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EX-31.2 - EXHIBIT 31.2 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit312.htm
EX-31.1 - EXHIBIT 31.1 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit311.htm
EX-15.2 - EXHIBIT 15.2 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit152.htm
EX-32.1 - EXHIBIT 32.1 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit321.htm
EX-15.1 - EXHIBIT 15.1 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit151.htm
EX-32.2 - EXHIBIT 32.2 - MERCURY GENERAL CORPmcy-2016331x10qxexhibit322.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 March 31, 2016
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 April 28, 2016, the Registrant had issued and outstanding an aggregate of 55,254,171 shares of its Common Stock.
 





MERCURY GENERAL CORPORATION
INDEX TO FORM 10-Q
 
 
 
 
 
 
Page
 
 
 
 
Item 1
 
Consolidated Balance Sheets as of March 31, 2016 and December 31, 2015
 
Consolidated Statements of Operations for the Three Months Ended March 31, 2016 and 2015
 
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2016 and 2015
 
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)
 
 
March 31, 2016
 
December 31, 2015
 
(unaudited)
 
 
ASSETS
 
 
 
Investments, at fair value:
 
 
 
Fixed maturity securities (amortized cost $2,855,224; $2,804,275)
$
2,942,514

 
$
2,880,003

Equity securities (cost $326,875; $313,528)
335,616

 
315,362

Short-term investments (cost $155,201; $185,353)
155,185

 
185,277

Total investments
3,433,315

 
3,380,642

Cash
235,109

 
264,221

Receivables:
 
 
 
Premium
465,737

 
436,621

Accrued investment income
40,768

 
42,747

Other
21,176

 
21,925

Total receivables
527,681

 
501,293

Deferred policy acquisition costs
203,565

 
201,762

Fixed assets, net
158,412

 
157,131

Current income taxes
11,907

 
9,041

Deferred income taxes
18,637

 
23,231

Goodwill
42,796

 
42,796

Other intangible assets, net
30,182

 
31,702

Other assets
30,459

 
16,826

Total assets
$
4,692,063

 
$
4,628,645

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Losses and loss adjustment expense reserves
$
1,174,968

 
$
1,146,688

Unearned premiums
1,078,571

 
1,049,314

Notes payable
290,000

 
290,000

Accounts payable and accrued expenses
116,765

 
122,571

Deferred income taxes

 

Other liabilities
224,381

 
199,187

Total liabilities
2,884,685

 
2,807,760

Commitments and contingencies


 


Shareholders’ equity:
 
 
 
Common stock without par value or stated value:
       Authorized 70,000 shares; issued and outstanding 55,254; 55,164
93,971

 
90,985

Additional paid-in capital
3,311

 
8,870

Retained earnings
1,710,096

 
1,721,030

Total shareholders’ equity
1,807,378

 
1,820,885

Total liabilities and shareholders’ equity
$
4,692,063

 
$
4,628,645

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 March 31,
 
2016
 
2015
Revenues:
 
 
 
Net premiums earned
$
767,085

 
$
720,737

Net investment income
29,655

 
31,506

Net realized investment gains (losses)
25,057

 
(9,961
)
Other
2,123

 
2,266

Total revenues
823,920

 
744,548

Expenses:
 
 
 
Losses and loss adjustment expenses
594,082

 
514,400

Policy acquisition costs
141,560

 
133,847

Other operating expenses
61,294

 
65,692

Interest
950

 
750

Total expenses
797,886

 
714,689

Income before income taxes
26,034

 
29,859

Income tax expense
2,711

 
3,694

Net income
$
23,323

 
$
26,165

Net income per share:
 
 
 
Basic
$
0.42

 
$
0.47

Diluted
$
0.42

 
$
0.47

Weighted average shares outstanding:
 
 
 
Basic
55,201

 
55,139

Diluted
55,208

 
55,159

Dividends paid per share
$
0.6200

 
$
0.6175





















 
See accompanying Condensed Notes to Consolidated Financial Statements.

4



MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 
Three Months Ended March 31,
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net income
$
23,323

 
$
26,165

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
6,357

 
7,107

Net realized investment (gains) losses
(25,057
)
 
9,961

Bond amortization, net
6,521

 
5,213

Excess tax benefit from exercise of stock options
(904
)
 
(82
)
Increase in premium receivables
(29,116
)
 
(22,214
)
Change in current and deferred income taxes
2,632

 
(6,102
)
Increase in deferred policy acquisition costs
(1,803
)
 
(1,899
)
Increase (decrease) in losses and loss adjustment expense reserves
28,280

 
(4,597
)
Increase in unearned premiums
29,258

 
18,866

Decrease in accounts payable and accrued expenses
(5,128
)
 
(38,258
)
Share-based compensation
(3,477
)
 
1,043

Changes in other payables
1,598

 
7,543

Other, net
13,195

 
8,706

Net cash provided by operating activities
45,679

 
11,452

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Fixed maturities available-for-sale in nature:
 
 
 
Purchases
(386,628
)
 
(374,582
)
Sales
149,744

 
16,733

Calls or maturities
180,125

 
87,365

Equity securities available-for-sale in nature:
 
 
 
Purchases
(163,408
)
 
(246,085
)
Sales
154,273

 
267,175

Changes in securities payable and receivable
(982
)
 
13,638

Net decrease in short-term investments and purchased options
29,086

 
198,620

Purchase of fixed assets
(4,596
)
 
(5,928
)
Sale of fixed assets
2

 
58

Business acquisition, net of cash acquired

 
7,771

Other, net
947

 
1,142

Net cash used in investing activities
(41,437
)
 
(34,093
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Dividends paid to shareholders
(34,257
)
 
(34,055
)
Excess tax benefit from exercise of stock options
903

 
82

Proceeds from stock options exercised

 
1,283

Net cash used in financing activities
(33,354
)
 
(32,690
)
Net decrease in cash
(29,112
)
 
(55,331
)
Cash:
 
 
 
Beginning of the year
264,221

 
289,907

End of period
$
235,109

 
$
234,576

SUPPLEMENTAL CASH FLOW DISCLOSURE
 
 
 
Interest paid
$
878

 
$
692

Income taxes paid
$
79

 
$
9,798


See accompanying Condensed Notes to Consolidated Financial Statements.

5


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, 2015.
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 March 31, 2016 and the results of operations 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, 2015. Readers are urged to review the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 for more complete descriptions and discussions. Operating results and cash flows for the three months ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016.
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 the 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, 2015.
Earnings per Share
Potentially dilutive securities representing approximately 77,000 and 49,000 shares of common stock for the three months ended March 31, 2016 and 2015, respectively, were excluded from the computation of diluted earnings per common share 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 $141.6 million and $133.8 million for the three months ended March 31, 2016 and 2015, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $15 million and $16 million for the three months ended March 31, 2016 and 2015, respectively.


6


2. Recently Issued Accounting Standards
In March 2016, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") 2016-09, "Compensation - Stock Compensation (Topic 718)," which simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. ASU 2016-09 becomes effective for the Company beginning January 1, 2017 and is required to be applied on a modified retrospective basis. The Company is evaluating the impact that ASU 2016-09 will have on its consolidated financial statements and related disclosures.
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)," which supersedes the guidance in Accounting Standards Codification (“ASC”) 840, "Leases." ASU 2016-02 requires a lessee to recognize lease assets and lease liabilities resulting from all leases. ASU 2016-02 retains the distinction between a finance lease and an operating lease. Lessor accounting is largely unchanged from ASC 840. ASU 2016-02 becomes effective for the Company beginning January 1, 2019. However, in transition, the Company will be required to recognize and measure leases at the beginning of the earliest period (the first quarter of 2017) using a modified retrospective approach.The Company is evaluating the effect that ASU 2016-02 will have on its consolidated financial statements and related disclosures.
In January 2016, the FASB issued ASU 2016-01, "Financial Instruments-Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities." The amendments in this ASU address certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01: (1) requires equity investments (except those accounted for under the equity method or those that result in the consolidation of the investee) to be measured at fair value with changes in the fair value recognized in net income; (2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (4) requires the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (5) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the notes to the financial statements and (6) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. ASU 2016-01 is effective for the Company beginning January 1, 2018. The Company does not anticipate that ASU 2016-01 will have a material impact on its consolidated financial statements and related disclosures.
In May 2015, the FASB issued ASU 2015-09, "Financial Services - Insurance (Topic 944), Disclosures About Short-Duration Contracts." ASU 2015-09 requires insurance entities to provide additional disclosures related to claims liabilities. The additional disclosure requirements for the annual reports include: (1) 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. ASU 2015-09 becomes effective for the Company beginning with the annual period ending December 31, 2016, and quarter periods beginning with the first quarter of 2017. 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.

In February 2015, the FASB issued ASU 2015-02, "Consolidation (Topic 810), Amendments to the Consolidation Analysis" 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 became effective on January 1, 2016 and did not have a material impact on the Company's consolidated financial statements. As in previous GAAP, consolidation analysis under ASU 2015-02 contains two primary consolidation models: the voting control model and the variable interest (“VIE”) model. An entity being evaluated for consolidation is required to first be subjected to the requirements of the VIE model. Only if the entity fails to meet the requirements to be consolidated under the VIE model, would the voting control consolidation model apply. The adoption of ASU 2015-02 did not have an impact on the Company's consolidated financial statements and related disclosures.
In May 2014, the FASB issued ASU 2014-09, "Revenue Recognition (Topic 606), Revenue from Contracts with Customers." ASU 2014-09 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

7


at the amount at which the entity expects to be entitled. In August 2015, the FASB issued ASU 2015-14, "Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date," which deferred the effective date of ASU 2014-09. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606), Principal versus Agent Considerations (Reporting Revenue Gross versus Net)." ASU 2016-08 requires an entity to determine whether it is providing the goods or services to a customer as the principal, or whether it is arranging for the goods or services to be provided to the customer by another party as the agent. ASU 2014-09 and ASU 2016-08 become effective for the Company beginning January 1, 2018. The Company is evaluating the impact that ASU 2014-09 and ASU 2016-08 will have on its consolidated financial statements and related 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 maturities, the carrying values of receivables and accounts payable approximate their fair market values. All investments are carried at fair value in the consolidated balance sheets.
The following table presents the estimated fair values of financial instruments:
 
 
March 31, 2016
 
December 31, 2015
 
(Amounts in thousands)
Assets
 
 
 
Investments
$
3,433,315

 
$
3,380,642

Liabilities
 
 
 
Options sold
$
262

 
$
260

Total return swaps
$
9,797

 
$
11,525

Secured notes
$
140,000

 
$
140,000

Unsecured note
$
150,000

 
$
150,000

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. See Note 4. Fair Value Option for additional information.
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 or currency in determining whether the Company has realized a 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. Liabilities for covered call options of $0.3 million were included in other liabilities at each of March 31, 2016 and December 31, 2015.
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 March 31, 2016 and December 31, 2015 based on models using inputs, such as interest rate yield curves and credit spreads, observable for substantially the full term of the contract.
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. Fair Value Measurement, 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. The fair values of the secured notes approximate their carrying values.

8


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. Fair Value Measurement, is based on the unadjusted quoted price for similar notes in active markets. The fair value of the unsecured note approximates its carrying value.
For additional disclosures regarding methods and assumptions used in estimating fair values, see Note 5. Fair Value Measurement.

4. Fair Value Option
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 primary reasons for electing the fair value option were simplification and cost-benefit considerations as well as the expansion of the use of fair value measurement by the Company consistent with the long-term measurement objectives of the FASB for accounting for financial instruments.
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 gains (losses) in the Company’s consolidated statements of operations, while interest and dividend income on investment holdings are recognized on an accrual basis at each measurement date and are included in net investment income in the Company’s consolidated statements of operations.
The following table presents gains (losses) due to changes in fair value of investments that are measured at fair value pursuant to application of the fair value option:
 
 
Three Months Ended March 31,
 
2016
 
2015
 
(Amounts in thousands)
Fixed maturity securities
$
11,563

 
$
1,251

Equity securities
6,907

 
(6,337
)
Short-term investments
61

 
202

Total
$
18,531

 
$
(4,884
)
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:
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.

9


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 March 31, 2016.
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 $44.8 million and $37.3 million at March 31, 2016 and December 31, 2015, 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.
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 automobile 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.

10


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.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair values:
 
 
March 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
21,939

 
$

 
$

 
$
21,939

Municipal securities

 
2,531,777

 

 
2,531,777

Mortgage-backed securities

 
56,532

 

 
56,532

Corporate securities

 
260,917

 

 
260,917

Collateralized loan obligations

 
51,520

 

 
51,520

Other asset-backed securities

 
19,829

 

 
19,829

Equity securities:
 
 
 
 
 
 
 
Common stock
301,768

 

 

 
301,768

Non-redeemable preferred stock

 
24,857

 

 
24,857

Private equity funds

 

 
8,991

 
8,991

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
70,380

 
6,056

 

 
76,436

Money market instruments
78,749

 

 

 
78,749

Total assets at fair value
$
472,836

 
$
2,951,488

 
$
8,991

 
$
3,433,315

Liabilities
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
Secured notes
$

 
$
140,000

 
$

 
$
140,000

Unsecured notes

 
150,000

 

 
150,000

Other liabilities:
 
 
 
 
 
 
 
Total return swaps

 
9,797

 

 
9,797

Options sold
262

 

 

 
262

Total liabilities at fair value
$
262


$
299,797

 
$

 
$
300,059


11


 
 
December 31, 2015
 
Level 1
 
Level 2
 
Level 3
 
Total
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
22,507

 
$

 
$

 
$
22,507

Municipal securities

 
2,505,040

 

 
2,505,040

Mortgage-backed securities

 
49,838

 

 
49,838

Corporate securities

 
243,372

 

 
243,372

Collateralized loan obligations

 
50,548

 

 
50,548

Other asset-backed securities

 
8,698

 

 
8,698

Equity securities:
 
 
 
 
 
 
 
Common stock
280,263

 

 

 
280,263

Non-redeemable preferred stock

 
24,668

 

 
24,668

Private equity fund

 

 
10,431

 
10,431

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
69,991

 
9,850

 

 
79,841

Money market instruments
105,436

 

 

 
105,436

Total assets at fair value
$
478,197

 
$
2,892,014

 
$
10,431

 
$
3,380,642

Liabilities
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
Secured notes
$

 
$
140,000

 
$

 
$
140,000

Unsecured notes

 
150,000

 

 
150,000

Other liabilities:
 
 
 
 
 
 
 
Total return swaps

 
11,525

 

 
11,525

Options sold
260

 

 

 
260

Total liabilities at fair value
$
260

 
$
301,525

 
$

 
$
301,785


The following table presents a summary of changes in fair value of Level 3 financial assets and financial liabilities:

 
Three Months Ended March 31,
 
2016
 
2015
 
Private Equity
Fund
 
Private Equity
Fund
 
(Amounts in thousands)
Beginning Balance
$
10,431

 
$
11,719

     Realized (losses) gains included in earnings
(1,440
)
 
802

Reclassification from Other assets

 
2,911

Ending Balance
$
8,991

 
$
15,432

The amount of total losses for the period included in earnings attributable to assets still held at March 31
$
(1,440
)
 
$
(802
)

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the three months ended March 31, 2016 and 2015.
At March 31, 2016, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.

12


6. Derivative Financial Instruments
The Company is exposed to certain risks relating to its ongoing business operations. The primary risk managed by using derivative instruments is equity price risk. Equity contracts (options sold) on various equity securities are intended to manage the price risk associated with forecasted purchases or sales of such securities.

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 formed and consolidated by the Company, 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 on the outstanding notional amount of the underlying obligations. The total return swap is secured by approximately $30 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets. The Company paid interest equal to LIBOR plus 145 basis points on approximately $86 million and $95 million of underlying obligations as of March 31, 2016 and December 31, 2015, respectively. 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, 2017.
On August 9, 2013, Animas Funding LLC (“AFL”), a special purpose investment vehicle formed and consolidated by the Company, 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 on the outstanding notional amount of the underlying obligations. 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. The Company paid interest equal to LIBOR plus 120 basis points on approximately $126 million and $124 million of underlying obligations as of March 31, 2016 and December 31, 2015, respectively.
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
 
March 31, 2016
 
December 31, 2015
 
March 31, 2016
 
December 31, 2015
 
(Amounts in thousands)
Total return swaps - Other liabilities
$

 
$

 
$
9,797

 
$
11,525

Options sold - Other liabilities

 

 
262

 
260

Total derivatives
$

 
$

 
$
10,059

 
$
11,785


 
Gains Recognized in Income
 
 
Three Months Ended March 31,
 
 
2016
 
2015
 
 
(Amounts in thousands)
 
Total return swaps - Net realized investment gains
$
1,163

 
$
2,988

 
Options sold - Net realized investment gains
944

 
447

 
Total
$
2,107

 
$
3,435

 
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. Fair Value Measurement.
7. Goodwill and Other Intangible Assets
Goodwill
There were no changes in the carrying amount of goodwill during the periods presented. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during the periods presented.

13


Other Intangible Assets
The following table presents the components of other intangible assets:
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
 
Useful Lives
 
(Amounts in thousands)
 
(in years)
As of March 31, 2016:
 
 
 
 
 
 
 
Customer relationships
$
52,430

 
$
(35,578
)
 
$
16,852

 
11
Trade names
15,400

 
(4,652
)
 
10,748

 
24
Technology
4,300

 
(3,118
)
 
1,182

 
10
Insurance license
1,400

 

 
1,400

 
Indefinite
Total other intangible assets, net
$
73,530

 
$
(43,348
)
 
$
30,182

 
 
 
 
 
 
 
 
 
 
As of December 31, 2015:
 
 
 
 

 
 
Customer relationships
$
52,430

 
$
(34,327
)
 
$
18,103

 
11
Trade names
15,400

 
(4,491
)
 
10,909

 
24
Technology
4,300

 
(3,010
)
 
1,290

 
10
Insurance license
1,400

 

 
1,400

 
Indefinite
Total other intangible assets, net
$
73,530

 
$
(41,828
)
 
$
31,702

 
 
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during the periods presented.
Other intangible assets with definite useful lives 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 March 31, 2016 and 2015, respectively.
The following table presents the estimated future amortization expense related to other intangible assets as of March 31, 2016:
 
Year
 
Amortization Expense
 
 
(Amounts in thousands)
Remainder of 2016

$
4,558

2017
 
5,349

2018
 
5,335

2019
 
4,905

2020
 
758

Thereafter
 
7,877

Total
 
$
28,782

        
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. As of March 31, 2016, all outstanding stock options have a term of ten years from the date of grant and become exercisable in four equal installments on the first through fourth anniversaries of the grant date. 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.
In February 2015, the Company's Board of Directors adopted the 2015 Incentive Award Plan (the "2015 Plan"), replacing the 2005 Equity Incentive Plan (the "2005 Plan") which expired in January 2015. The 2015 Plan was approved at the Company's Annual Meeting of Shareholders in May 2015. A maximum of 4,900,000 shares of common stock are authorized for issuance under the 2015 Plan upon exercise of stock options, stock appreciation rights and other awards, or upon vesting of restricted stock unit ("RSU") or deferred stock awards. As of March 31, 2016, 191,500 RSUs were outstanding, and 4,713,500 shares of common stock were available for future issuances under the 2015 Plan. As of March 31, 2016, 83,500 RSUs and 155,500 stock options were outstanding under the 2005 Plan.

14


The Compensation Committee of the Company’s Board of Directors granted RSU awards to the Company’s senior management and key employees which will vest based upon the Company's performance during three-year performance periods ending on December 31, 2017 and 2018 for RSU awards granted under the 2015 Plan, and ending on December 31, 2016 for RSU awards granted under the 2005 Plan:
 
Grant Year
 
2016
 
2015
 
2014
Three-year performance period ending December 31,
2018

 
2017

 
2016

Vesting shares, target (net of forfeited)
94,250

 
97,250

 
83,500

Vesting shares, maximum (net of forfeited)
176,719

 
182,344

 
156,563

The RSUs 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. Performance thresholds are based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth.
In February 2016, 88,074 shares of common stock, net of 58,822 shares withheld for payroll taxes, were issued upon the vesting of 146,896 RSUs awarded in 2013 resulting from the attainment of performance goals above the target threshold during the three-year performance period from 2013 to 2015.
As of March 31, 2016, 1,500, 2,000 and 2,000 target RSUs granted in 2016, 2015 and 2014 , respectively, were forfeited because the recipients were no longer employed by the Company.
The fair value of each RSU grant was determined based on the market price of the Company's common stock 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.
No stock options were awarded during the three months ended March 31, 2016 under the 2015 Plan.
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 increase to the total amount of unrecognized tax benefit related to tax uncertainties during the three months ended March 31, 2016. The increase 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 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 Company's 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. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates or laws is recognized in earnings in the period that includes the enactment date.

15


At March 31, 2016, 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. 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, 2015.
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, 2015.

11. Segment Information

The Company is primarily engaged in writing personal automobile insurance and provides related property and casualty insurance products to its customers through 14 subsidiaries in 13 states, principally in California.
The Company has one reportable business segment - the Property and Casualty business segment.
Property and Casualty Lines
The Property and Casualty business segment offers several insurance products to the Company’s individual customers and small business customers. These insurance products are: private passenger automobile which is the Company’s primary business, and related insurance products such as homeowners, commercial automobile and commercial property. These insurance products are primarily sold to the Company’s individual customers and small business customers, which increases retention of the Company’s private personal automobile client base. The insurance products comprising the Property and Casualty business segment are sold through the same distribution channels, mainly through independent and 100% owned insurance agents, and go through a similar underwriting process.
The Company’s Chief Operating Decision Maker evaluates operating results based on pre-tax underwriting results which is calculated as net premiums earned less (i) incurred losses and loss adjustment expenses; and (ii) underwriting expenses (policy acquisition costs and other operating expenses).
Expenses are allocated based on certain assumptions that are primarily related to premiums and losses. The Company’s net investment income, net realized investment (losses) gains, other income, and interest expense are excluded in evaluating pre-tax underwriting profit. The Company does not allocate its assets, including investments, or income taxes in evaluating pre-tax underwriting profit.

16


The following table presents operating results by reportable segment for the three months ended:
 
March 31, 2016
 
March 31, 2015
 
Property & Casualty Lines
 
Other (1)
 
Total
 
Property & Casualty Lines
 
Other (1)
 
Total
(Amounts in millions)
 
 
 
 
 
 
 
Net premiums earned
$
755.8

 
$
11.3

 
$
767.1

 
$
707.2

 
$
13.5

 
$
720.7

Less:
 
 
 
 
 
 
 
 
 
 
 
Incurred expenses
588.0

 
6.1

 
594.1

 
506.8

 
7.6

 
514.4

Underwriting expenses
197.9

 
4.9

 
202.8

 
193.9

 
5.6

 
199.5

Underwriting (loss) gain
(30.1
)
 
0.3

 
(29.8
)
 
6.5

 
0.3

 
6.8

Investment income
 
 
 
 
29.7

 
 
 
 
 
31.5

Net realized investment gains (losses)
 
 
 
 
25.0

 
 
 
 
 
(10.0
)
Other income
 
 
 
 
2.1

 
 
 
 
 
2.3

Interest expense
 
 
 
 
(1.0
)
 
 
 
 
 
(0.7
)
Pre-tax income
 
 
 
 
$
26.0

 
 
 
 
 
$
29.9

Net income
 
 
 
 
$
23.3

 
 
 
 
 
$
26.2

The following table presents the Company’s direct premiums written and net premiums earned by line of insurance business for the three months ended:
 
March 31, 2016
 
March 31, 2015
 
 
Property & Casualty Lines
 
Other (1)
 
Total
 
Property & Casualty Lines
 
Other (1)
 
Total
 
(Amounts in millions)
 
 
 
 
 
 
 
 
Private passenger automobile
$
631.8

 
$

 
$
631.8

 
$
591.5

 
$

 
$
591.5

 
Homeowners
99.1

 

 
99.1

 
89.1

 

 
89.1

 
Commercial automobile
40.9

 

 
40.9

 
36.2

 

 
36.2

 
Other
20.9

 
7.4

 
28.3

 
19.0

 
7.0

 
26.0

 
Direct premiums written
$
792.7

 
$
7.4

 
$
800.1

 
$
735.8

 
$
7.0

 
742.8

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Private passenger automobile
$
599.0

 
$

 
$
599.0

 
$
563.8

 
$

 
$
563.8

 
Homeowners
99.5

 

 
99.5

 
92.0

 

 
92.0

 
Commercial automobile
38.7

 

 
38.7

 
33.8

 

 
33.8

 
Other
18.6

 
11.3

 
29.9

 
17.6

 
13.5

 
31.1

 
Net premiums earned
$
755.8

 
$
11.3

 
$
767.1

 
$
707.2

 
$
13.5

 
$
720.7

 

 __________
(1)
"Other" represents net premiums written and earned from an operating segment that does not meet the quantitative thresholds required to be considered a reportable segment. This operating segment offers automobile mechanical breakdown warranties which are primarily sold through auto dealerships and credit unions.

12. Subsequent Event
The Company plans to cease operations in Michigan and Pennsylvania to focus resources on other states with better opportunities for sustained profitable growth. Combined results for Michigan and Pennsylvania were as follows:

17


 
 
 
 
 
 
Years ended December 31,
 
(in thousands, except ratios)
2015
 
2014
 
 
 
 
 
 
Net premiums written
$
14,413

 
$
18,375

 
Net premiums earned
$
15,366

 
$
18,573

 
Combined ratio
137
%
 
130
%
 
On April 29, 2016, the Company filed plans to exit these states with the respective state regulatory agencies. The Company expects to complete the run-off of its Michigan and Pennsylvania operations in 2017.
In line with the goal of improving operating efficiencies outside California and overall long-term profitability, the Company restructured its claims operations in states outside of California resulting in a workforce reduction of approximately 100 employees on April 29, 2016. The affected employees were located primarily in the Company's New Jersey and Florida branch offices. The Company expects to record a charge, in the second quarter of 2016, of approximately $2 million for employee termination costs.

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 California 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 automobile 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 risks and 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, 2015 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.
The following table presents direct premiums written, by state and line of insurance business, during the three months ended March 31, 2016 and 2015 :
Three Months Ended March 31, 2016
(Dollars in thousands)
 
 
Private
Passenger  Automobile
 
Homeowners
 
Commercial
Automobile
 
Other Lines
 
Total
 
 
California
$
522,139

 
$
83,966

 
$
20,035

 
$
24,792

 
$
650,932

 
81.4
%
Florida (1)
42,774

 
1

 
7,378

 
365

 
50,518

 
6.3
%
Other states (2)
66,890

 
15,156

 
13,529

 
3,034

 
98,609

 
12.3
%
Total
$
631,803

 
$
99,123

 
$
40,942

 
$
28,191

 
$
800,059

 
100.0
%
 
79.0
%
 
12.4
%
 
5.1
%
 
3.5
%
 
100.0
%
 
 
Three Months Ended March 31, 2015
(Dollars in thousands)
 
 
Private
Passenger  Automobile
 
Homeowners
 
Commercial
Automobile
 
Other Lines
 
Total
 
 
California
$
491,576

 
$
74,019

 
$
18,306

 
$
22,035

 
$
605,936

 
81.6
%
Florida (1)
37,223

 
1

 
6,457

 
221

 
43,902

 
5.9
%
Other states (2)
62,685

 
15,038

 
11,388

 
3,868

 
92,979

 
12.5
%
Total
$
591,484

 
$
89,058

 
$
36,151

 
$
26,124

 
$
742,817

 
100.0
%
 
79.6
%
 
12.0
%
 
4.9
%
 
3.5
%
 
100.0
%
 
 

(1) The Company is writing and expects to continue writing nominal premiums in the Florida homeowners market.
(2) No individual state accounted for more than 4% of total direct premiums written.

C. Regulatory and Legal Matters
The Department of Insurance (“DOI”) in each state in which the Company operates is responsible for conducting periodic financial, market conduct, and rating and underwriting 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 examinations:
 
State
  
Exam Type
  
Period Under Review
  
Status
GA
 
Financial
 
2011 to 2013
 
Received draft report and submitted response to the DOI.
CA
 
Market Conduct
 
2013 to 2014
 
Final report received.
CA
 
Rating and Underwriting
 
2014
 
Fieldwork began in July 2014.
VA
 
Market Conduct
 
2014 to 2015
 
Fieldwork began in April 2016.

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.
In February 2016, the California DOI approved a 5.0% rate increase on Mercury Insurance Company's private passenger automobile line of insurance business, which represented approximately 50% of the Company's net premiums earned in the first quarter of 2016. This rate increase was implemented in March 2016. In April 2016, the California DOI approved a 6.9% rate increase on California Automobile Insurance Company's private passenger automobile line of insurance business, which represented approximately 17% of the Company's total net premiums earned in the first quarter of 2016. The Company anticipates that this rate increase will be implemented in June 2016.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, "NNC") alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. The California DOI sought to impose a fine for each policy on which the Company allegedly permitted an agent to charge a broker fee, to impose a penalty for each policy on which the Company allegedly used a misleading advertisement, and to suspend certificates of authority for a period of one year. In January 2012, the Administrative Law Judge (“ALJ”) bifurcated the NNC between (a) the California DOI’s order to show cause ("OSC"), in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. In February 2012, the ALJ submitted a proposed decision dismissing the NNC, but the Commissioner rejected the ALJ's proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, but the challenge was unsuccessful. Following an evidentiary hearing in April 2013, post-hearing briefs and an unsuccessful mediation, the ALJ closed the evidentiary record on April 30, 2014. Although a proposed decision was to be submitted to the Commissioner on or before June 30, 2014, after which the Commissioner would have 100 days to accept, reject or modify the proposed decision, or require further evidence, the proposed decision was submitted on December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ’s proposed decision, which became the Commissioner's adopted Order. The Company received notice of this Order on January 10, 2015. The decision and Order found that from the period July 1, 1996, through 2006, the Company's "brokers" were actually operating as "de facto agents" and that the charging of "broker fees" by these producers constituted the charging of "premium" in excess of the Company's approved rates. The Order assessed a civil penalty in the amount of $27.6 million against the Company. The Company denies the allegations and/or findings in the Order, and believes that no monetary penalties are warranted. On February 9, 2015, the Company filed a Writ of Administrative Mandamus and Complaint for Declaratory Relief (the "Writ") in the Orange County Superior Court seeking, among other things, to require the Commissioner to vacate the Order, to stay the Order while the Superior Court action is pending, and to judicially declare as invalid the 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 Court did not order a stay, and the $27.6 million assessed penalty was accrued in 2014 and paid in March 2015. The Company filed an amended Writ on September 11, 2015, adding an explicit request for a refund of the penalty, with interest. The Court initially scheduled the matter for hearing on March 14, 2016 and filed its opening brief on October 19, 2015, but the Commissioner requested and received an extension of time to file an opposing brief and for the hearing on the Writ. The Company's reply brief was filed on April 15, 2016 and the hearing is scheduled for June 13, 2016. The Company intends to vigorously defend itself against the allegations, and seek reversal of the $27.6 million assessed fine, 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 also accrued a liability for the estimated cost to continue to defend itself in the false advertising OSC. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the false advertising OSC will be material to its financial position.

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, 2015.
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, 2015.
D. Critical Accounting Policies and Estimates
Losses and loss adjustment expense 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. A key assumption in estimating loss reserves is the degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact this assumption. 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 calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with loss reserve estimates. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory and legal environments, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them in establishing its loss reserve by reviewing historical patterns and trends and projecting these out to current loss reserves. The underlying factors and assumptions that serve as the basis for preparing the loss reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company also engages independent actuarial consultants to review the Company’s loss reserves and to provide the annual actuarial opinions under statutory accounting principles as required by state regulation. The Company analyzes loss reserves quarterly primarily using the incurred loss, paid loss, average severity coupled with the claim count development methods, and the generalized linear model ("GLM") described below. 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 insurance business or coverage within a line of insurance business. The Company may also evaluate qualitative factors such as known changes in laws or legal rulings that could affect claims handling or other external environmental factors or internal factors that could affect the settlement of claims. 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 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 method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of insurance business which have a long operating history.
The paid loss method analyzes historical payment patterns to estimate the amount of losses yet to be paid.
The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provide meaningful

22


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 GLM determines an average severity for each percentile of claims that have been closed as a percentage of estimated ultimate claims. The average severities are applied to open claims to estimate the amount of losses yet to be paid. The GLM utilizes operational time, determined as a percentile of claims closed rather than a finite calendar period, which neutralizes the effect of changes in the timing of claims handling.

At March 31, 2016 and December 31, 2015, the Company recorded its point estimate of approximately $1.17 billion and $1.15 billion, respectively, in loss reserves, which include approximately $469 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 March 31, 2016 and December 31, 2015, and estimated future payments for reopened claims. Management believes that the liability for loss reserves is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date; however, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The Company evaluates its 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 three months ended March 31, 2016, the Company reported unfavorable development of approximately $40 million on the 2015 and prior accident years’ loss reserves, which at December 31, 2015 totaled approximately $1.15 billion. The majority of the unfavorable development in the first quarter of 2016 was from the re-estimation of losses for California and Florida automobile liability coverages. Approximately $34 million of the $40 million of unfavorable development in 2016 relates to 2014 and prior accident years.
For the three months ended March 31, 2016, the Company recorded catastrophe losses of approximately $8 million which were primarily the result of severe winter storms in northern California and in 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, 2015.
Investments
The Company’s fixed maturity and equity securities 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, total return swaps, accounts payable, options sold, 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. Fair Value of Financial Instruments, of the 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 March 31, 2016 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

23


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 March 31, 2016, the Company’s deferred income taxes were in a net asset position mainly due to deferred tax assets generated by unearned premiums, alternative minimum tax credit carryforwards, expense accruals and loss reserve discounting. 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 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 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 three months ended March 31, 2016 was 10.4%, compared to 12.4% for the same period in 2015. The decrease in the effective tax rate was principally due to a decrease of $3.8 million in total pre-tax income during the first quarter of 2016 compared to total pre-tax income for the same period in 2015, while tax-exempt investment income, a component of pre-tax income, remained relatively consistent. The Company's effective tax rate for the three months ended March 31, 2016 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. See "Regulatory and Legal Matters" above and Note 10. Contingencies, of the Condensed Notes to Consolidated Financial Statements.

24


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 insurance business become unprofitable, a premium deficiency reserve may be required.

RESULTS OF OPERATIONS
Three Months Ended March 31, 2016 Compared to Three Months Ended March 31, 2015
Revenues
Net premiums written and net premiums earned during the three months ended March 31, 2016 increased 7.7% and 6.4%, respectively, from the corresponding period in 2015. 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 insurance business and growth in the number of homeowner policies written in California and private passenger automobile policies written 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 is a reconciliation of total net premiums written to net premiums earned:
 
 
Three Months Ended March 31,
 
2016
 
2015
 
(Amounts in thousands)
Net premiums written
$
797,666

 
$
740,492

Change in net unearned premium
(30,581
)
 
(19,755
)
Net premiums earned
$
767,085

 
$
720,737

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 March 31,
 
2016
 
2015
Loss ratio
77.5
%
 
71.4
%
Expense ratio
26.4
%
 
27.7
%
Combined ratio
103.9
%
%
99.1
%
Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company's loss ratio was affected by unfavorable development of approximately $40 million and favorable development of approximately $3 million on prior accident years' loss reserves during the first quarter of 2016 and 2015, respectively. The majority of the unfavorable development in the first quarter of 2016 was from the re-estimation of losses for California and Florida automobile liability coverages. Approximately $34 million of the $40 million of unfavorable development in 2016 relates to 2014 and prior accident years. The favorable development of $3 million in the first quarter of 2015 was primarily the result of the re-estimation of the liability reserve for the California personal automobile line of insurance business. The 2016 loss ratio was also negatively impacted by a total of $8 million of catastrophe losses primarily due to severe winter storms in northern California and in Texas. The 2015 loss ratio was also negatively impacted by a total of $2 million of catastrophe losses primarily the result of tornadoes in Oklahoma. Excluding the effect of estimated prior periods' loss development and catastrophe losses, the loss ratio was 71.2% and 71.5% for the first quarter of 2016 and 2015, respectively.

25


Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The 2016 expense ratio decreased compared to the 2015 expense ratio primarily due to lower profitability related expenses coupled with higher levels of earned premiums.
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 expense was $2.7 million and $3.7 million for the three months ended March 31, 2016 and 2015, respectively. The $1 million decrease in income tax expense was primarily due to a $3.8 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 2015.
Investments
The following table presents the investment results of the Company:
 
Three Months Ended March 31,
 
2016
 
2015
 
(Dollars in thousands)
Average invested assets at cost (1)
$
3,327,084

 
$
3,320,746

Net investment income (2)
 
 
 
Before income taxes
$
29,655

 
$
31,506

After income taxes
$
26,033

 
$
27,495

Average annual yield on investments (2)
 
 
 
Before income taxes
3.6
%
 
3.8
%
After income taxes
3.1
%
 
3.3
%
Net realized investment gains (losses)
$
25,057

 
$
(9,961
)
(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 gains (losses) included in net income:
 
Gains (Losses) Recognized in Net Income
 
Three Months Ended March 31, 2016
 
Sales
Changes in fair value 
Total
 
(Amounts in thousands)
Net realized investment gains (losses)
 
 
 
Fixed maturity securities (1)(2)
$
710

$
11,563

$
12,273

Equity securities (1)(3)
4,212

6,907

11,119

Short-term investments (1)
(503
)
61

(442
)
Total return swaps
(564
)
1,728

1,164

Options sold
955

(12
)
943

Total
$
4,810

$
20,247

$
25,057


26


 
(Losses) Gains Recognized in Net Income
 
Three Months Ended March 31, 2015
 
Sales
Changes in fair value
Total
 
(Amounts in thousands)
Net realized investment (losses) gains
 
 
 
Fixed maturity securities (1)(2)
$

$
1,251

$
1,251

Equity securities (1)(3)
(7,618
)
(6,337
)
(13,955
)
Short-term investments (1)
(894
)
202

(692
)
Total return swap
375

2,613

2,988

Options sold
617

(170
)
447

Total
$
(7,520
)
$
(2,441
)
$
(9,961
)
__________ 
(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 securities portfolio. The fair value increases in 2016 and 2015 were primarily caused by the overall improvement in the municipal bond market.
(3)
The increases in the fair values of equity securities in the first quarter of 2016 compared to the decreases in the first quarter of 2015, were primarily due to the relative improvement in the equities markets in the first quarter of 2016 compared to an overall decline in the equities markets in the first quarter of 2015.

Net Income
 
Three Months Ended March 31,
 
2016
 
2015
 
(Amounts in thousands, except per share data)
Net income
$
23,323

 
$
26,165

Basic average shares outstanding
55,201

 
55,139

Diluted average shares outstanding
55,208

 
55,159

Basic Per Share Data:
 
 
 
Net Income
$
0.42

 
$
0.47

Net realized investment gains (losses), net of tax
$
0.30

 
$
(0.12
)
Diluted Per Share Data:
 
 
 
Net Income
$
0.42

 
$
0.47

Net realized investment gains (losses), net of tax
$
0.29

 
$
(0.12
)

LIQUIDITY AND CAPITAL RESOURCES
A. Cash Flows
The Company has generated positive cash flow from operations since the public offering of its common stock in November 1985, 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 $390.3 million at March 31, 2016 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 three months ended March 31, 2016 was $45.7 million, an increase of $34.2 million compared to the corresponding period in 2015. The increase was primarily due to an increase in premium collections, and

27


decreases in operating expenses and income taxes paid, partially offset by higher paid losses and loss adjustment expenses. Operating expenses in the first quarter of 2015 included the payment of the $27.6 million penalty assessed by California DOI as discussed in “Regulatory and Legal Matters” above. The Company utilized the cash provided by operating activities during the first quarter of 2016 primarily for the payment of dividends to its shareholders.
The following table presents the estimated fair value of fixed maturity securities at March 31, 2016 by contractual maturity in the next five years:
 
 
Fixed Maturities
 
(Amounts in thousands)
Due in one year or less
$
90,297

Due after one year through two years
102,300

Due after two years through three years
126,795

Due after three years through four years
71,635

Due after four years through five years
111,008

Total due within five years
$
502,035

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.

28


The following table presents the composition of the total investment portfolio of the Company at March 31, 2016:
 
 
Cost (1)
 
Fair Value
 
(Amounts in thousands)
Fixed maturity securities:
 
 
 
U.S. government bonds and agencies
$
21,788

 
$
21,939

Municipal securities
2,434,739

 
2,531,777

Mortgage-backed securities
56,481

 
56,532

Corporate securities
270,707

 
260,917

Collateralized loan obligations
51,653

 
51,520

Other asset-backed securities
19,856

 
19,829

 
2,855,224

 
2,942,514

Equity securities:
 
 
 
Common stock
288,826

 
301,768

Non-redeemable preferred stock
25,161

 
24,857

Private equity funds
12,888

 
8,991

 
326,875

 
335,616

Short-term investments
155,201

 
155,185

Total investments
$
3,337,300

 
$
3,433,315


(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.
At March 31, 2016, 73.3% of the Company’s total investment portfolio at fair value and 85.5% of its total fixed maturity securities 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 March 31, 2016, 50.7% 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 are mostly long-term bonds and other debt with maturities of at least one year from purchase, and 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 instruments 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 Company's portfolio is heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity securities purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The holdings, which are heavily weighted with high coupon issues, are expected to be called prior to maturity. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is considered a better indicator of price volatility than simple maturity alone.

29


The following table presents the maturity and duration of the Company's fixed maturity securities portfolio:
 
 
 
March 31, 2016
 
December 31, 2015
 
(in years)
Total Fixed Maturity Securities
 
 
 
Nominal average maturities:
 
 
 
excluding short-term instruments
12.9
 
12.6
including short-term instruments
12.6
 
12.2
Call-adjusted average maturities:
 
 
 
excluding short-term instruments
3.6
 
3.4
including short-term instruments
3.5
 
3.3
Modified durations reflecting anticipated early calls:
 
 
 
excluding short-term instruments
3.3
 
3.2
including short-term instruments
3.2
 
3.1
Collateralized Mortgage Obligations Modified Durations
2.1
 
1.9
Short-term Instruments
 
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 March 31, 2016, consistent with the average rating at December 31, 2015. The Company's municipal bond holdings of which 99.4% were tax exempt, represented 85.5% of its fixed maturity securities portfolio at March 31, 2016, at fair value, and are broadly diversified geographically. See Item 3. Quantitative and Qualitative Disclosures About Market Risks for a breakdown of municipal bond holdings by state.
To calculate the weighted-average credit quality ratings disclosed throughout this Quarterly Report on Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each security’s average of ratings assigned by nationally recognized securities rating organizations.
Taxable holdings consist principally of investment grade issues. At March 31, 2016, fixed maturity securities holdings rated below investment grade and non-rated bonds totaled $50.2 million and $26.1 million, respectively, at fair value, and represented 1.9% and 3.8%, respectively, of total fixed maturity securities. The majority of non-rated issues are a result of municipalities pre-funding and collateralizing those issues with U.S. government securities with an implicit AAA- equivalent credit risk. At December 31, 2015, fixed maturity securities holdings rated below investment grade and non-rated bonds totaled $37.5 million and $6.2 million, respectively, at fair value, and represented 1.3% and 0.2%, respectively, of total fixed maturity securities.
Credit ratings for the Company’s fixed maturity securities portfolio were stable during the three months ended March 31, 2016, with 82.1% of fixed maturity securities at fair value experiencing no change in their overall rating. 1.8% and 3.2% of fixed maturity securities at fair value experienced upgrades and downgrades, respectively, during the first quarter of 2016. The downgrades were slight and still within the investment grade portfolio during the three months ended March 31, 2016.

30


The following table presents the credit quality ratings of the Company’s fixed maturity securities portfolio by security type at fair value:
 
March 31, 2016
 
(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
$
7,001

 
$

 
$

 
$

 
$

 
$
7,001

Government agency
14,938

 

 

 

 

 
14,938

Total
21,939

 

 

 

 

 
21,939

 
100.0
%
 
%
 
%
 
%
 
%
 
100.0
%
Municipal securities:
 
 
 
 
 
 
 
 
 
 
 
Insured
3,715

 
255,981

 
402,576

 
20,824

 
14,252

 
697,348

Uninsured
175,089

 
716,097

 
698,192

 
165,729

 
79,322

 
1,834,429

Total
178,804

 
972,078

 
1,100,768

 
186,553

 
93,574

 
2,531,777

 
7.1
%
 
38.4
%
 
43.4
%
 
7.4
%
 
3.7
%
 
100.0
%
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
Commercial
10,546

 
1,375

 
7,017

 
8,929

 
16,890

 
44,757

Agencies
4,040

 

 

 

 

 
4,040

Non-agencies:
 
 
 
 
 
 
 
 
 
 
 
Prime

 

 
608

 
92

 
1,968

 
2,668

Alt-A

 

 

 
1,153

 
3,914

 
5,067

Total
14,586

 
1,375

 
7,625

 
10,174

 
22,772

 
56,532

 
25.8
%
 
2.4
%
 
13.5
%
 
18.0
%
 
40.3
%
 
100.0
%
Corporate securities:
 
 
 
 
 
 
 
 
 
 
 
Basic materials

 

 

 
6,588

 
4,162

 
10,750

Communications

 

 
169

 
6,090

 

 
6,259

Consumer-cyclical

 

 
2,354

 
14,142

 
4,344

 
20,840

Consumer-non-cyclical

 

 
497

 
7,022

 
3,945

 
11,464

Energy

 

 
6,391

 
38,147

 
24,902

 
69,440

Financial
5,191

 
465

 
47,438

 
50,930

 
4,907

 
108,931

Industrial

 

 

 
4,626

 
2,626

 
7,252

Technology

 

 

 
6,461