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EX-31.2 - EXHIBIT 31.2 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit312.htm
EX-32.2 - EXHIBIT 32.2 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit322.htm
EX-32.1 - EXHIBIT 32.1 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit321.htm
EX-31.1 - EXHIBIT 31.1 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit311.htm
EX-15.2 - EXHIBIT 15.2 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit152.htm
EX-15.1 - EXHIBIT 15.1 - MERCURY GENERAL CORPmcy-2017331x10qxexhibit151.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, 2017
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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. 
Large accelerated filer
 
ý
  
Accelerated filer
 
o
 
 
 
 
 
 
Non-accelerated filer
 
o  (Do not check if a smaller reporting company)
  
Smaller reporting company
 
o
 
 
 
 
 
 
 
Emerging growth company
 
o
 
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 27, 2017, the Registrant had issued and outstanding an aggregate of 55,311,077 shares of its Common Stock.
 





MERCURY GENERAL CORPORATION
INDEX TO FORM 10-Q
 
 
 
 
 
 
Page
 
 
 
 
Item 1
 
Consolidated Balance Sheets as of March 31, 2017 and December 31, 2016
 
Consolidated Statements of Operations for the Three Months Ended March 31, 2017 and 2016
 
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2017 and 2016
 
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, 2017
 
December 31, 2016
 
(unaudited)
 
 
ASSETS
 
 
 
Investments, at fair value:
 
 
 
Fixed maturity securities (amortized cost $2,884,857; $2,795,410)
$
2,914,287

 
$
2,814,553

Equity securities (cost $388,408; $331,770)
425,506

 
357,327

Short-term investments (cost $260,697; $375,700)
260,705

 
375,680

Total investments
3,600,498

 
3,547,560

Cash
236,584

 
220,318

Receivables:
 
 
 
Premium
478,345

 
459,152

Accrued investment income
41,676

 
41,205

Other
23,079

 
24,635

Total receivables
543,100

 
524,992

Deferred policy acquisition costs
199,526

 
200,826

Fixed assets (net of accumulated depreciation $324,551; $319,429)
155,515

 
155,910

Deferred income taxes
41,393

 
45,277

Goodwill
42,796

 
42,796

Other intangible assets, net
24,287

 
25,625

Other assets
20,290

 
25,414

Total assets
$
4,863,989

 
$
4,788,718

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Loss and loss adjustment expense reserves
$
1,316,933

 
$
1,290,248

Unearned premiums
1,094,802

 
1,074,437

Notes payable
371,044

 
320,000

Accounts payable and accrued expenses
124,488

 
112,334

Current income taxes
8,646

 
9,962

Other liabilities
202,107

 
229,335

Total liabilities
3,118,020

 
3,036,316

Commitments and contingencies


 


Shareholders’ equity:
 
 
 
Common stock without par value or stated value:
       Authorized 70,000 shares; issued and outstanding 55,311; 55,289
96,544

 
95,529

Retained earnings
1,649,425

 
1,656,873

Total shareholders’ equity
1,745,969

 
1,752,402

Total liabilities and shareholders’ equity
$
4,863,989

 
$
4,788,718



See accompanying 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,
 
2017
 
2016
Revenues:
 
 
 
Net premiums earned
$
789,770

 
$
767,085

Net investment income
31,169

 
29,655

Net realized investment gains
24,460

 
25,057

Other
2,105

 
2,123

Total revenues
847,504

 
823,920

Expenses:
 
 
 
Losses and loss adjustment expenses
606,665

 
594,082

Policy acquisition costs
142,599

 
141,560

Other operating expenses
65,188

 
61,294

Interest
2,453

 
950

Total expenses
816,905

 
797,886

Income before income taxes
30,599

 
26,034

Income tax expense
3,619

 
2,711

Net income
$
26,980

 
$
23,323

Net income per share:
 
 
 
Basic
$
0.49

 
$
0.42

Diluted
$
0.49

 
$
0.42

Weighted average shares outstanding:
 
 
 
Basic
55,297

 
55,201

Diluted
55,312

 
55,208

Dividends paid per share
$
0.6225

 
$
0.6200





















 
See accompanying Notes to Consolidated Financial Statements.

4



MERCURY GENERAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

 
Three Months Ended March 31,
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net income
$
26,980

 
$
23,323

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
13,265

 
12,878

Net realized investment gains
(24,460
)
 
(25,057
)
Increase in premiums receivable
(19,193
)
 
(29,116
)
Changes in current and deferred income taxes
2,568

 
2,632

Decrease (increase) in deferred policy acquisition costs
1,300

 
(1,803
)
Increase in loss and loss adjustment expense reserves
26,685

 
28,280

Increase in unearned premiums
20,365

 
29,258

Increase (decrease) in accounts payable and accrued expenses
9,584

 
(5,128
)
Share-based compensation
35

 
35

Other, net
17,094

 
14,483

Net cash provided by operating activities
74,223

 
49,785

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Fixed maturity securities available for sale in nature:
 
 
 
Purchases
(278,293
)
 
(386,628
)
Sales
22,509

 
149,744

Calls or maturities
159,153

 
180,125

Equity securities available for sale in nature:
 
 
 
Purchases
(195,728
)
 
(163,408
)
Sales
142,855

 
154,273

Changes in securities payable and receivable
(39,264
)
 
(982
)
Net decrease in short-term investments and purchased options
115,294

 
29,086

Purchase of fixed assets
(3,425
)
 
(4,596
)
Sale of fixed assets

 
2

Other, net
559

 
947

Net cash used in investing activities
(76,340
)
 
(41,437
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Dividends paid to shareholders
(34,428
)
 
(34,257
)
     Employee taxes paid for withheld shares related to share-based compensation

 
(3,203
)
Proceeds from stock options exercised
1,171

 

Net proceeds from issuance of senior notes
371,640

 

Payoff of principal on loan and credit facilities
(320,000
)
 

Net cash provided by (used in) financing activities
18,383

 
(37,460
)
Net increase (decrease) in cash
16,266

 
(29,112
)
Cash:
 
 
 
Beginning of the year
220,318

 
264,221

End of period
$
236,584

 
$
235,109

SUPPLEMENTAL CASH FLOW DISCLOSURE
 
 
 
Interest paid
$
1,292

 
$
878

Income taxes paid
$
1,051

 
$
79






See accompanying Notes to Consolidated Financial Statements.

5


MERCURY GENERAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. General

Consolidation and Basis of Presentation

The interim 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, 2016. These interim 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. 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, 2017 and the results of operations and cash flows for the periods presented. All intercompany transactions and balances have been eliminated.

Certain financial information that is normally included in annual financial statements prepared in accordance with GAAP, but that is not required for interim reporting purposes, has been omitted from the accompanying interim consolidated financial statements and related notes. Readers are urged to review the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 for more complete descriptions and discussions. Operating results and cash flows for the three months ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.

Certain prior period amounts have been reclassified to conform to the current period presentation.

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 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, 2016.
Earnings per Share

Potentially dilutive securities representing approximately 77,000 shares of common stock were excluded from the computation of diluted earnings per common share for the three months ended March 31, 2016 because their effect would have been anti-dilutive. There were no potentially dilutive securities with anti-dilutive effect for the three months ended March 31, 2017.
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 $142.6 million and $141.6 million for the three months ended March 31, 2017 and 2016, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $14 million and $15 million for the three months ended March 31, 2017 and 2016, respectively.

6


2. Recently Issued Accounting Standards

In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-04, "Intangibles - Goodwill and Other (Topic 350), Simplifying the Test for Goodwill Impairment." ASU 2017-04 removes the requirement to compare the implied fair value of goodwill with its carrying amount as part of Step 2 of the goodwill impairment test and requires an entity to recognize an impairment charge for the amount by which the carrying amount of a reporting unit exceeds its fair value. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. ASU 2017-04 will be effective for the Company beginning January 1, 2020 with early adoption permitted. The Company does not anticipate that ASU 2017-04 will have a material impact on its consolidated financial statements and related disclosures.

In October 2016, the FASB issued ASU 2016-16, "Income Taxes (Topic 740), Intra-Entity Transfers of Assets Other Than Inventory." ASU 2016-16 requires entities to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. Current GAAP prohibits the recognition of current and deferred income taxes for an intra-entity asset transfer until the asset has been sold to an outside party. ASU 2016-16 will be effective for the Company beginning January 1, 2018. The Company is evaluating the impact that ASU 2016-16 will have on its consolidated financial statements and related disclosures.

In August 2016, the FASB issued ASU 2016-15, "Classification of Certain Cash Receipts and Cash Payments (Topic 230)." The new guidance is intended to reduce diversity in how certain transactions are classified in the consolidated statement of cash flows. ASU 2016-15 will be effective for the Company beginning January 1, 2018. The Company is evaluating the impact that ASU 2016-15 will have on its consolidated financial statements and related disclosures.

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326)." The amendments in this ASU replace the "incurred loss" methodology for recognizing credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of information including past events, current conditions and reasonable and supportable forecasts that affect the collectibility of reported amounts of financial assets that are not accounted for at fair value through net income, such as loans, certain debt securities, trade receivables, net investment in leases, off-balance sheet credit exposures and reinsurance receivables. Under the current GAAP incurred loss methodology, recognition of the full amount of credit losses is generally delayed until the loss is probable of occurring. Current GAAP restricts the ability to record credit losses that are expected, but do not yet meet the probability threshold. ASU 2016-13 becomes effective for the Company beginning with the first quarter ending March 31, 2020. While the Company is in the process of evaluating the impact of ASU 2016-13, it does not expect this ASU to have a material impact on its consolidated financial statements and related disclosures as most of its financial instruments with potential exposure to material credit losses are accounted for at fair value through net income.

In March 2016, the FASB issued 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. The Company adopted ASU 2016-09 for the quarter ended March 31, 2017. As a result of the adoption, the Company recognizes excess tax benefits in its provision for income taxes rather than paid-in capital. Additional amendments to accounting for income taxes and minimum statutory withholding tax requirements had no impact to retained earnings as of January 1, 2017, where the cumulative effect of these changes are required to be recorded. The Company elected to continue to estimate forfeitures expected to occur to determine the amount of compensation cost to be recognized in each period. The Company also elected to apply the presentation requirements for cash flows related excess tax benefits retrospectively to all periods presented, which resulted in an increase to both net cash provided by operating activities and net cash used in financing activities of approximately $903,000 for the three months ended March 31, 2016. The adoption of the presentation requirements for cash flows related to employee taxes paid for withheld shares resulted in an increase to both net cash provided by operating activities and net cash used in financing activities of approximately $3,200,000 for the three months ended March 31, 2016.

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 presented using a modified retrospective approach. While the Company is in the process of evaluating the impact of ASU 2016-02, it does not expect this ASU to have a material impact on its consolidated financial statements, except for recognizing lease assets and lease liabilities for its operating leases. The Company's lease obligations under various non-cancellable operating lease agreements amounted to approximately $27,000,000 at December 31, 2016.


7


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 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)." 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 in the amount to 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 for the Company to January 1, 2018. Subsequently, the FASB has issued additional ASUs on Topic 606 that do not change the core principle of the guidance in ASU 2014-09 but merely clarify certain aspects of it. The additional ASUs also become effective for the Company beginning January 1, 2018. As the accounting for insurance contracts is outside of the scope of ASU 2014-09, the Company does not expect the adoption of this ASU to have a material impact 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 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, 2017
 
December 31, 2016
 
 
 
 
 
(Amounts in thousands)
Assets
 
 
 
Investments
$
3,600,498

 
$
3,547,560

Total return swaps

 
667

Liabilities
 
 
 
Total return swaps
$
1,405

 
$
765

Options sold
285

 
20

Secured notes

 
140,000

Unsecured notes
374,633

 
180,000

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 gains in the consolidated statements of operations. 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 as realized gains from investments on the expiration date. If a call option is exercised, the premium is added to the proceeds from

8


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 are included in other liabilities in the Company's consolidated balance sheets.
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.
Secured Notes
The fair values of the Company’s $120 million secured note and $20 million secured note at December 31, 2016 approximate their carrying values.
Unsecured Notes
The fair value of the Company’s publicly traded $375 million unsecured note at March 31, 2017 was obtained from a third party pricing service. The fair value of the Company's $180 million unsecured note at December 31, 2016 approximates its carrying value.

For additional disclosures regarding methods and assumptions used in estimating fair values, see Note 5. Fair Value Measurements.

4. Fair Value Option

The Company applies the fair value option to all fixed maturity and equity investment 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 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 due to changes in fair value of investments that are measured at fair value pursuant to the application of the fair value option:
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands)
Fixed maturity securities
$
10,288

 
$
11,563

Equity securities
11,541

 
6,907

Short-term investments
28

 
61

Total
$
21,857

 
$
18,531

5. Fair Value Measurements

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

9


Level 1
Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.
Level 2
Pricing inputs are other than quoted prices in active markets, which are based on the following:
 
•     Quoted prices for similar assets or liabilities in active markets;
 
•     Quoted prices for identical or similar assets or liabilities in non-active markets; or
 
•     Either directly or indirectly observable inputs as of the reporting date.
Level 3
Pricing inputs are unobservable and significant to the overall fair value measurement, and the determination of fair value requires significant management judgment or estimation.
In certain cases, inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Thus, a Level 3 fair value measurement may include inputs that are observable (Level 1 or Level 2) and unobservable (Level 3). The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and consideration of factors specific to the asset or liability.
The Company uses prices and inputs that are current as of the measurement date, including during periods of market disruption. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3. The Company recognizes transfers between levels at either the actual date of the event or a change in circumstances that caused the transfer.
Summary of Significant Valuation Techniques for Financial Assets and Financial Liabilities
The Company’s fair value measurements are based on the market approach, which utilizes market transaction data for the same or similar instruments.
The Company obtained unadjusted fair values on 99.7% of its portfolio from an independent pricing service. For 0.3% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of March 31, 2017.
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: 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 $28.6 million and $30.0 million at March 31, 2017 and December 31, 2016, respectively, in commercial mortgage-backed securities.
Corporate securities/Short-term bonds: Valued based on a multi-dimensional model using multiple observable inputs, such as benchmark yields, reported trades, broker/dealer quotes and issue spreads, for identical or similar assets in active markets.

10


Non-redeemable preferred stock: Valued based on observable inputs, such as underlying and common stock of same issuer and appropriate spread over a comparable U.S. Treasury security, for identical or similar assets in active markets.
Total return swaps: Valued based on multi-dimensional models using inputs such as interest rate yield curves, underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets, observable for substantially the full term of the contract.
Collateralized loan obligations: Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets.
Other asset-backed securities: Comprised of securities that are collateralized by non-mortgage assets, such as 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.
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.
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 gains (losses) 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, 2017
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
12,271

 
$

 
$

 
$
12,271

Municipal securities

 
2,561,428

 

 
2,561,428

Mortgage-backed securities

 
37,847

 

 
37,847

Corporate securities

 
165,761

 

 
165,761

Collateralized loan obligations

 
89,790

 

 
89,790

Other asset-backed securities

 
47,190

 

 
47,190

Equity securities:
 
 
 
 
 
 
 
Common stock
383,529

 

 

 
383,529

Non-redeemable preferred stock

 
32,959

 

 
32,959

Private equity funds

 

 
9,018

 
9,018

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
69,958

 
20,257

 

 
90,215

Money market instruments
170,490

 

 

 
170,490

Total assets at fair value
$
636,248

 
$
2,955,232

 
$
9,018

 
$
3,600,498

Liabilities
 
 
 
 
 
 
 
Other liabilities:
 
 
 
 
 
 
 
Total return swaps
$

 
$
1,405

 
$

 
$
1,405

Options sold
285

 

 

 
285

Total liabilities at fair value
$
285


$
1,405


$


$
1,690


11


 
December 31, 2016
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Assets
 
 
 
 
 
 
 
Fixed maturity securities:
 
 
 
 
 
 
 
U.S. government bonds and agencies
$
12,275

 
$

 
$

 
$
12,275

Municipal securities

 
2,449,292

 

 
2,449,292

Mortgage-backed securities

 
39,777

 

 
39,777

Corporate securities

 
189,688

 

 
189,688

Collateralized loan obligations

 
86,525

 

 
86,525

Other asset-backed securities

 
36,996

 

 
36,996

Equity securities:
 
 
 
 
 
 
 
Common stock
316,450

 

 

 
316,450

Non-redeemable preferred stock

 
31,809

 

 
31,809

Private equity fund

 

 
9,068

 
9,068

Short-term investments:
 
 
 
 
 
 
 
Short-term bonds
70,393

 
20,233

 

 
90,626

Money market instruments
285,054

 

 

 
285,054

Other assets:
 
 
 
 
 
 


Total return swaps

 
667

 

 
667

Total assets at fair value
$
684,172

 
$
2,854,987

 
$
9,068

 
$
3,548,227

Liabilities
 
 
 
 
 
 
 
Other liabilities:
 
 
 
 
 
 
 
Total return swaps
$

 
$
765

 
$

 
$
765

Options sold
20

 

 

 
20

Total liabilities at fair value
$
20

 
$
765

 
$

 
$
785


The following table presents a summary of changes in fair value of Level 3 financial assets and financial liabilities:
 
Private Equity Fund
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands)
Beginning balance
$
9,068

 
$
10,431

     Realized (losses) included in earnings
(50
)
 
(1,440
)
Ending balance
$
9,018

 
$
8,991

The amount of total losses for the period included in earnings attributable to assets still held at March 31
$
(50
)
 
$
(1,440
)

There were no transfers between Levels 1, 2, and 3 of the fair value hierarchy during the three months ended March 31, 2017 and 2016.
At March 31, 2017, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
Financial Instruments Disclosed, But Not Carried, at Fair Value
The following tables present the carrying value and fair value of the Company’s financial instruments disclosed, but not carried, at fair value, and the level within the fair value hierarchy at which such instruments are categorized:

12


 
March 31, 2017
 
Carrying Value
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
 
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Liabilities
 
 
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
 
 
Unsecured notes
$
371,044

 
$
374,633

 
$

 
$
374,633

 
$

 
December 31, 2016
 
Carrying Value
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
 
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Liabilities
 
 
 
 
 
 
 
 
 
Notes payable:
 
 
 
 
 
 
 
 
 
Secured notes
$
140,000

 
$
140,000

 
$

 
$
140,000

 
$

Unsecured notes
180,000

 
180,000

 

 
180,000

 

Secured Notes
The fair values of the Company’s $120 million secured note and $20 million secured note at December 31, 2016 were 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. In addition, the fair values of these secured notes approximate their carrying values, as the interest rates on these securities are variable and approximate current market interest rates.
Unsecured Notes
The fair value of the Company’s publicly traded $375 million unsecured note at March 31, 2017 was obtained from a third party pricing service and pricing was based on the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes.
The fair value of the Company's $180 million unsecured note at December 31, 2016 was based on the unadjusted quoted price for similar notes in active markets. In addition, the fair value of this unsecured note approximates its carrying value, as the interest rate on this security is variable and approximates current market interest rates.
See Note 11. Notes Payable for additional information on secured and unsecured notes.
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, which was equal to LIBOR plus 145 basis points prior to the renewal of the agreement in January 2017 and LIBOR plus 128 basis points subsequent to the renewal, on approximately $106 million and $108 million of underlying obligations as of March 31, 2017 and December 31, 2016, respectively. The agreement had an initial term of one year, subject to annual renewal. In January 2017, the agreement was renewed for an additional year expiring February 17, 2018, and the interest rate was changed to LIBOR plus 128 basis points.

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, which has been renewed for an additional one-year term through February 17, 2018. 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, which was equal to LIBOR plus 135 basis points

13


prior to the amendment of the agreement in January 2017 and LIBOR plus 128 basis points subsequent to the amendment, on approximately $145 million and $152 million of underlying obligations as of March 31, 2017 and December 31, 2016, respectively. The agreement was amended in January 2017 and the interest rate was changed to LIBOR plus 128 basis points.

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, 2017
 
December 31, 2016
 
March 31, 2017
 
December 31, 2016
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Total return swaps - Other assets
$

 
$
667

 
$

 
$

Options sold - Other liabilities

 

 
285

 
20

Total return swaps - Other liabilities

 

 
1,405

 
765

Total derivatives
$

 
$
667

 
$
1,690

 
$
785

 
(Losses) Gains Recognized in Income
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands)
Total return swaps - Net realized investment (losses) gains
$
(1,019
)
 
$
1,164

Options sold - Net realized investment gains
296

 
943

Total
$
(723
)
 
$
2,107

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 Measurements.
7. Goodwill and Other Intangible Assets
Goodwill
There were no changes in the carrying amount of goodwill during the three months ended March 31, 2017 and 2016. Goodwill is reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during the three months ended March 31, 2017 and 2016. All of the Company's goodwill is associated with the Property and Casualty business segment (See Note 13. Segment Information for additional information on the reportable business segment).

14


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, 2017:
 
 
 
 
 
 
 
Customer relationships
$
52,430

 
$
(40,402
)
 
$
12,028

 
11
Trade names
15,400

 
(5,294
)
 
10,106

 
24
Technology
4,300

 
(3,547
)
 
753

 
10
Insurance license
1,400

 

 
1,400

 
Indefinite
Total other intangible assets, net
$
73,530

 
$
(49,243
)
 
$
24,287

 
 
 
 
 
 
 
 
 
 
As of December 31, 2016:
 
 
 
 

 
 
Customer relationships
$
52,430

 
$
(39,332
)
 
$
13,098

 
11
Trade names
15,400

 
(5,133
)
 
10,267

 
24
Technology
4,300

 
(3,440
)
 
860

 
10
Insurance license
1,400

 

 
1,400

 
Indefinite
Total other intangible assets, net
$
73,530

 
$
(47,905
)
 
$
25,625

 
 

Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during the three months ended March 31, 2017 and 2016.
Other intangible assets with definite useful lives are amortized on a straight-line basis over their useful lives. Other intangible assets amortization expense was $1.3 million and $1.5 million for the three months ended March 31, 2017 and 2016, respectively.

The following table presents the estimated future amortization expense related to other intangible assets as of March 31, 2017:
Year
 
Amortization Expense
 
 
(Amounts in thousands)
Remainder of 2017
 
$
4,011

2018
 
5,335

2019
 
4,905

2020
 
758

2021
 
738

Thereafter
 
7,140

Total
 
$
22,887

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, 2017, 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, 2017, 189,000 RSUs were outstanding and 4,711,000 shares of common stock were available for future issuances under the 2015 Plan.


15


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:
 
Grant Year
 
2016
 
2015
Three-year performance period ending December 31,
2018

 
2017

Vesting shares, target (net of forfeited)
93,250

 
95,750

Vesting shares, maximum (net of forfeited)
174,844

 
179,531


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 March 2017, a total of approximately $3.6 million was paid upon the vesting of 61,445 RSUs awarded in 2014 resulting from the attainment of performance goals above the target threshold during the three-year performance period ended December 31, 2016.
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 ended December 31, 2015.
As of March 31, 2017, 2,500 and 3,500 target RSUs granted in 2016 and 2015, 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, 2017.
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 $0.1 million increase to the total amount of unrecognized tax benefit related to tax uncertainties during the three months ended March 31, 2017. 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 2013 through 2015 for federal taxes, and 2003 through 2015 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 and believes a reasonable settlement could be reached during 2017 with regard to tax years 2003 through 2010. 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

16


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.

At March 31, 2017, 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. Loss and Loss Adjustment Expense Reserves

The following table presents the activity in loss and loss adjustment expense reserves:
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands)
Gross reserves at January 1
$
1,290,248

 
$
1,146,688

Less reinsurance recoverable
(13,161
)
 
(14,253
)
Net reserves at January 1
1,277,087

 
1,132,435

Incurred losses and loss adjustment expenses related to:
 
 
 
Current year
602,541

 
554,280

Prior years
4,124

 
39,802

Total incurred losses and loss adjustment expenses
606,665

 
594,082

Loss and loss adjustment expense payments related to:
 
 
 
Current year
275,890

 
261,753

Prior years
303,333

 
303,842

Total payments
579,223

 
565,595

Net reserves at March 31
1,304,529

 
1,160,922

Reinsurance recoverable
12,404

 
14,046

Gross reserves at March 31
$
1,316,933

 
$
1,174,968


The increase in the provision for insured events of prior years in 2017 of approximately $4.1 million was primarily attributable to higher than estimated California property losses.

The increase in the provision for insured events of prior years in 2016 of approximately $39.8 million primarily resulted from the re-estimation of losses for California and Florida automobile liability coverages, mostly related to 2014 and prior accident years.

For the three months ended March 31, 2017 and 2016, the Company recorded catastrophe losses of approximately $30 million and $8 million, respectively. The 2017 catastrophe losses were primarily due to severe rainstorms in California, while the 2016 catastrophe losses were mainly attributable to winter storms in Texas and northern California.











17


11. Notes Payable

Notes payable consists of the following:
 
 
Lender
 
Interest Rate
 
Maturity Date
 
March 31, 2017
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Amounts in thousands)
Secured credit facility(1)
 
Bank of America
 
LIBOR plus 40 basis points
 
December 3, 2018
 
$

 
$
120,000

Secured loan(1)
 
Union Bank
 
LIBOR plus 40 basis points
 
December 3, 2017
 

 
20,000

Unsecured credit facility(1)
 
Bank of America and Union Bank
 
LIBOR plus 112.5-162.5 basis points
 
December 3, 2019
 

 
180,000

Senior unsecured notes(2)
 
Publicly traded
 
4.40%
 
March 15, 2027
 
375,000

 

Unsecured credit facility(3)
 
Bank of America and Wells Fargo Bank
 
LIBOR plus 112.5-162.5 basis points
 
March 29, 2022
 

 

    Total principal amount
 
 
 
 
 
 
 
375,000

 
320,000

Less unamortized discount and debt issuance costs(4)
 
 
 
 
 
 
 
3,956

 

Total debt
 
 
 
 
 
 
 
$
371,044

 
$
320,000

__________ 
(1) 
On March 8, 2017, the loan and credit facility agreements were terminated and the Company repaid the total outstanding amounts with the proceeds from its public offering of $375 million of senior notes.
(2) 
On March 8, 2017, the Company completed a public debt offering issuing $375 million of senior notes. The notes are unsecured, senior obligations of the Company with a 4.40% annual coupon payable on March 15 and September 15 of each year commencing September 15, 2017. These notes mature on March 15, 2027. The Company used the proceeds from the senior notes to pay off amounts outstanding under the existing loan and credit facilities and for general corporate purposes. The Company incurred debt issuance costs of approximately $3.4 million, inclusive of underwriters' fees. The notes were issued at a slight discount of 99.847% of par, resulting in the effective annualized interest rate including debt issuance costs of approximately 4.45%.
(3) 
On March 29, 2017, the Company entered into an unsecured credit agreement that provides for revolving loans of up to $50 million and matures on March 29, 2022. The interest rates on borrowings under the credit facility are based on the Company's debt to total capital ratio and range from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is greater than or equal to 25% . Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is greater than or equal to 25%. The debt to capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. The Company's debt to capital ratio was 17.7% at March 31, 2017, resulting in a 15 basis point commitment fee on the $50 million undrawn portion of the credit facility. As of April 27, 2017, there have been no borrowings under this facility.
(4) 
The unamortized discount and debt issuance costs are associated with the publicly traded $375 million senior unsecured notes. These are amortized to interest expense over the life of the notes, and the unamortized balance is presented in our consolidated balance sheets as a direct deduction from the carrying amount of the debt. The unamortized debt issuance cost of approximately $250,000 associated with our $50 million five-year unsecured revolving credit facility maturing on March 29, 2022 is included in other assets in our consolidated balance sheets and amortized to interest expense over the term of the credit facility.
12. 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, 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, “2004 NNC”) alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer's insurance broker. The California DOI sought to impose a fine for each policy on which the Company allegedly permitted an agent to charge a broker

18


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 bifurcated the 2004 NNC between (a) the California DOI’s order to show cause (the “OSC”), in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance (the “NNC”), in which the California DOI asserts the unlawful rate allegations. In February 2012, the administrative law judge (“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, and the Commissioner responded with a demurrer. Following a hearing, the Superior Court sustained the Commissioner’s demurrer, based on the Company’s failure to exhaust its administrative remedies, and the Company appealed. The Court of Appeal affirmed the Superior Court's ruling that the Company was required to exhaust its administrative remedies, but expressly preserved for later appeal the legal basis for the ALJ’s dismissal: violation of the Company’s due process rights. 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, the proposed decision was not submitted until December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ’s proposed decision, which became the Commissioner’s adopted order (the "Order"). 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, and assessed a civil penalty in the amount of $27.6 million against the Company. 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 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.

On August 12, 2016, the Superior Court issued its ruling on the Writ, for the most part granting the relief sought by the Company. The Superior Court found that the Commissioner and the California DOI did commit due process violations, but declined to dismiss the case on those grounds. The Superior Court also agreed with the Company that the broker fees at issue were not premium, and that the penalties imposed by the Commissioner were improper, and therefore vacated the Order imposing the penalty. The Superior Court entered final judgment on November 17, 2016, issuing a writ requiring the Commissioner to refund the entire penalty amount within 120 days, plus prejudgment interest at the statutory rate of 7%. On January 12, 2017, the Commissioner filed a notice of appeal of the Superior Court's judgment entered on November 17, 2016. Since the matter has been appealed, the Company has not yet recognized in the consolidated financial statements the vacation of the Commissioner’s Order or established a receivable for the refund of the $27.6 million penalty plus any related interest owed. The Company had filed a motion to dismiss the false advertising portion of the case based on the Superior Court's findings, but the ALJ denied that motion after the appeal was filed. The ALJ did, however, grant the Company's alternative request to stay further proceedings pending the final determination of the appeal.
 
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.

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 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, 2016.

13. 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 11 states, principally in California.
The Company has one reportable business segment - the Property and Casualty business segment.

19


The Company’s Chief Operating Decision Maker evaluates operating results based on pre-tax underwriting results which is calculated as net premiums earned less (a) losses and loss adjustment expenses; and (b) 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 gains (losses), other income, and interest expense are excluded in evaluating pretax underwriting profit. The Company does not allocate its assets, including investments, or income taxes in evaluating pre-tax underwriting profit.
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.
Other Lines
The Other business segment 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 automobile dealerships and credit unions.
The following table presents the Company's operating results by reportable segment:
 
Three Months Ended
 
March 31, 2017
 
March 31, 2016
 
Property & Casualty Lines
 
Other
 
Total
 
Property & Casualty Lines
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
(Amounts in millions)
 
 
 
 
 
 
 
Net premiums earned
$
780.8

 
$
9.0

 
$
789.8

 
$
755.8

 
$
11.3

 
$
767.1

Less:
 
 
 
 
 
 
 
 
 
 
 
Losses and loss adjustment expenses
601.8

 
4.9

 
606.7

 
588.0

 
6.1

 
594.1

Underwriting expenses
203.8

 
4.0

 
207.8

 
197.9

 
4.9

 
202.8

Underwriting (loss) gain
(24.8
)
 
0.1

 
(24.7
)
 
(30.1
)
 
0.3

 
(29.8
)
Investment income
 
 
 
 
31.2

 
 
 
 
 
29.7

Net realized investment gains
 
 
 
 
24.5

 
 
 
 
 
25.0

Other income
 
 
 
 
2.1

 
 
 
 
 
2.1

Interest expense
 
 
 
 
(2.5
)
 
 
 
 
 
(1.0
)
Pre-tax income
 
 
 
 
$
30.6

 
 
 
 
 
$
26.0

Net income
 
 
 
 
$
27.0

 
 
 
 
 
$
23.3

    













20


The following table presents the Company’s net premiums earned and direct premiums written by line of insurance business:
 
Three Months Ended
 
March 31, 2017
 
March 31, 2016
 
Property & Casualty Lines
 
Other
 
Total
 
Property & Casualty Lines
 
Other
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
(Amounts in millions)
 
 
 
 
 
 
 
Private passenger automobile
$
613.3

 
$

 
$
613.3

 
$
599.0

 
$

 
$
599.0

Homeowners
105.7

 

 
105.7

 
99.5

 

 
99.5

Commercial automobile
41.3

 

 
41.3

 
38.7

 

 
38.7

Other
20.5

 
9.0

 
29.5

 
18.6

 
11.3

 
29.9

Net premiums earned
$
780.8

 
$
9.0

 
$
789.8

 
$
755.8

 
$
11.3

 
$
767.1

 
 
 
 
 
 
 
 
 
 
 
 
Private passenger automobile
$
639.0

 
$

 
$
639.0

 
$
631.8

 
$

 
$
631.8

Homeowners
103.8

 

 
103.8

 
99.1

 

 
99.1

Commercial automobile
43.0

 

 
43.0

 
40.9

 

 
40.9

Other
22.7

 
5.7

 
28.4

 
20.9

 
7.4

 
28.3

Direct premiums written
$
808.5

 
$
5.7

 
$
814.2

 
$
792.7

 
$
7.4

 
$
800.1



21


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. Certain statements contained in this report are forward-looking statements based on the Company’s current expectations and beliefs concerning future developments and their potential effects on the Company. There can be no assurance that future developments affecting the Company will be those anticipated by the Company. Actual results may differ from those projected in the forward-looking statements. These forward-looking statements involve significant risks and uncertainties (some of which are beyond the control of the Company) and are subject to change based upon various factors, including but not limited to the following risks and uncertainties: changes in the demand for the Company’s insurance products, inflation and general economic conditions, including general market risks associated with the Company’s investment portfolio; the accuracy and adequacy of the Company’s pricing methodologies; catastrophes in the markets served by the Company; uncertainties related to estimates, assumptions and projections generally; the possibility that actual loss experience may vary adversely from the actuarial estimates made to determine the Company’s loss reserves in general; the Company’s ability to obtain and the timing of the approval of premium rate changes for insurance policies issued in states where the Company operates; legislation adverse to the automobile insurance industry or business generally that may be enacted in the states where the Company operates; the Company’s success in managing its business in non-California states; the presence of competitors with greater financial resources and the impact of competitive pricing and marketing efforts; the ability of the Company to successfully manage its claims organization outside of California; the Company's ability to successfully allocate the resources used in the states with reduced or exited operations to its operations in other states; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions and trends in litigation and health care and auto repair costs and marketing efforts; and legal, regulatory and litigation risks. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as the result of new information, future events or otherwise. For a more detailed discussion of some of the foregoing risks and uncertainties, see the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 9, 2017.
OVERVIEW
A. General

The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty insurance industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a 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 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 11 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, and umbrella insurance. The Company's insurance 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.





22


The following tables present direct premiums written, by state and line of insurance business, during the three months ended March 31, 2017 and 2016:

Three Months Ended March 31, 2017
(Dollars in thousands)
 
Private
Passenger  Automobile
 
Homeowners
 
Commercial
Automobile
 
Other Lines
 
Total
 
 
California
$
538,676

 
$
89,052

 
$
23,383

 
$
26,246

 
$
677,357

 
83.2
%
Florida (1)
40,814

 
1

 
5,021

 
33

 
45,869

 
5.6
%
Other states (2)
59,510

 
14,793

 
14,546

 
2,148

 
90,997

 
11.2
%
Total
$
639,000

 
$
103,846

 
$
42,950

 
$
28,427

 
$
814,223

 
100.0
%
 
78.5
%
 
12.7
%
 
5.3
%
 
3.5
%
 
100.0
%
 
 

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
%
 
 
______________
(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.

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 awaiting final report.
CA
 
Market Conduct Claims
 
2015
 
Field work is expected to begin in the 2nd quarter of 2017.
CA
 
Rating and Underwriting
 
2014
 
Field work is completed. Awaiting draft report.
VA
 
Market Conduct
 
2014 to 2015
 
Received draft report and awaiting final report.

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 are expected to be material to the Company’s financial position.
In March 2017, 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 14% of the Company's total net premiums earned in the first quarter of 2017. The Company anticipates that this rate increase will be effective in May 2017. In addition, the California DOI approved a 6.9% rate increase on the California homeowners line of business, which represented approximately 11% of the Company's total net premiums earned in the first quarter of 2017. The Company anticipates that this rate increase will be effective in August 2017.
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

23


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, 2016.
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 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, 2016, and Note 12. Contingencies of the Notes to Consolidated Financial Statements of this Quarterly Report.
D. Critical Accounting Policies and Estimates

Loss 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

24


be estimated. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing 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, 2017 and December 31, 2016, the Company recorded its point estimate of approximately $1.32 billion and $1.29 billion, respectively, in loss reserves, which include approximately $552.7 million and $534.8 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, 2017 and December 31, 2016, 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, 2017, the Company reported unfavorable development of approximately $4 million on the 2016 and prior accident years’ loss reserves, which at December 31, 2016 totaled approximately $1.29 billion. The majority of the unfavorable development in the first quarter of 2017 was was attributable to higher than estimated California property losses.
For the three months ended March 31, 2017, the Company recorded catastrophe losses of approximately $30 million, which were primarily attributable to severe rainstorms in California. The Winter of 2017 was extremely wet, setting new precipitation records in parts of California.
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, 2016.

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 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 these financial instruments held at March 31, 2017 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

25


appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including the type of financial instrument, whether it is a new financial instrument and not yet established in the marketplace, and the characteristics particular to the transaction. Financial instruments for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, financial instruments that are thinly traded or not quoted will generally have diminished price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market makers willing to purchase and sell a financial instrument provides a source of transparency for products that otherwise are not actively quoted.
Income Taxes
At March 31, 2017, 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, 2017 was 11.8%, compared to 10.4% for the same period in 2016. The increase in the effective tax rate was principally due to an increase of $4.6 million in total pre-tax income during the first quarter of 2017 compared to total pre-tax income for the same period in 2016, 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, 2017 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 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 12. Contingencies of the Notes to Consolidated Financial Statements.

26


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, 2017 Compared to Three Months Ended March 31, 2016
Revenues

Net premiums earned and net premiums written during the three months ended March 31, 2017 increased 3.0% and 1.7%, respectively, from the corresponding period in 2016. 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 homeowners policies written in California.
 
Net premiums earned, a 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. 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.

The following is a reconciliation of total net premiums earned to net premiums written:
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands)
Net premiums earned
$
789,770

 
$
767,085

Change in net unearned premium
21,824

 
30,581

Net premiums written
$
811,594

 
$
797,666

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,
 
2017
 
2016
 
 
 
 
Loss ratio
76.8
%
 
77.5
%
Expense ratio
26.3
%
 
26.4
%
Combined ratio
103.1
%

103.9
%
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 $4 million and $40 million on prior accident years' loss reserves during the first quarter of 2017 and 2016, respectively. The majority of the unfavorable development in the first quarter of 2017 was attributable to higher than estimated California property losses. 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, mostly related to 2014 and prior accident years. In addition, the 2017 loss ratio was negatively impacted by approximately $30 million of catastrophe losses, primarily due to severe rainstorms in California. The 2016 loss ratio was also negatively impacted by a total of $8 million of catastrophe losses, primarily due to severe winter storms in Texas and northern California. 
Expense ratio is calculated by dividing the sum of policy acquisition costs and other operating expenses by net premiums earned. The 2017 expense ratio decreased slightly compared to the 2016 expense ratio. Advertising expenses for the first quarter of 2017 were slightly lower compared to the same period in 2016.

27


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 $3.6 million and $2.7 million for the three months ended March 31, 2017 and 2016, respectively. The $0.9 million increase in income tax expense was primarily due to a $4.6 million increase 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 2016.

Investments

The following table presents the investment results of the Company:
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Dollars in thousands)
Average invested assets at cost (1)
$
3,502,870

 
$
3,327,084

Net investment income (2)
 
 
 
Before income taxes
$
31,169

 
$
29,655

After income taxes
$
27,319

 
$
26,033

Average annual yield on investments (2)
 
 
 
Before income taxes
3.6
%
 
3.6
%
After income taxes
3.1
%
 
3.1
%
Net realized investment gains
$
24,460

 
$
25,057

__________ 
(1)  
Fixed maturities and short-term bonds at amortized cost; 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 period.
(2) 
Net investment income before and after income taxes increased slightly, with no material changes in average annual yield on investments before and after income taxes, primarily due to the increase in average invested assets.

The following tables present the components of net realized investment gains (losses) included in net income:
 
Three Months Ended March 31, 2017
 
Gains (Losses) Recognized in Net Income
 
Sales
 
Changes in fair value 
 
Total
 
 
 
 
 
 
 
(Amounts in thousands)
Net realized investment gains (losses)
 
 
 
 
 
Fixed maturity securities (1)(2)
$
(444
)
 
$
10,288

 
$
9,844

Equity securities (1)(3)
3,765

 
11,541

 
15,306

Short-term investments (1)
5

 
28

 
33

Total return swaps
288

 
(1,307
)
 
(1,019
)
Options sold
352

 
(56
)
 
296

Total
$
3,966

 
$
20,494

 
$
24,460


28


 
Three Months Ended March 31, 2016
 
Gains (Losses) Recognized in Net Income
 
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

__________ 
(1) 
The changes in fair value of the investment portfolio result from the application of the fair value option.
(2) 
The fair value increases in the first quarters of 2017 and 2016 were primarily due to the overall improvement in the market conditions affecting fixed maturity securities.
(3) 
The fair value increases in the first quarters of 2017 and 2016 were primarily due to the overall improvement in the equity markets.

Net Income
 
Three Months Ended March 31,
 
2017
 
2016
 
 
 
 
 
(Amounts in thousands, except per share data)
Net income
$
26,980

 
$
23,323

Basic average shares outstanding
55,297

 
55,201

Diluted average shares outstanding
55,312

 
55,208

Basic Per Share Data:
 
 
 
Net income
$
0.49

 
$
0.42

Net realized investment gains, net of tax
$
0.29

 
$
0.30

Diluted Per Share Data:
 
 
 
Net income
$
0.49

 
$
0.42

Net realized investment gains, net of tax
$
0.29

 
$
0.29




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. The Company does not attempt to match the duration and timing of asset maturities with those of liabilities; rather, it 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 $497.3 million at March 31, 2017 as well as $50 million of credit available on a $50 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.


29


Net cash provided by operating activities for the three months ended March 31, 2017 was $74.2 million, an increase of $24.4 million compared to the corresponding period in 2016. The increase was primarily due to an increase in premium collections and a decrease in operating expenses paid, partially offset by higher paid losses and loss adjustment expenses. The Company utilized the cash provided by operating activities during the first quarter of 2017 primarily for the payment of dividends to its shareholders and net purchases of investment securities.

The following table presents the estimated fair value of fixed maturity securities at March 31, 2017 by contractual maturity in the next five years:
 
Fixed Maturity Securities
 
(Amounts in thousands)
Due in one year or less
$
293,810

Due after one year through two years
220,766

Due after two years through three years
101,258

Due after three years through four years
113,851

Due after four years through five years
83,681

Total due within five years
$
813,366

B. Reinsurance

For California homeowners policies, the Company has reduced its catastrophe exposure from earthquakes by placing earthquake risks directly with the California Earthquake Authority ("CEA"). However, the Company continues to have catastrophe exposure to fires following an earthquake.

The Company is party to a Catastrophe Reinsurance Treaty ("Treaty") covering a wide range of perils that is effective through June 30, 2017. The Treaty provides for $115 million of coverage on a per occurrence basis after covered catastrophe losses exceed a $100 million Company retention limit. The first $100 million of losses above the Company's $100 million retention are covered 100% by the reinsurers. Losses above $200 million are shared pro-rata with 5% coverage by the reinsurers and 95% retention by the Company, up to $15 million total coverage provided by the reinsurers. The treaty specifically excludes coverage for California earthquake losses on fixed property policies, such as homeowners, but does cover losses from fires following an earthquake.

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

Portfolio Composition

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

30


The following table presents the composition of the total investment portfolio of the Company at March 31, 2017:
 
Cost (1)
 
Fair Value
 
 
 
 
 
(Amounts in thousands)
Fixed maturity securities:
 
 
 
U.S. government bonds and agencies
$
12,288

 
$
12,271

Municipal securities
2,534,888

 
2,561,428

Mortgage-backed securities
37,002

 
37,847

Corporate securities
165,165

 
165,761

Collateralized loan obligations
88,616

 
89,790

Other asset-backed securities
46,898

 
47,190

 
2,884,857

 
2,914,287

Equity securities:
 
 
 
Common stock
343,141

 
383,529

Non-redeemable preferred stock
32,436

 
32,959

Private equity funds
12,831

 
9,018

 
388,408

 
425,506

Short-term investments
260,697

 
260,705

Total investments
$
3,533,962

 
$
3,600,498

______________
(1) 
Fixed maturities and short-term bonds at amortized cost; equities and other short-term investments at cost.
At March 31, 2017, 70.9% of the Company’s total investment portfolio at fair value and 87.5% 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, 2017, 65.4% 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.

31


The following table presents the maturity and duration of the Company's fixed maturity securities portfolio:
 
March 31, 2017
 
December 31, 2016