
(5,622
)
Net decrease in short-term investments and purchased options
210,274

 
23,788

Purchase of fixed assets
(16,384
)
 
(20,880
)
Sale of fixed assets
136

 
209

Business acquisition, net of cash acquired
7,771

 

Other, net
2,291

 
2,896

Net cash used in investing activities
(43,464
)
 
(186,832
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Dividends paid to shareholders
(102,183
)
 
(101,461
)
Excess tax benefit from exercise of stock options
106

 
169

Proceeds from stock options exercised
2,111

 
1,800

Proceeds from bank loan

 
100,000

Net cash (used in) provided by financing activities
(99,966
)
 
508

Net increase in cash
5,277

 
13,173

Cash:
 
 
 
Beginning of the year
289,907

 
266,508

End of period
$
295,184

 
$
279,681

SUPPLEMENTAL CASH FLOW DISCLOSURE
 
 
 
Interest paid
$
2,228

 
$
1,840

Income taxes paid
$
31,385

 
$
60,049


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, 2014.
The condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”), which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions and balances have been eliminated.
The financial data of the Company included herein are unaudited. 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 September 30, 2015 and the results of operations, comprehensive income, and cash flows for the periods presented. These statements were prepared in accordance with the instructions for interim reporting and do not contain certain information that was included in the annual financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014. Readers are urged to review the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 for more complete descriptions and discussions. Operating results and cash flows for the nine months ended September 30, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015.
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 condensed 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, 2014).
Earnings per Share
Potentially dilutive securities representing approximately 5,000 and 18,000 shares of common stock for the three months ended September 30, 2015 and 2014, respectively, and 2,000 and 31,000 shares of common stock for the nine months ended September 30, 2015 and 2014, 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
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. The Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. Deferred policy acquisition cost amortization was $132.9 million and $131.1 million for the three months ended September 30, 2015 and 2014, respectively, and $401.9 million and $394.0 million for the nine months ended September 30, 2015 and 2014, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $39.0 million and $17.1 million for the nine months ended September 30, 2015 and 2014, respectively.


7


2. Recently Issued Accounting Standards
In May 2014, the Financial Accounting Standards Board (“FASB”) issued a new standard that requires entities to apply a five-step model to determine the amount and timing of revenue recognition. The model specifies, among other criteria, that revenue should be recognized when an entity transfers control of goods or services to a customer at the amount at which the entity expects to be entitled. In August 2015, the FASB issued an update which defers the effective date of this standard to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that annual reporting period. Early application is now permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that annual reporting period. The Company is evaluating the impact of this standard on its consolidated financial statements and related disclosures.
In February 2015, the FASB issued amendments affecting the consolidation evaluation of limited partnerships and similar entities, fees paid to a decision maker or a service provider as a variable interest, and variable interests in a variable interest entity held by related parties of the reporting entities. The amendments are effective for annual and interim reporting periods beginning after December 15, 2015. The adoption of the new standard will not have a material impact on the Company's consolidated financial statements.
In May 2015, the FASB issued a new standard that requires insurance entities to provide additional disclosures related to claims liabilities. The additional disclosure requirements for the annual reports include: (1) the claims development information by accident year, on a net of reinsurance basis, for the number of years for which claims incurred remain outstanding but not to exceed the most recent 10 years, and for the most recent reporting period presented, an insurer also needs to disclose the amount of total net outstanding claims for all accident years included in the claims development tables; (2) a reconciliation of claims development information and the aggregate carrying amount of the liability for unpaid claims and claim adjustment expenses; and (3) information about the claims frequency and the amount of the incurred-but-not-reported liabilities for each accident year presented. In addition, a description of the methodology used to determine the amounts disclosed is required. The roll forward of the liability for unpaid claims and claims adjustment expenses, currently required only for annual periods, will also be required for interim periods. This standard will be effective for annual periods beginning after December 15, 2015, and interim periods within annual reporting periods beginning after December 15, 2016. Although the adoption of this standard will not have a material impact on its consolidated financial statements, the Company will expand the nature and extent of its insurance contracts disclosures.
3. Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include investments, receivables, options sold, total return swaps, accounts payable, and secured and unsecured notes payable. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values.
The following table presents the estimated fair values of financial instruments at September 30, 2015 and December 31, 2014:
 
 
September 30, 2015
 
December 31, 2014
 
(Amounts in thousands)
Assets
 
 
 
Investments
$
3,348,386

 
$
3,403,822

Liabilities
 
 
 
Options sold
$
266

 
$
194

Total return swaps
$
6,059

 
$
4,025

Secured notes
$
140,000

 
$
140,000

Unsecured note
$
150,000

 
$
150,000

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.

8


Options Sold
The Company writes covered call options through listed and over-the-counter exchanges. When the Company writes an option, an amount equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security in determining the Company's realized gain or loss. The Company, as writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option. For additional disclosures regarding methods and assumptions used in estimating fair values of these securities, see Note 5.
Total return swaps
The fair values of the total return swaps reflect the estimated amounts that, upon termination of the contracts, would be received for selling an asset or paid to transfer a liability in an orderly transaction at September 30, 2015 and December 31, 2014 based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract. For additional disclosures regarding methods and assumptions used in estimating fair values, see Note 5.
Secured notes payable
The fair value of the Company’s $120 million secured note and $20 million secured note, classified as Level 2 in the fair value hierarchy described in Note 5, is estimated based on assumptions and inputs, such as the market value of underlying collateral and reset rates, for similarly termed notes that are observable in the market.
Unsecured note payable
The fair value of the Company’s $150 million unsecured note, classified as Level 2 in the fair value hierarchy described in Note 5, is based on the unadjusted quoted price for similar notes in active markets.

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 the 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 the expansion of the use of the Company’s fair value measurement consistent with the long-term measurement objectives of the FASB for accounting for financial instruments.
The following table presents (losses) gains 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 September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(Amounts in thousands)
Fixed maturity securities
$
(1,602
)
 
$
3,536

 
$
(30,609
)
 
$
73,149

Equity securities
(16,938
)
 
(23,995
)
 
(34,234
)
 
(6,355
)
Short-term investments
2

 
(69
)
 
638

 
(211
)
Total
$
(18,538
)
 
$
(20,528
)
 
$
(64,205
)
 
$
66,583

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 are not readily available, the Company’s own assumptions are used 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 at fair value on the consolidated balance sheets are categorized based on the level of judgment associated with inputs used to measure their fair values and the level of market price observability, as follows:

9


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.
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 99.7% of its portfolio from an independent pricing service. For 0.3% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of September 30, 2015.
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/Short-term bonds: 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 in active markets.
Options sold/Purchased options: Comprised of free-standing exchange listed derivatives that are actively traded and valued based on unadjusted 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 and commercial mortgage loans valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. The Company had holdings of $49.9 million and $32.5 million at September 30, 2015 and December 31, 2014, respectively, 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.

10


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.
Total return swaps: Valued based on multi-dimensional models using inputs such as interest rate yield curves, underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets, observable for substantially the full term of the contract.
Collateralized loan obligations: Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets.
Other asset-backed securities: Comprised of securities that are collateralized by non-mortgage assets, such as auto loans, valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets.
Secured notes payable: Valued based on underlying collateral and reset rates for similarly termed notes that are observable in the market.
Unsecured notes payable: Valued based on the unadjusted quoted price for similar notes in active markets.
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/Private equity funds: 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 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 (losses) gains in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.

11


The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2015 and December 31, 2014, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
 
 
September 30, 2015
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
25,150

 
$
0

 
$

 
$
25,150

Municipal securities

 
2,495,881

 

 
2,495,881

Mortgage-backed securities

 
63,045

 

 
63,045

Corporate securities

 
248,246

 

 
248,246

Collateralized loan obligations

 
49,665

 

 
49,665

Other asset-backed securities

 
4,877

 

 
4,877

Equity securities:
 
 
 
 
 
 
 
Common stock:
 
 
 
 
 
 
 
Public utilities
64,324

 

 

 
64,324

Banks, trusts and insurance companies
11,700

 

 

 
11,700

Industrial and other
186,172

 

 

 
186,172

Non-redeemable preferred stock

 
24,795

 

 
24,795

Private equity funds

 
0

 
11,696

 
11,696

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
59,996

 
2,005

 

 
62,001

Money market instruments
100,834

 
0

 

 
100,834

Total assets at fair value
$
448,176

 
$
2,888,514

 
$
11,696

 
$
3,348,386

Liabilities
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
Secured Notes
$

 
$
140,000

 
$

 
$
140,000

Unsecured Notes

 
150,000

 

 
150,000

Other liabilities:
 
 
 
 
 
 
 
Total return swaps

 
6,059

 

 
6,059

Options sold
266

 
0

 

 
266

Total liabilities at fair value
$
266


$
296,059

 
$

 
$
296,325


12


 
 
December 31, 2014
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
16,108

 

 

 
$
16,108

Municipal securities

 
2,275,455

 

 
2,275,455

Mortgage-backed securities

 
47,691

 

 
47,691

Corporate securities

 
256,930

 

 
256,930

Collateralized loan obligations

 
22,216

 

 
22,216

Equity securities:
 
 
 
 
 
 
 
Common stock:
 
 
 
 
 
 
 
Public utilities
105,485

 

 

 
105,485

Banks, trusts and insurance companies
9,757

 

 

 
9,757

Energy and other
257,356

 

 

 
257,356

Non-redeemable preferred stock

 
28,563

 

 
28,563

Private equity fund

 

 
11,719

 
11,719

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
69,999

 
18,362

 

 
88,361

Money market instruments
284,181

 

 

 
284,181

Total assets at fair value
$
742,886

 
$
2,649,217

 
$
11,719

 
$
3,403,822

Liabilities
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
Secured Notes
$

 
$
140,000

 
$

 
$
140,000

Unsecured Notes

 
150,000

 

 
150,000

Other liabilities:
 
 
 
 
 
 
 
Total return swaps

 
4,025

 

 
4,025

Options sold
194

 

 

 
194

Total liabilities at fair value
$
194

 
$
294,025

 
$

 
$
294,219


The following tables present a summary of changes in fair value of Level 3 financial assets and financial liabilities held at fair value:

 
Three Months Ended September 30,
 
2015
 
2014
 
Private Equity
Fund
 
Private Equity
Fund
 
(Amounts in thousands)
Beginning Balance
$
13,745

 
$
12,966

     Realized losses included in earnings
(2,049
)
 
(296
)
Settlement

 

Ending Balance
$
11,696

 
$
12,670

The amount of total losses for the period included in earnings attributable to assets still held at September 30
$
(2,049
)
 
$
(296
)


13


 
 
Nine Months Ended September 30,
 
2015
 
2014
 
Private Equity
Fund
 
Collateralized
Debt Obligations
 
Private Equity
Fund
 
(Amounts in thousands)
Beginning Balance
$
11,719

 
$
4,302

 
$
12,548

     Realized (losses) gains included in earnings
(2,910
)
 
(755
)
 
122

Reclassification from other assets
2,911

 

 

     Sales

 
(3,547
)
 

Settlement
(24
)
 

 

Ending Balance
$
11,696

 
$
0

 
$
12,670

The amount of total (losses) gains for the period included in earnings attributable to assets still held at September 30
$
(2,910
)
 
$

 
$
122

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the nine months ended September 30, 2015 and 2014.
At September 30, 2015, the Company did not have any nonrecurring fair value 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.

The Company also enters into derivative contracts to enhance returns on its investment portfolio.
On February 13, 2014, Fannette Funding LLC (“FFL”), a special purpose investment vehicle, entered into a total return swap agreement with Citibank. Under the total return swap agreement, FFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest equal to LIBOR plus 135 basis points on the outstanding notional amount of the underlying obligations, which was approximately $115 million as of September 30, 2015. The total return swap is secured by approximately $20 million of U.S. Treasuries and $10 million of cash as collateral, which are included in short-term investments and cash, respectively, on the consolidated balance sheets. The agreement had an initial term of one year, subject to annual renewal, and was renewed for an additional one-year term expiring February 13, 2016.
On August 9, 2013, Animas Funding LLC (“AFL”), a special purpose investment vehicle, entered into a three-year total return swap agreement with Citibank. Under the total return swap agreement, AFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest equal to LIBOR plus 120 basis points on the outstanding notional amount of the underlying obligations, which was approximately $128 million as of September 30, 2015. The total return swap is secured by approximately $40 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets.
Fair value amounts, and (losses) gains on derivative instruments
The following tables present the location and amounts of derivative fair values in the consolidated balance sheets and derivative (losses) gains in the consolidated statements of operations:
 
 
Asset Derivatives
 
Liability Derivatives
 
September 30, 2015
 
December 31, 2014
 
September 30, 2015
 
December 31, 2014
 
(Amount in thousands)
Total return swaps - Other liabilities
$

 
$

 
$
6,059

 
$
4,025

Options sold - Other liabilities

 

 
266

 
194

Total derivatives
$

 
$

 
$
6,325

 
$
4,219



14


 
(Losses) Gains Recognized in Income
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(Amounts in thousands)
Total return swaps - Net realized investment losses
$
(4,422
)
 
$
(3,090
)
 
$
(710
)
 
$
(482
)
Options sold - Net realized investment gains
695

 
1,627

 
2,219

 
2,681

Total
$
(3,727
)
 
$
(1,463
)
 
$
1,509

 
$
2,199

Most options sold 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 options sold, see Note 5.
7. Goodwill and Other Intangible Assets
Goodwill
There were no changes in the carrying amount of goodwill for the nine months ended September 30, 2015. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during any of the periods presented.
Other Intangible Assets
The following table presents the components of other intangible assets as of September 30, 2015 and December 31, 2014:
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
 
Useful Lives
 
(Amounts in thousands)
 
(in years)
As of September 30, 2015:
 
 
 
 
 
 
 
Customer relationships
$
51,755

 
$
(33,084
)
 
$
18,671

 
11
Trade names
15,400

 
(4,331
)
 
11,069

 
24
Technology
4,300

 
(2,902
)
 
1,398

 
10
Insurance license
1,400

 
0

 
1,400

 
Indefinite
Total other intangible assets, net
$
72,855

 
$
(40,317
)
 
$
32,538

 
 
 
 
 
 
 
 
 
 
As of December 31, 2014:
 
 
 
 

 
 
Customer relationships
$
51,755

 
$
(29,402
)
 
$
22,353

 
11
Trade names
15,400

 
(3,850
)
 
11,550

 
24
Technology
4,300

 
(2,580
)
 
1,720

 
10
Total other intangible assets, net
$
71,455

 
$
(35,832
)
 
$
35,623

 
 
Other intangible assets are amortized on a straight-line basis over their useful lives. Other intangible assets amortization expense was $1.5 million for each of the three months ended September 30, 2015 and 2014, and $4.5 million for each of the nine months ended September 30, 2015 and 2014.

15


The following table presents the estimated future amortization expense of other intangible assets as of September 30, 2015:
 
Year
 
Amortization Expense
 
 
(Amounts in thousands)
Remainder of 2015

$
1,495

2016
 
5,980

2017
 
5,253

2018
 
5,239

2019
 
4,809

Thereafter
 
8,362

Total
 
$
31,138

    
The Company recognized $1.4 million of intangible assets for a state insurance license related to the acquisition of Workmen's Automobile Insurance Company. See Note 10 for the acquisition's cost allocation.
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during any of the periods presented.
8. Share-Based Compensation
Share-based compensation expense for all share-based payment awards granted or modified 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 the grant-date assumptions and weighted-average fair values.
The Company adopted the 2015 Incentive Award Plan (the “2015 Plan”) in 2015 as described fully on Form S-8 filed in February 2015 with the Securities and Exchange Commission, and which was approved at the Company's Annual Meeting of Shareholders in May 2015. 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 under the 2015 Plan for 2015, and under the Company’s 2005 Equity Incentive Award Plan for 2014 and 2013 as follows:
 
Grant Year
 
2015
 
2014
 
2013
Three-year performance period ending December 31,
2017

 
2016

 
2015

Vesting shares, target (net of forfeited)
96,750

 
85,500

 
78,500

Vesting shares, maximum (net of forfeited)
181,406

 
160,313

 
176,625

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 performance during the performance period achieves the threshold established by the Compensation Committee of the Company’s Board of Directors. Vesting of grants will be based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. As of September 30, 2015, 1,000, 8,000 and 6,000 target restricted stock units granted in 2015, 2014 and 2013, respectively, were forfeited because the recipients are no longer employed by the Company.
The fair value of each restricted share grant was 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 will be recognized and any recognized compensation cost will be reversed.
9. Income Taxes
For financial statement purposes, the Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return only if, the positions are “more-likely-than-not” sustainable. Once this threshold has been met, the Company’s measurement of its expected tax benefits is recognized in its financial statements.
There was a $0.2 million decrease to the total amount of unrecognized tax benefit related to tax uncertainties during the nine months ended September 30, 2015. The decrease was the result of tax positions taken regarding state tax apportionment issues based on management’s best judgment given the facts, circumstances, and information available at the reporting date. The Company

16


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 with the Internal Revenue Service and the taxing authorities of various states. Tax years that remain subject to examination by major taxing jurisdictions are 2012 through 2014 for federal taxes, and 2003 through 2014 for California state taxes. The Company is currently under examination by the California Franchise Tax Board (“FTB”) for tax years 2003 through 2013. The FTB issued Notices of Proposed Assessments to the Company for tax years 2003 through 2010, which the Company formally protested. The proposed adjustments for tax years 2003 through 2006 were affirmed following an administrative protest process with the FTB examination. The Company is in settlement discussions with the FTB. If a reasonable settlement is not reached, the Company intends to pursue other options, including a formal hearing with the State Board of Equalization or litigation in superior court. Management believes that the resolution of these examinations and assessments will not have a material impact on the 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 September 30, 2015, the Company’s deferred income taxes were in a net asset position, which included a combination of ordinary and capital deferred tax benefits. In assessing the Company’s ability to realize 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 character within the carryback and carryforward periods available under the tax law. Management considers the 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. Acquisition
Pursuant to an October 22, 2014 Stock Purchase Agreement, on January 2, 2015, the Company purchased all the issued and outstanding shares of Workmen's Automobile Insurance Company ("WAIC"), a California domiciled property and casualty insurance company. The Company paid $8 million in cash for the shares of WAIC, of which $2 million has been withheld in escrow for up to three years as security for any loss development on claims incurred on or prior to June 30, 2014. Based on its most recent evaluation of the claims reserves for WAIC for loss incurred on or prior to June 30, 2014, the Company estimates that it will recover the $2 million held in escrow and, therefore, the Company has deducted it from cash consideration to arrive at the fair value of total consideration transferred. In accordance with regulatory approval requirements, the Company made a $15 million cash capital contribution to WAIC on January 12, 2015.
The total cost of the acquisition has been allocated to the assets acquired and the liabilities assumed based upon estimates of their fair values at the acquisition date.

17


The following table summarizes the consideration paid for WAIC and the allocation of the purchase price:
 
January 2, 2015
 
(Amounts in thousands)
Consideration
 
Cash
$
8,000

Less: Amount held in escrow
2,000

Fair value of total consideration transferred
$
6,000

 
 
Acquisition-related costs
$
231

Recognized amounts of identifiable assets acquired and liabilities assumed
 
Total assets
$
31,078

Total liabilities
(26,478
)
Total identifiable net assets
4,600

Intangible asset - state insurance license
1,400

Total
$
6,000

The fair value of the total assets acquired includes cash, investments, receivables, deferred taxes, other assets, and fixed assets. The fair value of the total liabilities assumed includes loss and loss adjustment expenses, unearned premiums, accounts payable, and other accrued liabilities.
The intangible asset has an indefinite life. See Note 7 for further discussion.
The following table reflects the amount of revenue and net income of WAIC included in the Company's consolidated statement of operations for the nine months ended September 30, 2015:
 
Nine Months Ended September 30, 2015
 
(Amounts in thousands)
WAIC
 
Revenue (1)
$
18,538

Net loss
$
(3,606
)
____________
(1) Includes net premiums earned, net investment income, and net realized investment gains/losses.
11. 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, 2014.
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. 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, 2014.

18



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 non-California business; the impact of potential third party “bad-faith” legislation, changes in laws, regulations or new interpretations of existing laws and regulations, tax position challenges by the Franchise Tax Board, 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 insurance policies; the investment yields the Company is able to obtain on its investments 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, including those which may be related to climate change, 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 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. U.S. generally accepted accounting principles ("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 Part I, Item 1A. Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 and in Part II. Item 1A. Risk Factors of this Quarterly Report on Form 10-Q.
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

19


of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a significant 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 14 insurance subsidiaries (“Insurance Companies”) in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, 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, together with its agent relationships, provide the Company with competitive advantages because they allow the Company to charge lower prices while realizing better margins than many competitors.
The following table presents direct premiums written, by state and line of business, during the nine months ended September 30, 2015 and 2014 :
Nine Months Ended September 30, 2015
(Dollars in thousands)
 
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
1,461,576

 
$
247,871

 
$
58,538

 
$
73,671

 
$
1,841,656

 
81.3
%
Florida 
115,808

 
8

 
20,578

 
725

 
137,119

 
6.1
%
Other states (1)
185,710

 
52,952

 
35,655

 
10,993

 
285,310

 
12.6
%
Total
$
1,763,094

 
$
300,831

 
$
114,771

 
$
85,389

 
$
2,264,085

 
100.0
%
 
77.9
%
 
13.3
%
 
5.1
%
 
3.7
%
 
100.0
%
 
 
Nine Months Ended September 30, 2014
(Dollars in thousands)
 
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
1,395,236

 
$
226,833

 
$
50,645

 
$
61,249

 
$
1,733,963

 
80.5
%
Florida
100,706

 
7

 
19,717

 
4,798

 
125,228

 
5.8
%
Other states (1)
182,127

 
55,405

 
30,956

 
25,905

 
294,393

 
13.7
%
Total
$
1,678,069

 
$
282,245

 
$
101,318

 
$
91,952

 
$
2,153,584

 
100.0
%
 
77.9
%
 
13.1
%
 
4.7
%
 
4.3
%
 
100.0
%
 
 

(1) No individual state accounts for more than 5% of total direct premiums written.




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.

20


The following table presents a summary of current financial and market conduct examinations:
 
State
  
Exam Type
  
Period Under Review
  
Status
GA
 
Financial
 
2011 to 2013
 
Fieldwork completed. Awaiting final report.
CA
 
Market Conduct
 
2013 to 2014
 
Fieldwork completed. Awaiting final report.
NJ
 
Market Conduct
 
2013 to 2014
 
Received final report.
CA
 
Special Investigation Unit Performance
 
2012 to 2013
 
Received final report.
CA
 
Rating and Underwriting
 
2014
 
Fieldwork began in July 2014

During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company. None of the findings reported to date is expected to be material to the Company’s financial position.
The California DOI approved a 6.4% rate increase on the Company’s California preferred private passenger automobile line of business, which represents approximately 50% of the Company's total net premium earned.  The rate increase was implemented in May 2015. In addition, the California DOI approved a 6.9% rate increase for its California standard private passenger automobile line of business, which represents approximately 15% of the Company’s total net premiums earned.  The rate increase was implemented in August 2015.
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 included allegations of noncompliance with applicable California insurance law and sought to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and reserved the right to 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. On March 2, 2015, MIC, MCC, and CAIC entered into an agreement with the California DOI, pursuant to which all allegations in the 2010 NNC were settled for $1 million, which was subsequently paid.
In March 2006, the California DOI issued an Amended 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 action sought to impose a fine for each policy for which the Company allegedly permitted an agent to charge a broker fee, a penalty for each time the Company allegedly used a misleading advertisement, and to suspend certificates of authority for a period of one year. In January 2012, an Administrative Law Judge (“ALJ”) bifurcated the 2004 NNC between (a) the California DOI’s order to show cause, in which the California DOI asserted the false advertising allegations, and (b) the California DOI’s notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. Following an evidentiary hearing on the rate allegations in April 2013, and an unsuccessful mediation, the ALJ submitted a proposed decision on the rating portion of the 2004 NNC. The ALJ found that from the period July 1, 1996 through 2006, Mercury’s “brokers” were actually operating as “de facto agents” and that the charging of “broker fees” by those producers constituted the charging of “premium” in excess of the Company’s approved rates, and recommended a civil penalty in the amount of $27,593,550 against the Company. On January 7, 2015, the California Insurance Commissioner issued an order (the “Order”) adopting the ALJ’s proposed decision and imposing the proposed penalty. The Company paid the $27,593,550 penalty in March 2015 without waiving its right to challenge the Order in court. On February 9, 2015, the Company filed a Petition for Writ of Administrative Mandamus and Complaint for Declaratory Relief (the “Writ”) in the Orange County Superior Court seeking, among other things, to vacate the Order and the monetary penalty, and to declare as invalid the ALJ’s and the Insurance Commissioner's interpretation of certain provisions of the California Insurance Code. Subsequent to the filing of the Writ, a consumer group petitioned and was granted the right to intervene in the Superior Court action. The Company filed an amended Writ on September 11, 2015, adding a request for the return of the penalty. The court has scheduled the matter for hearing on March 14, 2016, and the Company has filed its opening brief. The Company has had preliminary discussions with the California DOI regarding the false advertising portion of the case, and a status conference is scheduled for January 6, 2016.
The Company denies the allegations and findings in the 2004 NNC, and believes that no monetary penalties are warranted. The Company intends to vigorously defend itself against the allegations and findings, to seek to have the Order vacated and to pursue recovery of the $27,593,550 penalty that was accrued in 2014 and paid in 2015 plus any interest that has accrued as a result of the payment of the penalty, unless a reasonable settlement can be reached. The Company has accrued a liability for the estimated cost to continue to defend itself and recover the penalty paid.

21


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, 2014.
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. 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, 2014.
D. Critical Accounting Policies and Estimates
Losses and loss adjustment expenses reserves ("loss reserves")
Preparation of the Company’s consolidated financial statements requires management’s 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 loss 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 independent actuarial consultants to review the Company’s loss reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultants for GAAP reporting or periodic 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 as part of its loss reserve analysis. When deciding among methods to use, 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 loss 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.
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 loss 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 September 30, 2015 and December 31, 2014, the Company recorded its point estimate of approximately $1.13 billion and $1.09 billion, respectively, in losses and loss adjustment expenses liabilities, which include approximately $428 million and $441 million, respectively, of incurred but not reported loss reserves (“IBNR”). 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 September 30, 2015 and December 31, 2014, 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

22


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 loss 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 nine months ended September 30, 2015, the Company reported favorable development of approximately $3 million on the 2014 and prior accident years’ losses and loss adjustment expenses reserves, which at December 31, 2014 totaled approximately $1.09 billion. The favorable development in 2015 came primarily from California personal automobile lines of business, which was partially offset by adverse development in other states.
For the nine months ended September 30, 2015, the Company recorded catastrophe losses of approximately $11 million which were primarily related to tornadoes in Oklahoma and severe storms in the Midwest and Texas.
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, 2014.
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
Financial instruments recorded in the consolidated balance sheets include investments, receivables, options sold, total return swaps, accounts payable, and secured and unsecured 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 described 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. 99.7% of the fair value of financial instruments held at September 30, 2015 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 by financial instrument. Observable market prices and pricing parameters of a 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 because they are less actively traded currently or in future periods. 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 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 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 are not actively quoted.
Income Taxes
At September 30, 2015, the Company’s deferred income taxes were in a net asset position mainly due to deferred tax assets generated by unearned premiums, expense accruals, loss reserve discounting, and alternative minimum tax credit carryforwards. These deferred tax assets were substantially offset by deferred tax liabilities resulting from deferred acquisition costs and unrealized gains on securities held. 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 the Company’s deferred tax assets which are ordinary in character takes into consideration the

23


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, tax-planning strategies available to generate future taxable capital gains, and the Company’s capacity to absorb capital losses carried back to prior years, each of which would contribute to the realization of deferred tax benefits. The Company has significant unrealized gains in its investment portfolio that could be realized through asset dispositions, at management’s discretion. In addition, the Company expects to hold certain 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. Management believes its long-term time horizon for holding these securities allows it to avoid any forced sales prior to maturity. Further, the Company has the capability to generate additional realized capital gains by entering into sale-leaseback transactions using one or more of its appreciated real estate holdings. Finally, the Company has the capacity to recoup capital deferred tax assets through tax capital loss carryback claims for taxes paid within permitted carryback periods.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations and believes 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 generated during future periods. By prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability 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 nine months ended September 30, 2015 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, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate for the nine months ended September 30, 2015 was (9.5)%, compared to 27.8% for the same period in 2014. The decrease in the effective tax rate is principally due to a $229 million decrease in total pre-tax income for the nine months ended September 30, 2015 compared to the total pre-tax income for the same period in 2014, while tax-exempt investment income, a component of total pre-tax income, remained relatively consistent. The Company's effective tax rate for the nine months ended September 30, 2015 was lower than the statutory tax rate primarily as a result of tax-exempt investment income earned.
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 the 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.
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 sheets and are computed monthly on a 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.


24




RESULTS OF OPERATIONS
Three Months Ended September 30, 2015 compared to Three Months Ended September 30, 2014
Revenue
Net premiums written and net premiums earned for the three months ended September 30, 2015 increased 8.2% and 5.7%, respectively, from the corresponding period in 2014. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile line of business and growth in the number of homeowner policies written in California and private passenger automobile in several states outside of California.
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 periods presented and earned on a pro-rata basis over the term of the policies.

The following table presents a reconciliation of total net premiums written to net premiums earned:
 
 
Three Months Ended September 30,
 
2015
 
2014
 
(Amounts in thousands)
Net premiums written
$
778,921

 
$
720,153

Change in net unearned premium
(33,401
)
 
(14,916
)
Net premiums earned
$
745,520

 
$
705,237

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, expense, and combined ratios determined in accordance with GAAP:
 
 
Three Months Ended September 30,
 
2015
 
2014
Loss ratio
73.2
%
 
69.8
%
Expense ratio
26.0
%
 
26.9
%
Combined ratio
99.2
%
 
96.7
%
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The 2015 loss ratio includes approximately $1 million of catastrophe losses and approximately $2 million of unfavorable development on prior accident year loss reserves. The 2014 loss ratio includes approximately $1 million of catastrophe losses and $2 million of favorable development on prior accident year loss reserves. The loss ratio for the three months ended September 30, 2015 increased compared to the same period in 2014 primarily due to unfavorable loss reserve development, increased frequency and severity on California homeowners claims, and rising loss costs on the California private passenger automobile line of business.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The 2015 expense ratio decreased compared to the 2014 expense ratio primarily due to lower average commission rates paid to agents resulting from profitability-based adjustments to agent compensation.
Combined ratio is equal to loss ratio plus expense ratio and 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 $(3.0) million and $5.8 million for the three months ended September 30, 2015 and 2014, respectively. The $8.8 million decrease in income tax expense to an income tax benefit was primarily due to a $25 million reduction in total pre-tax income, while tax-exempt investment income, a component of total pre-tax income, remained relatively unchanged compared to the same period in 2014.

25


Investments
The following table presents the investment results of the Company:
 
Three Months Ended September 30,
 
2015
 
2014
 
(Dollars in thousands)
Average invested assets at cost (1)
$
3,278,469

 
$
3,237,993

Net investment income (2)
 
 
 
Before income taxes
$
30,898

 
$
32,564

After income taxes
$
27,115

 
$
28,677

Average annual yield on investments (2)
 
 
 
Before income taxes
3.8
%
 
4.0
%
After income taxes
3.3
%
 
3.5
%
Net realized investment losses
$
(26,286
)
 
$
(20,089
)
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each respective period.
(2)
Net investment income and average annual yield on investments decreased slightly due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher, with lower yielding investments purchased during low interest rate environments.

The following tables present the components of net realized investment (losses) gains included in net income:
 
Gains (Losses) Recognized in Net Income
 
Three Months Ended September 30, 2015
 
Sales
Changes in fair value 
Total
 
(Amounts in thousands)
Net realized investment losses
 
 
 
Fixed maturity securities (1)(2)
$
10

$
(1,602
)
$
(1,592
)
Equity securities (1)(3)
(4,032
)
(16,938
)
(20,970
)
Short-term investments (1)

2

2

Total return swaps
74

(4,496
)
(4,422
)
Options sold
753

(57
)
696

Total
$
(3,195
)
$
(23,091
)
$
(26,286
)
 
Gains (Losses) Recognized in Net Income
 
Three Months Ended September 30, 2014
 
Sales
Changes in fair value
Total
 
(Amounts in thousands)
Net realized investment losses
 
 
 
Fixed maturity securities (1)(2)
$
724

$
3,536

$
4,260

Equity securities (1)(3)
1,622

(23,995
)
(22,373
)
Short-term investments (1)
(444
)
(69
)
(513
)
Total return swap
497

(3,587
)
(3,090
)
Options sold
1,303

324

1,627

Total
$
3,702

$
(23,791
)
$
(20,089
)
__________ 
(1)
The changes in fair value of the investment portfolio result from the application of the fair value option.
(2)
The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio. The fair value decreases in 2015 were slightly affected by the increase in credit-related spreads during the three months ended September 30, 2015. The fair value increases in 2014 were primarily caused by the overall improvement in the municipal bond market.

26


(3)
In the 2015 period, the decreases in the fair value of equity securities were primarily due to a decline in the value of the Company’s holdings in industrial stocks and an overall decline in the equities markets. In the 2014 period, the decreases in fair value were primarily caused by the decline in the energy and utilities sectors.

Net Income
 
Three Months Ended September 30,
 
2015
 
2014
 
(Amounts in thousands, except per share data)
Net income
$
15,270

 
$
31,296

Basic average shares outstanding
55,164

 
55,002

Diluted average shares outstanding
55,178

 
55,014

Basic Per Share Data:
 
 
 
Net Income
$
0.28

 
$
0.57

Net realized investment losses, net of tax
$
(0.31
)
 
$
(0.24
)
Diluted Per Share Data:
 
 
 
Net Income
$
0.28

 
$
0.57

Net realized investment losses, net of tax
$
(0.31
)
 
$
(0.24
)

Nine Months Ended September 30, 2015 compared to Nine Months Ended September 30, 2014
Revenue
Net premiums written and net premiums earned for the nine months ended September 30, 2015 increased 5.1% and 5.3%, respectively, from the corresponding period in 2014. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile line of business and growth in the number of homeowner policies written in California and private passenger automobile in several states outside of California.
 
The following table presents a reconciliation of total net premiums written to net premiums earned:
 
 
Nine Months Ended September 30,
 
2015
 
2014
 
(Amounts in thousands)
Net premiums written
$
2,252,961

 
$
2,143,605

Change in net unearned premium
(55,158
)
 
(56,778
)
Net premiums earned
$
2,197,803

 
$
2,086,827

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, expense, and combined ratios determined in accordance with GAAP:
 
 
Nine Months Ended September 30,
 
2015
 
2014
Loss ratio
71.9
%
 
69.6
%
Expense ratio
27.0
%
 
26.8
%
Combined ratio
98.9
%
 
96.4
%
The 2015 loss ratio includes approximately $11 million of catastrophe losses and approximately $3 million of favorable development on prior accident year loss reserves. The 2014 loss ratio includes approximately $7 million of catastrophe losses and $10 million of favorable development on prior accident year loss reserves. The loss ratio for the nine months ended September 30, 2015 increased compared to the same period in 2014 primarily due to higher catastrophe losses, less favorable development on

27


prior accident years' loss reserves, and increasing loss frequency and severity on the California private passenger automobile line of business.
The increase in expense ratio resulted primarily from an increase in advertising expenses as a result of the national advertising campaign launched in 2015.
Income tax (benefit) expense was $(4.4) million and $76.7 million for the nine months ended September 30, 2015 and 2014, respectively. The $81.1 million decrease in income tax expense to an income tax benefit was primarily due to a $229 million reduction in total pre-tax income, while tax-exempt investment income, a component of total pre-tax income, remained relatively unchanged compared to the same period in 2014.
Investments
The following table presents the investment results of the Company:
 
Nine Months Ended September 30,
 
2015
 
2014
 
(Dollars in thousands)
Average invested assets at cost (1)
$
3,296,775

 
$
3,185,457

Net investment income (2)
 
 
 
Before income taxes
$
94,101

 
$
93,656

After income taxes
$
82,320

 
$
83,227

Average annual yield on investments (2)
 
 
 
Before income taxes
3.8
%
 
3.9
%
After income taxes
3.3
%
 
3.5
%
Net realized investment (losses) gains
$
(75,595
)
 
$
102,813

(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each respective period.
(2)
Net investment income before income taxes increased due to higher average invested asset balances. Net investment income and average annual yield on investments after income taxes decreased slightly due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher, with lower yielding investments purchased during low interest rate environments.

The following tables present the components of net realized investment (losses) gains included in net income:
 
Gains (Losses) Recognized in Net Income
 
Nine Months Ended September 30, 2015
 
Sales
Changes in fair value 
Total
 
(Amounts in thousands)
Net realized investment (losses) gains
 
 
 
Fixed maturity securities (1)(2)
$
214

$
(30,609
)
$
(30,395
)
Equity securities (1)(3)
(11,718
)
(34,234
)
(45,952
)
Short-term investments (1)
(1,396
)
638

(758
)
Total return swaps
1,324

(2,034
)
(710
)
Options sold
2,203

17

2,220

Total
$
(9,373
)
$
(66,222
)
$
(75,595
)

28


 
(Losses) Gains Recognized in Net Income
 
Nine Months Ended September 30, 2014
 
Sales
Changes in fair value
Total
 
(Amounts in thousands)
Net realized investment (losses) gains
 
 
 
Fixed maturity securities (1)(2)
$
(2,708
)
$
73,149

$
70,441

Equity securities (1)(3)
37,183

(6,355
)
30,828

Short-term investments (1)
(452
)
(211
)
(663
)
Total return swap
2,455

(2,937
)
(482
)
Options sold
2,427

262

2,689

Total
$
38,905

$
63,908

$
102,813

__________ 
(1)
The changes in fair value of the investment portfolio result from the application of the fair value option.
(2)
The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio. The fair value decreases in 2015 were adversely affected by the increase in market interest rates during the nine months ended September 30, 2015. The increases in 2014 were primarily caused by the overall improvement in the municipal bond market.
(3)
In the 2015 period, the decreases in the fair value of equity securities were primarily due to a decline in the value of the Company’s holdings in industrial stocks. In the 2014 period, the decreases in fair value were primarily caused by the decline in the energy and utilities sectors.

Net Income
 
Nine Months Ended September 30,
 
2015
 
2014
 
(Amounts in thousands, except per share data)
Net income
$
51,074

 
$
198,905

Basic average shares outstanding
55,154

 
54,986

Diluted average shares outstanding
55,172

 
54,995

Basic Per Share Data:
 
 
 
Net Income
$
0.93

 
$
3.62

Net realized investment (losses) gains, net of tax
$
(0.89
)
 
$
1.22

Diluted Per Share Data:
 
 
 
Net Income
$
0.93

 
$
3.62

Net realized investment (losses) gains, net of tax
$
(0.89
)
 
$
1.22


LIQUIDITY AND CAPITAL RESOURCES
A. Cash Flows
The Company has generated positive cash flow from operations for more than twenty consecutive years and 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 $458.0 million at September 30, 2015 as well as $100 million of credit available on a $250 million revolving credit facility, 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 nine months ended September 30, 2015 was $148.7 million, a decrease of $50.8 million compared to the corresponding period in 2014. The decrease was primarily due to the increase in paid losses, loss

29


adjustment expenses, and operating expenses, which include the $27.6 million penalty assessed by California DOI as discussed in “Regulatory and Litigation Matters” in “Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations”; partially offset by an increase in premiums collections. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders.
The following table presents the estimated fair value of the Company’s fixed maturity securities at September 30, 2015 by contractual maturity in the next five years:
 
 
Fixed Maturities
 
(Amounts in thousands)
Due in one year or less
$
77,659

Due after one year through two years
121,267

Due after two years through three years
65,949

Due after three years through four years
72,221

Due after four years through five years
65,538

Total due within five years
$
402,634

B. Reinsurance
The Company is party to a Catastrophe Reinsurance Treaty (“Treaty”) that is effective through June 30, 2016. The Treaty provides for $100 million coverage on a per occurrence basis after covered catastrophe losses exceed a $100 million Company retention limit, excludes coverage in Florida, and limits certain coverages to 37% of catastrophe losses resulting from earthquakes and fire following earthquakes. The annual premium is $4.1 million.
C. 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 enables 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.

30


The following table presents the composition of the total investment portfolio of the Company at September 30, 2015:
 
 
Cost (1)
 
Fair Value
 
(Amounts in thousands)
Fixed maturity securities:
 
 
 
U.S. government bonds and agencies
$
25,052

 
$
25,150

Municipal securities
2,406,829

 
2,495,881

Mortgage-backed securities
61,363

 
63,045

Corporate securities
254,722

 
248,246

Collateralized loan obligations
49,615

 
49,665

Other asset-backed securities
4,860

 
4,877

 
2,802,441

 
2,886,864

Equity securities:
 
 
 
Common stock:
 
 
 
Public utilities
61,275

 
64,324

Banks, trusts and insurance companies
10,052

 
11,700

Industrial and other
198,043

 
186,172

Non-redeemable preferred stock
25,635

 
24,795

Private equity funds
12,888

 
11,696

 
307,893

 
298,687

Short-term investments
162,834

 
162,835

Total investments
$
3,273,168

 
$
3,348,386


(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.
At September 30, 2015, 72.9% of the Company’s total investment portfolio at fair value and 84.5% 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 dividend received deduction, and private equity funds. At September 30, 2015, 61.9% 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.
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 maturities of the overall bond portfolio were 13.3 years and 12.6 years (12.9 years and 11.4 years when including short-term instruments) at September 30, 2015 and December 31, 2014, respectively. 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 maturities of the overall bond portfolio were 3.6 years and 3.4 years (3.4 years and 3.1 years when including short-term instruments) at September 30, 2015 and December 31, 2014, respectively, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio reflecting anticipated early calls were 2.8 years and 2.8 years (2.7 years and 2.6 years when including short-term instruments) at September 30, 2015 and December 31, 2014, respectively, including collateralized mortgage obligations with a modified duration of 1.8 years at both September 30, 2015 and December 31, 2014, 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. As it measures four factors (maturity, coupon rate, yield

31


and call terms) which determine sensitivity to changes in interest rate, modified duration is considered a better indicator of price volatility than simple maturity alone.
Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of A+, at fair value, at September 30, 2015, consistent with the average rating at December 31, 2014. To calculate the weighted-average credit quality ratings as 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 security’s average of ratings assigned by nationally recognized securities rating organizations.
Tax-exempt bond holdings are broadly diversified geographically. Taxable holdings consist principally of investment grade issues. At September 30, 2015, fixed maturity holdings rated below investment grade and non-rated bonds totaled $38.7 million and $5.5 million, respectively, at fair value, and represented 1.3% and 0.2%, respectively, of total fixed maturity securities. At December 31, 2014, fixed maturity holdings rated below investment grade and non-rated bonds totaled $37.2 million and $10.8 million, respectively, at fair value, and represented 1.4% and 0.4%, respectively, of total fixed maturity securities.
Credit ratings for the Company’s fixed maturity portfolio were stable during the nine months ended September 30, 2015, with 97.5% of fixed maturity securities at fair value experiencing no change in their overall rating. 0.4% and 2.1% of fixed maturity securities at fair value experienced upgrades and downgrades, respectively, during the period. The downgrades were slight and still within the investment grade portfolio during the nine months ended September 30, 2015.

32


The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at fair value:
 
September 30, 2015
 
(Dollars in thousands)
 
AAA(1)
 
AA(1)(2)
 
A(1)(2)
 
BBB(1)(2)
 
Non-Rated/Other(1)
 
Total
Fair
Value(1)
U.S. government bonds and agencies:
 
 
 
 
 
 
 
 
 
 
 
Treasuries
$
16,891

 
$

 
$

 
$

 
$

 
$
16,891

Government agency
8,259

 

 

 

 

 
8,259

Total
25,150

 

 

 

 

 
25,150

 
100.0
%
 
%
 
%
 
%
 
%
 
100.0
%
Municipal securities:
 
 
 
 
 
 
 
 
 
 
 
Insured
6,475

 
371,066

 
461,923

 
6,938

 
5,140

 
851,542

Uninsured
233,403

 
613,711

 
606,509

 
187,380

 
3,336

 
1,644,339

Total
239,878

 
984,777

 
1,068,432

 
194,318

 
8,476

 
2,495,881