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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-K



ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the Fiscal Year Ended December 31, 2005



Commission File No. 001-12257



MERCURY GENERAL
CORPORATION

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|California                                                     |  | 95-221-1612                         
|(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



Securities
registered pursuant to Section 12(b) of the Act:



|               |  |                                     
|-------------- |  | ------------------------------------
|Title of Class |  | Name of Exchange on Which Registered
|Common Stock   |  | New York Stock Exchange             



Securities registered pursuant
to Section 12(g) of the Act:



NONE



Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes  x    No   ̈



Indicate by check mark if the Registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes   ̈    No  x



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  x    No   ̈



Indicate by check mark if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in
Part III of this Form 10-K or any amendment to this Form 10-K.  x



Indicate by check mark whether the Registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x            Accelerated filer   ̈            Non-accelerated
filer   ̈



Indicate by check mark whether the Registrant is
a shell company (as defined in Rule 12b-2 of the Act).  Yes   ̈    No  x



The aggregate market value of the
Registrants voting and non-voting common equity held by non-affiliates of the Registrant at June 30, 2005 was approximately $1,432,000,000 (based upon the closing sales price on the New York Stock Exchange for such date, as reported by
the Wall Street Journal).



At February 28, 2006, the Registrant had
issued and outstanding an aggregate of 54,625,156 shares of its Common Stock.



Documents Incorporated by Reference



Portions of the
definitive proxy statement for the Annual Meeting of Shareholders of Registrant to be held on May 10, 2006 are incorporated herein by reference into Part III hereof.



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Item 1.    Business



General



Mercury General Corporation (Mercury General) and its subsidiaries (collectively, the Company) are engaged primarily in writing automobile
insurance in a number of states, principally California. During 2005, private passenger automobile insurance and commercial automobile insurance accounted for 85.5% and 4.5%, respectively, of the Companys total direct premiums written. The
percentage of direct automobile insurance premiums written during 2005 by state was 72.4% in California, 9.2% in Florida, 7.5% in New Jersey, 4.2% in Texas and 6.7% in all other states. The Company also writes homeowners insurance, mechanical
breakdown insurance, commercial and dwelling fire insurance and commercial property insurance. The non-automobile lines of insurance accounted for 10.0% of direct premiums written in 2005, of which approximately 57.0% was in the homeowners line.



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



In 2005, all of the Companys subsidiaries
actively writing insurance, except American Mercury Insurance Company (AMI), American Mercury Lloyds Insurance Company (AML) and Mercury County Mutual Insurance Company (MCM), maintained a rating of A+ (Superior)
by A.M. Best & Co. (A.M. Best). This is the second highest of the fifteen rating categories in the A.M. Best rating system, which range from A++ (Superior) to F (In Liquidation). AMI, AML and MCM which accounted for
approximately 9% of the Companys 2005 net premiums written, maintained an A.M. Best rating of A- (Excellent).



The principal executive offices of Mercury General are located in Los Angeles, California. The home office of its California insurance subsidiaries and the
Companys computer and operations center is located in Brea, California. The Company also owns an office building in Rancho Cucamonga, California, which is used to support the Companys California operations and future expansion. During
2005, the Company acquired office buildings located in St. Petersburg, Florida and in Oklahoma City, Oklahoma which house employees of the Company and several outside tenants. The Company maintains branch offices in a number of locations in
California as well as branch offices in Richmond, Virginia; Latham, New York; Vernon Hills, Illinois; Atlanta, Georgia; and Austin, Dallas, Fort Worth, Houston and San Antonio, Texas. The Company has approximately 5,000 employees.



Website Access to Information



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



Organization



Mercury General, an insurance holding
company, is the parent of Mercury Casualty Company (MCC), a California automobile insurer founded in 1961 by George Joseph, the Companys Chief Executive Officer. Including



2



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MCC, Mercury General has eighteen subsidiaries. The Companys insurance operations are conducted through the following insurance company subsidiaries:



|                                                  |  |                        |  |                                                    
|------------------------------------------------- |  | ---------------------- |  | ---------------------------------------------------
|Company Name                                      |  | Date Formed orAcquired |  | Primary States                                     
|Mercury Casualty Company (MCC)                  |  | January 1961           |  | California Arizona Florida Nevada New York Virginia
|Mercury Insurance Company (MIC)                 |  | November 1972          |  | California                                         
|California Automobile Insurance Company (CAIC)  |  | June 1975              |  | California                                         
|Mercury Insurance Company of Illinois (MIC IL)  |  | August 1989            |  | Illinois                                           
|Mercury Insurance Company of Georgia (MIC GA)   |  | March 1989             |  | Georgia                                            
|Mercury Indemnity Company of Georgia (MID GA)   |  | November 1991          |  | Georgia                                            
|Mercury National Insurance Company (MNIC)       |  | December 1991          |  | Illinois Michigan                                  
|American Mercury Insurance Company (AMI)        |  | December 1996          |  | Oklahoma Florida Georgia Texas                     
|American Mercury Lloyds Insurance Company (AML) |  | December 1996          |  | Texas                                              
|Mercury County Mutual Insurance Company (MCM)   |  | September 2000         |  | Texas                                              
|Mercury Insurance Company of Florida (MIC FL)   |  | August 2001            |  | Florida Pennsylvania                               
|Mercury Indemnity Company of America (MIDAM)    |  | August 2001            |  | New Jersey                                         



California General Underwriters
Insurance Company, Inc.s only business is to assume all of the risks under policies written by one or more of the above companies covering the Companys fleet of vehicles. Mercury Select Management Company, Inc. (MSMC), a
Texas corporation serves as the attorney-in-fact for AML. The Company operates Concord Insurance Services, Inc. (Concord), a Texas insurance agency headquartered in Houston, Texas. MCM, a mutual insurance company organized under Chapter
17 of the Texas Insurance Code, is managed and controlled by the Company through a management agreement. The Company also operates two managing general agents, one of which, American Mercury MGA, Inc. (AMMGA), manages a portion of the
Companys business in Texas, and the other, Mercury Group, Inc. (MGI), manages a portion of the Companys business in Florida.



Management services are provided to Mercury Generals subsidiaries by Mercury Insurance Services, LLC (MISLLC), a subsidiary of MCC. Mercury
General and its subsidiaries are referred to collectively as the Company unless the context indicates otherwise. Mercury General Corporation individually is referred to as Mercury General. All of the subsidiaries as a group,
excluding MSMC, AMMGA, MGI, MISLLC and Concord, are referred to as the Insurance Companies. The term California Companies refers to MCC, MIC and CAIC.



Underwriting



The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Department of Insurance or similar governmental agency of
the applicable states (referred to herein as the DOI). Automobile insurance rates on voluntary business in California are subject to prior approval by the California DOI. The Company uses its own extensive database to establish rates and
classifications. The California DOI has in effect rating factor regulations that influence the weight the Company ascribes to various classifications of data. See RegulationAutomobile Insurance Rating Factor Regulations.



3



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At December 31, 2005, good drivers (as defined by the California Insurance Code) accounted for
approximately 79% of all voluntary private passenger automobile policies in force in California, while higher risk categories accounted for approximately 21%. The private passenger automobile renewal rate in California (the rate of acceptance of
offers to renew) averages approximately 96%. The Company also offers homeowners, commercial property and commercial automobile and mechanical breakdown insurance in California.



In states outside of California, the Company offers non-standard, standard and preferred private passenger automobile insurance.
Private passenger automobile policies in force for non-California operations represented approximately 25% of total private passenger automobile policies in force at December 31, 2005. In addition, the Company offers mechanical breakdown
insurance in many states outside of California and homeowners insurance in Florida, Illinois, Oklahoma, Georgia and Texas.



Production and Servicing of Business



The Company sells its policies through more than 4,900 independent agents and brokers, of which approximately 1,000 are located in each of California and Florida.
The remainder are located in Georgia, Illinois, Texas, Oklahoma, New York, New Jersey, Virginia, Pennsylvania, Arizona, Nevada and Michigan. Over half of the agents in California have represented the Company for more than ten years. The agents, most
of whom also represent one or more competing insurance companies, are independent contractors selected and contracted by the Company.



Other than one broker that produced approximately 14%, 14% and 16% during 2005, 2004, and 2003, respectively, of the Companys direct premiums written, no
agent or broker accounted for more than 2% of direct premiums written.



The Company believes that it compensates its agents and brokers above the industry average. During 2005, total commissions incurred were approximately 17% of net premiums written.



The Companys advertising budget is allocated among television, newspaper,
internet and direct mailing media to provide the best coverage available within defined media markets. While the majority of these advertising costs are borne by the Company, a portion of these costs are reimbursed by the Companys independent
agents based upon the number of account leads generated by the advertising. The Company believes that its advertising program is important to create brand awareness and to remain competitive in the current insurance climate, and it intends to
maintain the current level of advertising in 2006. During 2005, the Company incurred approximately $34 million in advertising expense. See Competitive Conditions.



Claims



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



Loss and
Loss Adjustment Expense Reserves



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



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



4



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The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment
expenses, net of reinsurance deductions, as shown on the Companys consolidated financial statements for the periods indicated:



|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|-------------------------------------------------------------------------------------- |  | ----------------------- | --------- | - | ---- | - | --------- | ---- |  | - | ---------
|                                                                                       |  | Year ended December 31,
|                                                                                       |  | 2005                    |           |   | 2004 |   |           | 2003
|                                                                                       |  | (Amounts in thousands) 
|Net reserves for losses and loss adjustment expenses, beginning of year                |  | $                       | 886,607   |   |      | $ | 786,156   |      |  | $ | 664,889  
|Incurred losses and loss adjustment expenses:                                          |  |                         |           |   |      |   |           |      |  |   |          
|Provision for insured events of the current year                                       |  |                         | 1,909,453 |   |      |   | 1,640,197 |      |  |   | 1,447,986
|(Decrease) increase in provision for insured events of prior years                     |  |                         | (46,517   | ) |      |   | (57,943   | )    |  |   | 4,065    
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|Total incurred losses and loss adjustment expenses                                     |  |                         | 1,862,936 |   |      |   | 1,582,254 |      |  |   | 1,452,051
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|Payments:                                                                              |  |                         |           |   |      |   |           |      |  |   |          
|Losses and loss adjustment expenses attributable to insured events of the current year |  |                         | 1,218,784 |   |      |   | 1,020,154 |      |  |   | 892,658  
|Losses and loss adjustment expenses attributable to insured events of prior years      |  |                         | 525,125   |   |      |   | 461,649   |      |  |   | 438,126  
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|Total payments                                                                         |  |                         | 1,743,909 |   |      |   | 1,481,803 |      |  |   | 1,330,784
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|Net reserves for losses and loss adjustment expenses at the end of the period          |  |                         | 1,005,634 |   |      |   | 886,607   |      |  |   | 786,156  
|Reinsurance recoverable                                                                |  |                         | 16,969    |   |      |   | 14,137    |      |  |   | 11,771   
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          
|Gross liability at end of year                                                         |  | $                       | 1,022,603 |   |      | $ | 900,744   |      |  | $ | 797,927  
|                                                                                       |  |                         |           |   |      |   |           |      |  |   |          



The decrease in the provision
for insured events of prior years in 2005 and 2004 relates largely to a decrease in the estimated inflation rates on earlier accident years on bodily injury coverage for California automobile insurance. For 2003, the increase largely relates to an
increase in the ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of
inflationary trends in health care costs, auto parts and body shop labor costs.



During 2005, the state of Florida was struck by several hurricanes. The Company has estimated that its pre-tax losses resulting from these hurricanes is approximately $27 million. The estimate is based upon the total number of claims
reported and the number of unreported claims anticipated as a result of the hurricanes. This compares with pre-tax losses of approximately $22 million incurred from hurricanes in 2004.



The difference between the reserves reported in the Companys consolidated financial statements prepared in accordance with
accounting principles generally accepted in the United States of America (GAAP) and those reported in the statements filed with the DOI in accordance with statutory accounting principles (SAP) is shown in the following table:



|                                  |  |                        |           |      |   |         |  |   |        
|--------------------------------- |  | ---------------------- | --------- | ---- | - | ------- |  | - | -------
|                                  |  | December 31,          
|                                  |  | 2005                   |           | 2004 |   | 2003   
|                                  |  | (Amounts in thousands)
|Reserves reported on a SAP basis  |  | $                      | 1,005,634 |      | $ | 886,607 |  | $ | 786,156
|Reinsurance recoverable           |  |                        | 16,969    |      |   | 14,137  |  |   | 11,771 
|                                  |  |                        |           |      |   |         |  |   |        
|Reserves reported on a GAAP basis |  | $                      | 1,022,603 |      | $ | 900,744 |  | $ | 797,927
|                                  |  |                        |           |      |   |         |  |   |        



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Under SAP, reserves are stated net of reinsurance recoverable in contrast to GAAP where reserves are stated gross
of reinsurance recoverable.



The following table presents the development
of loss reserves for the period 1995 through 2005. The top line of the table shows the reserves at the balance sheet date, net of reinsurance recoverable for each of the indicated years. This amount represents the estimated losses and loss
adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including an estimate for losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the cumulative
amounts paid as of successive years with respect to that reserve liability. The middle portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including
cumulative payments made since the end of the respective year. Estimates change as more information becomes known about the frequency and severity of claims for individual years. The bottom line shows the redundancy (deficiency) that exists when the
original reserve estimates are greater (less) than the re-estimated reserves at December 31, 2005.



In evaluating the information in the table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. This table does
not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future
redundancies or deficiencies based on this table.



|                                                     |  |                        |         |   |      |   |         |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|---------------------------------------------------- |  | ---------------------- | ------- | - | ---- | - | ------- | ---- |  | ---- | ------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - | ---- | - | ------- | - | ---- | - | ------- |  | - | ------- |  | - | ------- |  | ---------
|                                                     |  | As of December 31,    
|                                                     |  | 1995                   |         |   | 1996 |   |         | 1997 |  | 1998 |         |  | 1999 |         |   | 2000 |   |         | 2001 |  |   | 2002    |   | 2003 |   | 2004    |   | 2005
|                                                     |  | (Amounts in thousands)
|Net reserves for losses and loss adjustment expenses |  | $                      | 250,990 |   |      | $ | 311,754 |      |  | $    | 386,270 |  | $    | 385,816 |   |      | $ | 418,800 |      |  | $ | 463,803 |   |      | $ | 516,592 |   |      | $ | 664,889 |  | $ | 786,156 |  | $ | 886,607 |  | 1,005,634
|Paid (cumulative)as of:                              |  |                        |         |   |      |   |         |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|One year later                                       |  |                        | 167,226 |   |      |   | 206,390 |      |  |      | 247,310 |  |      | 263,805 |   |      |   | 294,615 |      |  |   | 321,643 |   |      |   | 360,781 |   |      |   | 438,126 |  |   | 461,649 |  |   | 525,125 |  |          
|Two years later                                      |  |                        | 225,158 |   |      |   | 291,552 |      |  |      | 338,016 |  |      | 366,908 |   |      |   | 403,378 |      |  |   | 431,498 |   |      |   | 491,243 |   |      |   | 591,054 |  |   | 628,280 |  |   |         |  |          
|Three years later                                    |  |                        | 248,894 |   |      |   | 316,505 |      |  |      | 369,173 |  |      | 395,574 |   |      |   | 429,787 |      |  |   | 462,391 |   |      |   | 528,052 |   |      |   | 637,555 |  |   |         |  |   |         |  |          
|Four years later                                     |  |                        | 253,708 |   |      |   | 324,337 |      |  |      | 379,233 |  |      | 402,000 |   |      |   | 439,351 |      |  |   | 476,072 |   |      |   | 538,276 |   |      |   |         |  |   |         |  |   |         |  |          
|Five years later                                     |  |                        | 255,688 |   |      |   | 329,109 |      |  |      | 381,696 |  |      | 405,910 |   |      |   | 446,223 |      |  |   | 478,158 |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Six years later                                      |  |                        | 257,041 |   |      |   | 329,825 |      |  |      | 383,469 |  |      | 409,853 |   |      |   | 445,892 |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Seven years later                                    |  |                        | 256,654 |   |      |   | 330,883 |      |  |      | 386,427 |  |      | 408,138 |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Eight years later                                    |  |                        | 257,292 |   |      |   | 333,634 |      |  |      | 384,557 |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Nine years later                                     |  |                        | 260,056 |   |      |   | 331,741 |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Ten years later                                      |  |                        | 258,170 |   |      |   |         |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Net reserves re-estimated as of:                     |  |                        |         |   |      |   |         |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|One year later                                       |  |                        | 247,122 |   |      |   | 324,572 |      |  |      | 376,861 |  |      | 393,603 |   |      |   | 442,437 |      |  |   | 480,732 |   |      |   | 542,775 |   |      |   | 668,954 |  |   | 728,213 |  |   | 840,090 |  |          
|Two years later                                      |  |                        | 254,920 |   |      |   | 329,210 |      |  |      | 378,057 |  |      | 407,047 |   |      |   | 449,094 |      |  |   | 481,196 |   |      |   | 549,262 |   |      |   | 660,705 |  |   | 717,289 |  |   |         |  |          
|Three years later                                    |  |                        | 257,958 |   |      |   | 327,749 |      |  |      | 383,588 |  |      | 410,754 |   |      |   | 446,242 |      |  |   | 483,382 |   |      |   | 546,667 |   |      |   | 662,918 |  |   |         |  |   |         |  |          
|Four years later                                     |  |                        | 257,196 |   |      |   | 329,339 |      |  |      | 386,522 |  |      | 409,744 |   |      |   | 449,325 |      |  |   | 482,905 |   |      |   | 545,518 |   |      |   |         |  |   |         |  |   |         |  |          
|Five years later                                     |  |                        | 256,395 |   |      |   | 332,570 |      |  |      | 385,770 |  |      | 410,982 |   |      |   | 448,813 |      |  |   | 480,740 |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Six years later                                      |  |                        | 257,692 |   |      |   | 332,939 |      |  |      | 386,883 |  |      | 411,046 |   |      |   | 447,225 |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Seven years later                                    |  |                        | 258,743 |   |      |   | 333,720 |      |  |      | 386,952 |  |      | 408,857 |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Eight years later                                    |  |                        | 259,467 |   |      |   | 334,096 |      |  |      | 384,752 |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Nine years later                                     |  |                        | 260,091 |   |      |   | 331,933 |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Ten years later                                      |  |                        | 258,021 |   |      |   |         |      |  |      |         |  |      |         |   |      |   |         |      |  |   |         |   |      |   |         |   |      |   |         |  |   |         |  |   |         |  |          
|Net cumulative redundancy (deficiency)               |  |                        | (7,031  | ) |      |   | (20,179 | )    |  |      | 1,518   |  |      | (23,041 | ) |      |   | (28,425 | )    |  |   | (16,937 | ) |      |   | (28,926 | ) |      |   | 1,971   |  |   | 68,867  |  |   | 46,517  |  |          



6



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|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  
|---------------------------------------- |  | ---------------------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | --------- | -
|                                         |  | As of December 31,     |  
|                                         |  | 1996                   |   |  | 1997    |   |  | 1998    |   |  | 1999    |   |  | 2000    |   |  | 2001    |   |  | 2002    |   |  | 2003    |   |  | 2004    |   |  | 2005      |  
|                                         |  | (Amounts in thousands) |  
|Gross liabilityend of year              |  | 336,685                |   |  | 409,061 |   |  | 405,976 |   |  | 434,843 |   |  | 492,220 |   |  | 534,926 |   |  | 679,271 |   |  | 797,927 |   |  | 900,744 |   |  | 1,022,603 |  
|Reinsurance recoverable                  |  | (24,931                | ) |  | (22,791 | ) |  | (20,160 | ) |  | (16,043 | ) |  | (28,417 | ) |  | (18,334 | ) |  | (14,382 | ) |  | (11,771 | ) |  | (14,137 | ) |  | (16,969   | )
|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  
|Net liabilityend of year                |  | 311,754                |   |  | 386,270 |   |  | 385,816 |   |  | 418,800 |   |  | 463,803 |   |  | 516,592 |   |  | 664,889 |   |  | 786,156 |   |  | 886,607 |   |  | 1,005,634 |  
|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  
|Gross re-estimated liabilitylatest      |  | 360,228                |   |  | 410,429 |   |  | 431,258 |   |  | 465,165 |   |  | 511,672 |   |  | 565,868 |   |  | 679,836 |   |  | 735,696 |   |  | 855,510 |   |  |           |  
|Re-estimated recoverablelatest          |  | (28,295                | ) |  | (25,677 | ) |  | (22,401 | ) |  | (17,940 | ) |  | (30,932 | ) |  | (20,350 | ) |  | (16,918 | ) |  | (18,407 | ) |  | (15,420 | ) |  |           |  
|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  
|Net re-estimated liabilitylatest        |  | 331,933                |   |  | 384,752 |   |  | 408,857 |   |  | 447,225 |   |  | 480,740 |   |  | 545,518 |   |  | 662,918 |   |  | 717,289 |   |  | 840,090 |   |  |           |  
|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  
|Gross cumulative redundancy (deficiency) |  | (23,543                | ) |  | (1,368  | ) |  | (25,282 | ) |  | (30,322 | ) |  | (19,452 | ) |  | (30,942 | ) |  | (565    | ) |  | 62,231  |   |  | 45,234  |   |  |           |  
|                                         |  |                        |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |         |   |  |           |  



For the year ended
December 31, 2005, the Company had positive development of approximately $46.5 million on the 2004 and prior year loss and loss adjustment expense reserves which at December 31, 2004 totaled $901 million. The Company attributes more than
half of this redundancy to a change in the inflation rate assumptions used to establish bodily injury coverage reserves for the California automobile insurance lines of business for the 2003 and 2004 accident years. The redundancies, related to
changes in bodily injury inflation rate changes on the 2004 and 2003 accident years, were approximately $23 million and $5 million, respectively.



At December 31, 2004, the Company had estimated California automobile insurance bodily injury inflation rates of approximately 1% on the 2003 and 2004 accident
years. At December 31, 2005, these assumptions were reduced to deflation amounts of approximately negative 1% for the 2003 accident year and approximately negative 4% for the 2004 accident year. The Company changed its inflation assumptions
based on factors that continued to develop throughout 2005. These included a favorable trend in the average amounts paid on closed claims for the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage
of time as more claims from an accident period are closed.



Bodily injury
inflation for the most recent accident years is one of the most difficult components of the Companys reserves to estimate because a large portion of the claims have not yet been settled. As time passes and more claims from an accident year are
settled, the actual inflation rate becomes more certain. Since there are still a significant amount of open bodily injury claims for the 2005 and 2004 accident years, it is possible that inflation rate assumptions will change as more claims are
settled in the future.



In addition, approximately one third of the
positive development on the reserves established at December 31, 2004 relates to a reduction in the loss adjustment expense reserves for the California automobile insurance lines of business. During the year ended December 31, 2005, there
was a decrease in the expenditures to outside legal counsel for the defense of personal automobile claims in California. This led to a reduction in the ultimate expense amount expected to be paid out and therefore a redundancy in the reserves
established at December 31, 2004. The Company believes that many factors could be contributing to the reduction in payments to outside legal counsel. These include cost savings from the usage of more flat fee billing arrangements with outside
counsel, faster closure rates of bodily injury liability cases and a decrease in bodily injury claims frequency due to factors such as improvements made in vehicle safety.



The Company had smaller redundancies and deficiencies in its other coverages offered within its California automobile insurance line
of business, as well as in other lines of business in California and other states. When aggregated, these account for the remainder of the positive reserve development experienced in 2005. The positive development in total was more than offset by
the reserve needs for the current accident year.



For the year ended
December 31, 2004, the Companys loss reserves as estimated at December 31, 2003 produced a redundancy of approximately $58 million which was reflected in the consolidated financial statements



7



---

as a reduction to the 2004 calendar year incurred losses. The Company attributes most of this redundancy to a change in the inflation rate assumptions used to
establish reserves on the bodily injury coverage for California private passenger automobile insurance on the 2002 and 2003 accident years.



At year-end 2003, the Company had assumed bodily injury severity inflation on California private passenger automobile insurance of 9% on the 2001 accident year, 6%
on the 2002 accident year and 7% on the 2003 accident year. At year-end 2004, these assumptions were reduced to 8% for 2001, 1% for 2002 and 1% for 2003. The Company reduced the inflation rate assumptions based on factors that emerged during 2004
including moderating to decreasing average amounts paid on closed claims in the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage of time as more claims from an accident period are closed.



The change in these inflation assumptions accounted for approximately
$41 million of the decrease in the expected ultimate loss on the reserves established at December 31, 2003. Each percentage point change in the inflation rate assumption accounts for approximately $2.5 million of the redundancy on the 2002
accident year losses and approximately $5 million on the 2003 accident year losses. The effect is greater on the latter accident year because the lowering of the rate for accident year 2002 has a compounding effect on accident year 2003.



The remainder of the redundancy on the 2003 accident year primarily occurred in the
Companys California homeowners and Florida personal automobile lines of business. California homeowners had approximately $6 million in reserve redundancy and Florida personal automobile had approximately $8 million in reserve redundancy.



For calendar year 2002, the Companys previously estimated loss
reserves produced a small redundancy which was reflected in the following years incurred losses. This redundancy was primarily the result of changing bodily injury severity inflation assumptions for the 2002 accident year as discussed above.



For calendar years 1998 through 2001, the Companys previously
estimated loss reserves produced a deficiency which was reflected in the following years incurred losses. The Company attributes a large portion of the deficiency to an increase in the ultimate liability for bodily injury, physical damage and
collision claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in health care costs, auto parts and body shop labor costs.



For calendar year 1997, the Companys previously estimated loss
reserves produced a small deficiency indicating that the Company was reasonably accurate in establishing the initial reserve for that year.



For calendar years 1995 and 1996, the Companys previously estimated loss reserves produced deficiencies. These deficiencies relate to increases in the
Companys ultimate estimates for loss adjustment expenses, which are based principally on the Companys actual experience. The adverse development on such reserves reflects increases in the legal expenses of defending the Companys
insureds.



Operating Ratios



Loss and Expense Ratios



Loss and underwriting expense ratios are used to interpret the underwriting experience
of property and casualty insurance companies. Losses and loss adjustment expenses, on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses on a statutory basis are
stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. The statutory underwriting profit margin is the extent to
which the combined loss and underwriting expense ratios are less than 100%. The Insurance Companies loss ratio, expense ratio and combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in
the following table. The Insurance



8



---

Companies ratios include lines of insurance other than private passenger automobile. Since these other lines represent only 14.5% of premiums written, the
Company believes its ratios can be compared to the industry ratios included in the table.



|                                                       |  |                         |      |  |      |   |  |      |   |  |       |   |  |       |  
|------------------------------------------------------ |  | ----------------------- | ---- |  | ---- | - |  | ---- | - |  | ----- | - |  | ----- | -
|                                                       |  | Year ended December 31, |     
|                                                       |  | 2005                    |      |  | 2004 |   |  | 2003 |   |  | 2002  |   |  | 2001  |  
|Loss Ratio                                             |  | 65.4                    | %    |  | 62.6 | % |  | 67.7 | % |  | 72.8  | % |  | 73.2  | %
|Expense Ratio                                          |  | 26.5                    |      |  | 26.4 |   |  | 25.9 |   |  | 25.6  |   |  | 26.0  |  
|                                                       |  |                         |      |  |      |   |  |      |   |  |       |   |  |       |  
|Combined Ratio                                         |  | 91.9                    | %    |  | 89.0 | % |  | 93.6 | % |  | 98.4  | % |  | 99.2  | %
|                                                       |  |                         |      |  |      |   |  |      |   |  |       |   |  |       |  
|Industry combined ratio (all writers) (1)              |  | 95.0                    | %(2) |  | 93.5 | % |  | 97.9 | % |  | 103.7 | % |  | 107.4 | %
|Industry combined ratio (excluding direct writers) (1) |  | (N.A.                   | )    |  | 93.9 | % |  | 98.4 | % |  | 103.7 | % |  | 106.0 | %

---

|(1) |  | Source: A.M. Best, Aggregates & Averages (2002 through 2005), for all property and casualty insurance companies (private passenger automobile line only, after policyholder
dividends).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Source: A.M. Best, Bests Review, January 2006, Review Preview.
|--- |  | -----------------------------------------------------------------

(N.A.) Not available.



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



|               |  |                         |   |  |      |   |  |      |   |  |      |   |  |      |  
|-------------- |  | ----------------------- | - |  | ---- | - |  | ---- | - |  | ---- | - |  | ---- | -
|               |  | Year ended December 31, |  
|               |  | 2005                    |   |  | 2004 |   |  | 2003 |   |  | 2002 |   |  | 2001 |  
|Loss Ratio     |  | 65.4                    | % |  | 62.6 | % |  | 67.7 | % |  | 72.8 | % |  | 73.2 | %
|Expense Ratio  |  | 27.0                    |   |  | 26.6 |   |  | 26.3 |   |  | 26.0 |   |  | 26.4 |  
|               |  |                         |   |  |      |   |  |      |   |  |      |   |  |      |  
|Combined Ratio |  | 92.4                    | % |  | 89.2 | % |  | 94.0 | % |  | 98.8 | % |  | 99.6 | %
|               |  |                         |   |  |      |   |  |      |   |  |      |   |  |      |  



Premiums to Surplus Ratio



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



|                       |  |                                       |           |      |   |           |  |      |           |      |   |           |  |   |          
|---------------------- |  | ------------------------------------- | --------- | ---- | - | --------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|                       |  | Year ended December 31,              
|                       |  | 2005                                  |           | 2004 |   | 2003      |  | 2002 |           | 2001
|                       |  | (Amounts in thousands, except ratios)
|Net premiums written   |  | $                                     | 2,950,523 |      | $ | 2,646,704 |  | $    | 2,268,778 |      | $ | 1,865,046 |  | $ | 1,442,886
|Policyholders surplus |  | $                                     | 1,487,574 |      | $ | 1,361,072 |  | $    | 1,169,427 |      | $ | 1,014,935 |  | $ | 1,045,104
|Ratio                  |  |                                       | 2.0 to 1  |      |   | 1.9 to 1  |  |      | 1.9 to 1  |      |   | 1.8 to 1  |  |   | 1.4 to 1 



Risk-Based Capital



The NAIC employs a risk-based capital formula for casualty
insurance companies that establishes recommended minimum capital requirements for casualty companies. The formula was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing
risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. Based on the formula adopted by the NAIC, the
Company has calculated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2005. Each of the Insurance Companies policyholders surplus exceeded the highest level of minimum required capital.



9



---

Statutory Accounting Principles



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



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



| |  |  | Certain assets are included in the consolidated balance sheets whereas, under SAP, such assets are designated as nonadmitted assets, and charged directly against statutory
surplus. These assets consist primarily of premium receivables that are outstanding over 90 days, federal deferred tax assets in excess of statutory limitations, furniture, equipment, leasehold improvements and prepaid expenses.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | Fixed maturities securities, which are classified as available-for-sale, are reported at current market values, rather than at amortized cost, or the lower of amortized cost or market,
depending on the specific type of security, as required by SAP.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Equity securities are reported at quoted market values which may differ from the NAIC market values as required by SAP.
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | Costs for computer software developed or obtained for internal use are capitalized and amortized over their useful life, rather than expensed as incurred, as required by SAP.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Investments and Investment Results



The Companys investments are directed by the Companys Chief Investment Officer under the supervision of the Companys Board of Directors. The
Company follows an investment policy that is regularly reviewed and revised. The Companys policy emphasizes investment grade, fixed income securities and maximization of after-tax yields and places certain restrictions to limit portfolio
concentrations and market exposure. Sales of securities are undertaken, with resulting gains or losses, in order to enhance after-tax yield and keep the portfolio in line with current market conditions. Tax considerations, including the impact of
the alternative minimum tax (AMT), are important in portfolio management. Changes in loss experience, growth rates and profitability produce significant changes in the Companys exposure to AMT liability, requiring appropriate
shifts in the investment asset mix between taxable bonds, tax-exempt bonds and equities in order to maximize after-tax yield.



10



---

The following table sets forth the composition of the investment portfolio of the Company at the dates indicated:



|                                                    |  |                        |           |                  |   |                  |  |       |           |      |   |           |  |   |           |  |   |          
|--------------------------------------------------- |  | ---------------------- | --------- | ---------------- | - | ---------------- |  | ----- | --------- | ---- | - | --------- |  | - | --------- |  | - | ---------
|                                                    |  | December 31,          
|                                                    |  | 2005                   |           | 2004             |   | 2003            
|                                                    |  | Amortized Market       |           | Amortized Market |   | Amortized Market
|                                                    |  | Cost                   |           | Value            |   | Cost             |  | Value |           | Cost |   | Value    
|                                                    |  | (Amounts in thousands)
|Taxable bonds                                       |  | $                      | 554,472   |                  | $ | 549,903          |  | $     | 533,715   |      | $ | 536,261   |  | $ | 350,750   |  | $ | 356,181  
|Tax-exempt state and municipal bonds                |  |                        | 2,034,796 |                  |   | 2,091,142        |  |       | 1,623,147 |      |   | 1,700,932 |  |   | 1,492,873 |  |   | 1,576,606
|Sinking fund preferred stocks                       |  |                        | 4,477     |                  |   | 4,510            |  |       | 8,093     |      |   | 8,118     |  |   | 12,460    |  |   | 12,522   
|                                                    |  |                        |           |                  |   |                  |  |       |           |      |   |           |  |   |           |  |   |          
|Total fixed maturity investments                    |  |                        | 2,593,745 |                  |   | 2,645,555        |  |       | 2,164,955 |      |   | 2,245,311 |  |   | 1,856,083 |  |   | 1,945,309
|Equity investments incl. perpetual preferred stocks |  |                        | 225,310   |                  |   | 276,108          |  |       | 210,553   |      |   | 254,362   |  |   | 223,113   |  |   | 264,393  
|Short-term cash investments                         |  |                        | 321,049   |                  |   | 321,049          |  |       | 421,369   |      |   | 421,369   |  |   | 329,812   |  |   | 329,812  
|                                                    |  |                        |           |                  |   |                  |  |       |           |      |   |           |  |   |           |  |   |          
|Total investments                                   |  | $                      | 3,140,104 |                  | $ | 3,242,712        |  | $     | 2,796,877 |      | $ | 2,921,042 |  | $ | 2,409,008 |  | $ | 2,539,514
|                                                    |  |                        |           |                  |   |                  |  |       |           |      |   |           |  |   |           |  |   |          



The Company continually
evaluates the recoverability of its investment holdings. When a decline in value of fixed maturities or equity securities is considered other than temporary, the Company writes the security down to fair value by recognizing a loss in the
consolidated statement of income. Declines in value considered to be temporary are charged as unrealized losses to shareholders equity as accumulated other comprehensive income. See Item 7. Managements Discussion and Analysis of
Financial Condition and Results of OperationsLiquidity and Capital Resources, and Note 2 of Notes to Consolidated Financial Statements.



At year-end, approximately 64% of the Companys total investment portfolio, at market values, and 79% of its total fixed maturity investments, at market
values, were invested in investment grade tax-exempt revenue and municipal bonds. Shorter duration sinking fund preferred stocks and collateralized mortgage obligations represented a combined 6.4% of the Companys total investment portfolio, at
market values, at December 31, 2005. The average Standard & Poors rating of the Companys bond holdings was AA at December 31, 2005. Holdings of lower than investment grade bonds constitute approximately 1.6% of total
invested assets.



The nominal average maturity of the overall bond
portfolio, including collateralized mortgage obligations and short-term cash investments, was 11.5 years at December 31, 2005, which reflects a heavy portfolio mix in investment grade tax-exempt revenue and municipal bonds. The call-adjusted
average maturity of the overall bond portfolio was shorter, approximately 3.4 years, because holdings are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified duration of the overall bond portfolio
reflecting anticipated early calls was 2.9 years at December 31, 2005, including collateralized mortgage obligations with modified durations of approximately 1.5 years and short-term cash investments that carry no duration. Modified duration
measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms), which
determine sensitivity to changes in interest rates, modified duration is considered a much better indicator of price volatility than simple maturity alone. The longer the duration, the greater the price volatility in relation to changes in interest
rates.



Equity holdings consist of perpetual preferred stocks and
dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. At year end, short-term cash investments consisted of highly rated short duration securities redeemable on a daily or weekly
basis. This component of the portfolio is increased by management when longer term investment opportunities are considered unattractive as a result of the current interest rate environment.



11



---

The following table summarizes the investment results of the Company for the five years ended December 31,
2005:



|                                                                                         |  |                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|---------------------------------------------------------------------------------------- |  | ----------------------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|                                                                                         |  | Year ended December 31, |          
|                                                                                         |  | 2005                    |           |   | 2004 |   |           | 2003 |  |   | 2002      |   |  | 2001 |          
|                                                                                         |  | (Amounts in thousands)  |          
|Average invested assets (includes short-term cash investments (1))                       |  | $                       | 3,058,110 |   |      | $ | 2,662,224 |      |  | $ | 2,310,966 |   |  | $    | 2,035,279 |   |  | $ | 1,828,455 |  
|Net investment income:                                                                   |  |                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Before income taxes                                                                      |  |                         | 122,582   |   |      |   | 109,681   |      |  |   | 104,520   |   |  |      | 113,083   |   |  |   | 114,511   |  
|After income taxes                                                                       |  |                         | 105,724   |   |      |   | 95,897    |      |  |   | 93,318    |   |  |      | 99,071    |   |  |   | 98,909    |  
|Average annual yield on investments:                                                     |  |                         |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Before income taxes                                                                      |  |                         | 4.0       | % |      |   | 4.1       | %    |  |   | 4.5       | % |  |      | 5.6       | % |  |   | 6.3       | %
|After income taxes                                                                       |  |                         | 3.5       | % |      |   | 3.6       | %    |  |   | 4.0       | % |  |      | 4.9       | % |  |   | 5.4       | %
|Net realized investment gains (losses) after income taxes (2)                            |  |                         | 10,504    |   |      |   | 16,292    |      |  |   | 7,285     |   |  |      | (45,768   | ) |  |   | 4,233     |  
|Net (decrease) increase in unrealized gains/losses on all investments after income taxes |  | $                       | (14,000   | ) |      | $ | (4,284    | )    |  | $ | 42,693    |   |  | $    | 25,165    |   |  | $ | (13,896   | )

---

|(1) |  | Fixed maturities and equities at cost.
|--- |  | --------------------------------------

|(2) |  | Includes investment write-downs, net of tax benefit that the Company considered to be other than temporary of $1.4 million in 2005, $0.6 million in 2004, $5.9 million in 2003 and $46.6
million in 2002. There were no investment write-downs in 2001.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Competitive Conditions



The property and casualty
insurance industry is highly competitive. The insurance industry consists of a large number of companies, many of which operate in more than one state, offering automobile, homeowners and commercial property insurance, as well as insurance coverage
in other lines. Many of the Companys competitors have larger volumes of business and greater financial resources than the Company. Based on the most recent regularly published statistical compilations of premiums written, the Company in 2004
was the third largest writer of private passenger automobile insurance in California. The Companys competitors having greater shares of the California market sell insurance through exclusive agents, rather than through independent agents and
brokers.



The property and casualty insurance industry is highly
cyclical, characterized by periods of high premium rates and shortages of underwriting capacity (hard market) followed by periods of severe price competition and excess capacity (soft market). In managements view, 2004
and 2005 were periods of very good results for companies underwriting automobile insurance. The Company expects 2006 to be profitable for the industry and consequently the market should continue to be very competitive. However, the Company also
believes that industry results may begin to deteriorate primarily as a result of loss inflation without offsetting rate increases. This could lead to a hardening of the market over the next 18 months.



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



All rates charged by private passenger automobile insurers are subject to the prior
approval of the California DOI. See RegulationAutomobile Insurance Rating Factor Regulations.



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



12



---

Reinsurance



Effective January 8, 2005, the Company terminated a property per risk reinsurance treaty that had been in place with Swiss Re since January 1999, and replaced
it with a similar treaty with Employers Reinsurance Corporation (ERC). The new treaty, which covers commercial property and homeowners lines, provides first layer coverage of $250,000 in excess of $750,000 for each risk, second layer
coverage of $1,000,000 in excess of $1,000,000 per risk and third layer coverage of $3,000,000 in excess of $2,000,000 per risk.



The Swiss Re treaty was terminated on a cut off basis meaning that Swiss Re will remain liable for losses occurring prior to the date of termination. The Swiss
Re treaty provides first layer coverage of $250,000 in excess of $750,000, second layer coverage of $1,000,000 in excess of $1,000,000, third layer coverage of $3,000,000 in excess of $2,000,000 and fourth layer coverage of $5,000,000 in excess of
$5,000,000.



Prior to October 1, 2004, the Company had in place a
treaty reinsurance agreement with Swiss Re, where risks written under personal umbrella policies were ceded to Swiss Re on a quota share basis. Prior to May 1, 2003 the treaty was on a 100% quota share basis and provided $4 million coverage in
excess of $1 million for each risk. Effective May 1, 2003, the treaty was replaced with a 33% quota share agreement for umbrella policies with coverage amounts up to but not exceeding $2 million. Effective October 1, 2004, the umbrella
coverage was terminated. The Company has chosen to end the treaty on a run-off basis meaning that the treaty will remain active for one year after the termination date with policies incepting September 30, 2004 and prior being covered per the
treaty terms. Policies incepting on October 1, 2004 and after do not have any reinsurance coverage.



Effective April 1, 2005, the Company purchased catastrophe reinsurance that provides coverage on Florida and Georgia property equal to 95% of $80 million in
excess of the first $70 million of losses per occurrence. The reinsurance was placed with domestic and non-domestic reinsurers and several Lloyds syndicates. This treaty affords coverage in addition to that provided by the Florida
Hurricane Catastrophe Trust Fund (FHCF). The Company estimates that the FHCF provides coverage equal to 90% of approximately $28 million in excess of approximately $9 million.



For California, the Company has reduced its catastrophe exposure from earthquakes due
to the placement of earthquake risks, written in conjunction with California homeowners policies, with the California Earthquake Authority. See RegulationCalifornia Earthquake Authority. Although the Companys catastrophe
exposure to earthquakes has been reduced, the Company continues to have catastrophe exposure for fire following an earthquake.



ERC reinsures AMI through working layer treaties for property and casualty losses in excess of $500,000 up to $3 million. AMI has other reinsurance treaties and
facultative arrangements in place for various smaller lines of business.



MCM maintains reinsurance treaties with several reinsurers covering policies prior to January 1, 2001. The Company also holds a formal guarantee from ERC which reimburses MCM if any of the reinsurers fails to satisfy its obligations
under its respective reinsurance agreement.



If any reinsurers are unable
to perform their obligations under the reinsurance treaty, the Company will be required, as primary insurer, to discharge all obligations to its insureds in their entirety.



Regulation



The Companys business in the states in which it operates is subject to significant regulation and supervision by the DOI of each state, each of which has
broad regulatory, supervisory and administrative powers.



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California Department of Insurance Oversight



The powers of the California DOI primarily include the prior approval of insurance
rates and rating factors, the establishment of capital and surplus requirements and standards of solvency, restrictions on dividend payments and transactions with affiliates. The regulations of and supervision by the California DOI are designed
principally for the benefit of policyholders and not for insurance company shareholders.



Persistency discounts are discounts provided to consumers based on the number of consecutive years the consumer has had insurance coverage. In 1990, following the enactment of Proposition 103 and its prior approval requirement
for insurance premiums in California, the California DOI issued regulations permitting persistency as a rating factor. The regulations provided no definition of persistency. Following a 1994 market conduct examination of the Company, the California
DOI determined that the Companys persistency discount, awarded only to consumers previously insured by the Company or its agents and brokers (so-called loyalty persistency), was unfairly discriminatory. In response, in 1995 the
Company obtained approval for a persistency discount awarded to insureds with continuous coverage with any insurerwhat has come to be called portable persistency. This discount was consistently reapproved until 2002 when the
California DOI, under then Commissioner Harry Low, took the position that only loyalty persistencythat is, the kind of persistency discount the Company awarded prior to 1995was allowable under Proposition 103.



In 2003, the California DOI required all insurers offering persistency discounts to
eliminate their portability. However, Senate Bill 841 (SB 841), enacted in 2003, amended the California Insurance Code to allow portable persistency discounts. SB 841 was challenged in the courts and on September 27, 2005 was
overturned in a decision by the California Court of Appeal in The Foundation for Taxpayer and Consumer Rights, et al. v. Garamendi. The Companys petition for review of this decision was denied by the California Supreme Court in January
2006. Consequently, the Company has filed and received approval for a revenue neutral rate change eliminating persistency which effectively increases the rates charged to some insureds moderately and lowers rates for all others. Since the new rates
went in effect, the Company has seen an increase in the number of new applications. However, it is not yet possible to determine if this will have a material impact on the Company or its operations.



In February 2004, the California DOI issued a Notice of Non-Compliance
(NNC) based on the trial court ruling in the Robert Krumme litigation. The NNC alleges that the Company willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time
fee charged by the consumers insurance broker. The Company filed a Notice of Defense which is based on the same grounds that formed the Companys defense in the Robert Krumme case as well as what the San Francisco Superior Court
appeared to regard as the DOIs acquiescence to our practices. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. If a monetary penalty is imposed, the Company is unable to estimate the
ultimate amount of any monetary penalty, and therefore no reserve for the potential monetary penalty has been established in the consolidated financial statements.



The California DOI is also responsible for conducting periodic financial examinations of insurance companies domiciled in California.
During 2005, the California DOI completed a financial examination of the California Companies as of December 31, 2003. These examinations resulted in no material recommendations.



The California DOIs Market Conduct Division is responsible for conducting periodic examinations of companies to ensure
compliance with the California Insurance Code and the California Code of Regulations with respect to rating, underwriting and claims handling practices. In November 2005, the DOI issued a NNC related to several issues raised from a market conduct
examination dating back to 2002. The Company has filed a Statement of Compliance and a request for public hearing that states and evidences support that the alleged non-compliance does not exist. In December 2005, the DOI issued a NNC challenging
the Companys marital status rating factor. The Company has filed a Statement of Compliance asserting that its rating factor is applied according to industry standard and has been approved as such by the DOI. During 2005, the DOI completed an
examination which



14



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covered a compliance review of the activities of the Companys Special Investigation Unit. The examination resulted in no material recommendations.



State Insurance Agency Oversight in Other States



The Insurance Companies outside California are subject to the
regulatory powers of the DOIs of the various states in which they operate. Those powers are similar to the regulatory powers in California enumerated above. Generally, the regulations relate to standards of solvency and are designed for the benefit
of policyholders and not of insurance company shareholders.



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



The DOI of each state is also responsible for conducting periodic financial
examinations of the insurance companies domiciled in its state. In 2005, the Florida DOI completed financial examinations of MICFL and MIDAM as of December 31, 2003. The Texas DOI completed financial examinations of MCM and AMI Lloyds as of
December 31, 2004. The Oklahoma DOI completed a financial examination of AMI as of December 31, 2004. These examinations resulted in no material recommendations. At December 31, 2005, the Georgia DOI is conducting a financial
examination of the Companys Georgia insurance subsidiaries for the period ending December 31, 2003, and the DOI in the states of Florida and Illinois are conducting financial examinations for the Companys insurance subsidiaries
domiciled in these states for the period ending December 31, 2004. Reports for these examinations are not yet available.



In addition to the financial examinations, the DOI in each state conducts market conduct examinations to ensure compliance with the insurance statutes and
regulations of each state in which the Company operates with respect to rating, underwriting and claims handling practices. At December 31, 2005, the DOI for the states of Texas, Florida and Arizona are conducting market conduct examinations of
the Companys automobile lines of business and the Florida DOI is also conducting a market conduct examination of the Companys homeowners line of business. In February 2006, the Company responded to a Proposed Consent Order (the
Order) received from the Florida DOI. The Order details preliminary findings from the market conduct examination. As of December 31, 2005, the Company has accrued for those items that it believes will have a financial impact. In
addition, the Order proposes a fine for an unspecified amount of money. The Company has established an accrual for a potential fine; however, it is possible that the actual fine could be greater or less than the amount accrued. The Company believes
that the fine, if any, should not have a material effect on the Companys operations or financial condition. During 2005, the New Jersey DOI conducted a market conduct examination of MIDAM as of January 10, 2004. The New Jersey DOI issued an
Adopted Report on February 16, 2006, and the Company is currently in the process of responding to the New Jersey DOI.



The operations of the Company are dependent on the laws of the states in which it does business and changes in those laws can materially affect the revenue and
expenses of the Company. The Company retains its own legislative advocates in California. The Company also makes financial contributions to officeholders and candidates. In 2005 and 2004, those contributions amounted to $352,550 and $534,800,
respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines to be appropriate.



Insurance Guarantee Association



The California Insurance Guarantee Association (the Association) was created to provide for payment of claims for which
insolvent insurers of most casualty lines are liable but which cannot be paid out of such insurers



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assets. The Company is subject to assessment by the Association for its pro-rata share of such claims based on premiums written in the particular line in the year
preceding the assessment by insurers writing that line of insurance in California. Such assessments are based upon estimates of losses to be incurred in liquidating an insolvent insurer. In a particular year, the Company cannot be assessed an amount
greater than 2% of its premiums written in the preceding year. Assessments are recouped through a mandated surcharge to policyholders the year after the assessment. Insurance subsidiaries in the other states are also subject to the provisions of
similar insurance guaranty associations. The Company accounts for assessments in accordance with AICPA Statement of Position 97-3 Accounting by Insurance and Other Enterprises for Insurance-Related Assessments (SOP 97-3),
which requires the recognition of a liability when an assessment is levied or information is available indicating that an assessment is probable. In addition, SOP 97-3 prohibits the recognition of an asset for recoveries related to new business or
renewal of short duration policies.



During 2005, the Company paid
approximately $5 million in assessments to the New Jersey Unsatisfied Claim and Judgment Fund and the New Jersey Property-Liability Insurance Guaranty Association for assessments relating to its personal automobile line of business. In addition, the
Company paid approximately $1 million to the Florida Citizens Property Insurance Corporation for assessments relating to its homeowners line of business. As permitted by state law, all of the Florida assessment and approximately $4 million of the
New Jersey assessment is recoupable through a surcharge to policyholders. During 2005, the Company began to recoup these assessments and will continue recouping them in 2006. It is possible that there will be additional assessments in 2006.



Holding Company Act



The California Companies are subject to regulation by the California DOI pursuant to
the provisions of the California Insurance Holding Company System Regulatory Act (the Holding Company Act). The California DOI may examine the affairs of each of the California Companies at any time. The Holding Company Act requires
disclosure of any material transactions among the companies. Certain transactions and dividends defined to be of an extraordinary type may not be effected if the California DOI disapproves the transaction within 30 days after notice.
Such transactions include, but are not limited to, certain reinsurance transactions and sales, purchases, exchanges, loans and extensions of credit, and investments, in the net aggregate, involving more than the lesser of 3% of the respective
California Companys admitted assets or 25% of statutory surplus as regards policyholders, as of the preceding December 31. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the
preceding 12 months, exceeds the greater of 10% of the insurance companys statutory policyholders surplus as of the preceding December 31 or the insurance companys statutory net income for the preceding calendar year. An
insurance company is also required to notify the California DOI of any dividend after declaration, but prior to payment.



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



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



Assigned Risks



Automobile liability insurers in
California are required to sell bodily injury liability, property damage liability, medical expense and uninsured motorist coverage to a proportionate number (based on the insurers share of the



16



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California automobile casualty insurance market) of those drivers applying for placement as assigned risks. Drivers seek placement as assigned risks
because their driving records or other relevant characteristics, as defined by Proposition 103, make them difficult to insure in the voluntary market. In 2005, assigned risks represented 0.1% of total automobile direct premiums written and 0.1% of
total automobile direct premium earned. The Company attributes the low level of assignments to the competitive voluntary market. Many of the other states in which the Company conducts business offer similar programs to that of California. These
programs are not a significant contributor to the business written in those states.



Automobile Insurance Rating Factor Regulations



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



In December 2005, the California Insurance Commissioner introduced new regulations
designed to reduce the impact of automobile insurance rates based on where people live. Current regulations allow companies to average the weight of all the optional factors, and the average weight of the optional rating factors must be less than
the third statutory factor. The proposed regulation requires each individual optional factor such as territory to have less weight than the third statutory factor. The Commissioner expects these regulations to be effective in late 2006 after public
hearings and review by the California Office of Administrative Law (OAL). Following the announcement of the effective date of this proposed regulation, every insurer will have 90 days to submit a class plan which complies with these
regulations.



The insurance industry has argued that territory is a
useful predictor of risk because it takes into account aspects such as the number of accidents and theft in a particular area. Many insurers, including the Company, place a higher weight on this optional factor. Certain studies have predicted that
reducing the weight of territory in developing automobile insurance rates would likely hurt consumers in the rural and suburban areas where automobile insurance rates would, on average, increase and help consumers in the urban areas where automobile
insurance rates would, on average, decrease. Depending upon the results of the public hearing and the OAL review, the insurance industry may challenge the Commissioners proposal in court on the basis that the results of this regulation are
unfairly discriminatory.



The outcome of these proposed regulations is
not certain at the present time and the Company is unable to determine the impact that these proposed regulations, if enacted, would have on its business.



California Financial Responsibility Law



California requires proof of insurance for the registration (new or renewal) of a motor vehicle. It also provides for substantial penalties for failure to supply
proof of insurance if a driver is stopped for a traffic violation. In addition, California provides that uninsured drivers who are injured in an automobile accident are able to recover only actual, out-of-pocket medical expenses and lost wages and
are not entitled to receive awards for general damages, i.e., pain and suffering. This restriction also applies to drunk drivers and fleeing felons. The law has helped in controlling loss costs.



17



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California Earthquake Authority



The California Earthquake Authority (CEA) is a quasi-governmental organization that was established to provide a market
for earthquake coverage to California homeowners. Since 1998, the Company places all new and renewal earthquake coverage offered with its homeowners policy through the CEA. The Company receives a small fee for placing business with the CEA.



Upon the occurrence of a major seismic event, the CEA has the ability to
assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each companys participation percentage multiplied by the amount of the total assessment. Based upon the most recent
information provided by the CEA, the Companys maximum total exposure to CEA assessments at April 29, 2005, is approximately $54 million.



Terrorism Risk Insurance Act of 2002



The federal government enacted the Terrorism Risk Insurance Act of 2002 (the Act) to establish a temporary Federal program that provides for a system of
shared public and private compensation for insured commercial property and casualty losses resulting from acts of terrorism, as defined within the Act. Scheduled to expire on December 31, 2005, the Act was extended for two additional years and
amended by the Terrorism Risk Insurance Extension Act of 2005 (the Extension Act). The Terrorism Insurance Program (the Program) requires commercial property and casualty insurers licensed in the United States to participate.
The Extension Act modified the provisions of the Act by providing exclusions of certain insured coverages such as commercial automobile insurance, creating a Program trigger for funding of certified events occurring after March 31, 2006 which
exceed aggregate industry losses of $50 million in 2006 and $100 million in 2007. The U.S. government funding for certified events will remain at 90% of covered losses in 2006; decreasing to 85% of covered losses in 2007. Each insurance company is
subject to a deductible based upon a percentage of the previous years direct earned premium; with the percentage increasing each year. The Program, as amended, runs through December 31, 2007.



The Company writes a limited amount of commercial property policies and does not write
policies on properties considered to be a target of terrorist activities such as airports, hotels, large office structures, amusement parks, landmark defined structures or other public facilities. In addition, the Company does not insure a high
concentration of commercial policies in any one area where increased exposure to terrorist threats exist. Consequently, the Company believes its exposure relating to acts of terrorism is low. Less than six percent of the Companys commercial
property policyholders purchased this coverage in 2005.



EXECUTIVE
OFFICERS OF THE COMPANY



The following table sets forth certain
information concerning the executive officers of the Company as of February 15, 2006:



|                      |  |     |  |                                                  
|--------------------- |  | --- |  | -------------------------------------------------
|Name                  |  | Age |  | Position                                         
|George Joseph         |  | 84  |  | Chairman of the Board and Chief Executive Officer
|Gabriel Tirador       |  | 41  |  | President and Chief Operating Officer            
|Bruce E. Norman       |  | 57  |  | Senior Vice PresidentMarketing                  
|Maria Fitzpatrick     |  | 48  |  | Vice President and Chief Information Officer     
|Christopher Graves    |  | 40  |  | Vice President and Chief Investment Officer      
|Kenneth G. Kitzmiller |  | 59  |  | Vice PresidentUnderwriting                      
|Rick McCathron        |  | 34  |  | Vice PresidentWest Region                       
|Joanna Y. Moore       |  | 50  |  | Vice President and Chief Claims Officer          
|Peter Simon           |  | 46  |  | Vice President and Chief Technology Officer      
|Theodore R. Stalick   |  | 42  |  | Vice President and Chief Financial Officer       
|John Sutton           |  | 58  |  | Interim Vice PresidentSouth East Region         
|Charles Toney         |  | 44  |  | Vice President and Chief Actuary                 
|Kenneth Van Wagner    |  | 47  |  | Vice PresidentNorth East Region                 
|Judy A. Walters       |  | 59  |  | Vice PresidentCorporate Affairs and Secretary   



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Mr. Joseph, Chief Executive Officer of the Company and Chairman of its Board of Directors, has served in those
capacities since 1961. Mr. Joseph has more than 50 years experience in the property and casualty insurance business.



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



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



Ms. Fitzpatrick, Vice President and Chief Information Officer, joined the Company
in February 2004, and is responsible for information technology operations. Prior to joining Mercury, she served as the Senior Vice PresidentChief Information Officer for Pacificare Health Systems from 2000 to 2003 and Vice President of
Systems Development at Pacificare Health Systems since 1996.



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



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



Mr. McCathron, Vice PresidentWest Region, joined the Company in the
underwriting department in 1993. He was named to his current position in April 2004. In this position, Mr. McCathron is responsible for all aspects of the Companys operations in Arizona, Illinois, Michigan, Nevada, Oklahoma and
Texas. Mr. McCathron has served in various positions and responsibilities since joining the Company.



Ms. Moore, Vice President and Chief Claims Officer, joined the Company in the claims department in 1981. She was named Vice President of Claims of Mercury
General in 1991 and has held her present position since 1995.



Mr. Simon, Vice President and Chief Technology Officer, has been employed by the Company since 1980. He was appointed to his current position in October 2003. Prior to this appointment, Mr. Simon served as a Vice President in the
Information Systems Department since December 1999.



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



Mr. Sutton, Interim Vice
PresidentSouth East Region, joined the Company in July of 2000 as Assistant to the Chairman and CEO, a position he still holds. He was named Interim Vice President of the South East Region in August 2005, and in this capacity he
is responsible for all aspects of the Companys operations in Florida, Georgia and Virginia. Prior to joining the Company, he was President and Chief Executive Officer of The Covenant Group, a Connecticut-based insurance holding
company.



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



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Mr. Van Wagner, Vice PresidentNorth East Region, joined the Company as the New York State Administrator
in 1999. He was named to his current position in August 2005. In this position, Mr. Van Wagner is responsible for all aspects of the Companys operation in New Jersey, New York and Pennsylvania. Prior to joining the Company, Mr. Van
Wagner worked for Prudential Property and Casualty in a variety of positions from 1981 to 1999.



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



Item 1A.    Risk Factors



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



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



Risks Related to the Company and its Business



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



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



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



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



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



The Companys financial condition,
liquidity and results of operations depend on the Companys ability to underwrite and set premiums accurately for the risks it faces. Premium rate adequacy is necessary to generate sufficient premium to offset losses, loss adjustment expenses
and underwriting expenses and to earn a profit. In



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order to price its products accurately, the Company must collect and properly analyze a substantial volume of data; develop, test and apply appropriate rating
formulae; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. The Companys ability to undertake these efforts successfully, and as a result, price accurately, is
subject to a number of risks and uncertainties, including, without limitation:



| |  |  | availability of sufficient reliable data,
| | - |  | -----------------------------------------



| |  |  | incorrect or incomplete analysis of available data,
| | - |  | ---------------------------------------------------



| |  |  | uncertainties inherent in estimates and assumptions, generally,
| | - |  | ---------------------------------------------------------------



| |  |  | selection and application of appropriate rating formulae or other pricing methodologies,
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | the Companys ability to innovate with new pricing strategies, and the success of those innovations,
| | - |  | ----------------------------------------------------------------------------------------------------



| |  |  | the Companys ability to predict retention (e.g., policy life expectancy) accurately,
| | - |  | -------------------------------------------------------------------------------------



| |  |  | unanticipated court decisions, legislation or regulatory action,
| | - |  | ----------------------------------------------------------------



| |  |  | ongoing changes in the Companys claim settlement practices,
| | - |  | ------------------------------------------------------------



| |  |  | changing driving patterns,
| | - |  | --------------------------



| |  |  | unexpected inflation in the medical sector of the economy, and
| | - |  | --------------------------------------------------------------



| |  |  | unanticipated inflation in auto repair costs, auto parts prices and used car prices.
| | - |  | ------------------------------------------------------------------------------------



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



The effects of emerging claim and coverage issues on the Companys business
are uncertain and may have an adverse effect on the Companys business.



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



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



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



From time to time, the private passenger auto insurance
industry comes under pressure from state regulators, legislators and special interest groups to reduce, freeze or set rates at levels that do not correspond with underlying costs, in the opinion of the Companys management. The homeowners
insurance business faces similar pressure, particularly as regulators in catastrophe-prone states seek an acceptable methodology to price for catastrophe



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exposure. In addition, various insurance underwriting and pricing criteria regularly come under attack by regulators, legislators and special interest groups. The
result could be legislation or regulations that would adversely affect the Companys business, financial condition and results of operations.



The Company remains highly dependent upon California and several other key states to produce revenues.



For the year ended December 31, 2005, the Company generated approximately 72.4%
of its direct automobile insurance premiums written in California, 9.2% of its direct automobile insurance premiums written in Florida and 7.5% of its direct automobile insurance premiums written in New Jersey. The Companys financial results
are therefore subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states and changes in any of these conditions could negatively impact the Companys results of operations.



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



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



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



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



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



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



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



The Company sells its insurance policies through more than 4,900 independent brokers
and agents. The Company must compete with other insurance carriers for these brokers and agents business. Some competitors offer a larger variety of products, lower prices for insurance coverage, higher commissions, or more attractive non-cash
incentives. To maintain its relationship with these independent agents, the Company must pay



22



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competitive commissions, be able to respond to their needs quickly and adequately, and create a consistently high level of customer satisfaction. If these independent
agents find it preferable to do business with the Companys competitors, it would be difficult to renew the Companys existing business or attract new business. Recent or future regulations may also limit the manner in which the
Companys producers are compensated or incentivized. Such developments could negatively impact the Companys relationship with these parties and ultimately reduce revenues.



One independent broker of the Company is responsible for a significant amount of the Companys revenues, and the loss of
business provided by that broker could adversely affect the Companys results of operations and financial condition.



The Company markets its insurance policies primarily through independent agents and brokers. One broker provided 14% of the Companys direct written premiums
in the year ended December 31, 2005. Loss of all or a substantial portion of the business provided by this broker could have a material adverse effect on the Companys business.



Changes in market interest rates or defaults may have an adverse effect on the Companys investment portfolio, which may
adversely affect the Companys financial results.



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



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



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



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



The Companys expansion plans may adversely affect its future profitability.



The Company is currently expanding and intends to further expand its operations in several of the states in which the Company has
operations and into states in which it has not yet begun operations. The intended



23



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expansion will necessitate increased expenditures. The Company expects to fund these expenditures out of cash flow from operations. The expansion may not occur, or if
it does occur may not be successful in providing increased revenues or profitability. If the Companys cash flow from operations is insufficient to cover the increased costs of the expansion or if the expansion does not provide the benefits
anticipated, the Companys financial condition and results of operations and ability to grow its business may be harmed.



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



The Companys future capital requirements depends on many factors, including its
ability to write new business successfully, its ability to establish premium rates and reserves at levels sufficient to cover losses and the success of its current expansion plans. The Company may need to raise additional funds through financings or
curtail its growth and reduce its assets. Any equity or debt financing, if available at all, may not be available on terms that are favorable to us. In the case of equity financings, dilution to the Companys shareholders could result, and in
any case such securities may have rights, preferences and privileges that are senior to those of the Companys current shareholders. If the Company cannot obtain adequate capital on favorable terms or at all, its business, operating results and
financial condition could be adversely affected.



The Company
relies on its information technology systems to manage many aspects of its business, and any failure of these systems to function properly or any interruption in their operation, could result in a material adverse effect on the Companys
business, financial condition and results of operations.



The
Company depends on the accuracy, reliability and proper functioning of its information technology systems. The Company relies on these information technology systems to effectively manage many aspects of its business, including underwriting, policy
acquisition, claims processing and handling, accounting, reserving and actuarial processes and policies, and to maintain its policyholder data. The Company is developing and deploying a new Next Generation information technology system that is
intended to manage many of these functions across all of the states in which it operates and all of the lines of insurance it offers. The failure of hardware or software that supports the Companys information technology systems, the loss of
data contained in the systems or any delay or failure in the full deployment of the Companys Next Generation information technology system could disrupt its business and could result in decreased premiums, increased overhead costs and
inaccurate reporting, all of which could have a material adverse effect on the Companys business, financial condition and results of operations.



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



| |  |  | earthquake, fire, flood and other natural disasters;
| | - |  | ----------------------------------------------------



| |  |  | terrorist attacks and attacks by computer viruses or hackers;
| | - |  | -------------------------------------------------------------



| |  |  | power loss;
| | - |  | -----------



| |  |  | unauthorized access; and
| | - |  | ------------------------



| |  |  | computer systems, or Internet, telecommunications or data network failure.
| | - |  | --------------------------------------------------------------------------



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



24



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Changes in accounting standards issued by the Financial Accounting Standards Board (FASB) or
other standard-setting bodies may adversely affect the Companys consolidated financial statements.



The Companys consolidated financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, the Company
is required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes the Company is required to adopt could change the current accounting
treatment that the Company applies to its consolidated financial statements and that such changes could have a material adverse effect on the Companys results and financial condition. See Note 1 of Notes to Consolidated Financial
Statements.



The Companys disclosure controls and
procedures may not prevent or detect all acts of fraud.



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



Failure to maintain an effective system of internal control over financial reporting may have an adverse effect on the Companys stock price.



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



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



As the Company expands its operations, it must hire and train new employees, and retain current employees to handle the resulting increase in new inquiries,
policies, customers and claims. The failure of the Company to successfully hire and retain a sufficient number of skilled employees could result in the Company having to slow the growth of its business in some jurisdictions. In addition, the failure
to adequately staff its claims department could result in decreased quality of the Companys claims operations.



25



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The Companys success also depends heavily upon the continued contributions of its executive officers, both
individually and as a group. The Companys future performance will be substantially dependent on its ability to retain and motivate its management team. The loss of the services of any of the Companys executive officers, and particularly
George Joseph, could prevent the Company from successfully implementing its business strategy, which could have a material adverse effect on the Companys business, financial condition and results of operations.



The Company faces litigation risks which, if decided adversely to the Company,
could impact its financial results.



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



In addition, potential litigation involving new claim, coverage and business practice issues could adversely affect the Companys business by changing the way policies are priced, extending coverage beyond its underwriting
intent or increasing the size of claims. The effects of these and other unforeseen emerging claim, coverage and business practice issues could negatively impact the Companys revenues or its methods of doing business.



Risks Related to the Companys Industry



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



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



The Company may from time to time undertake strategic marketing and operating
initiatives to improve its competitive position and drive growth. If the Company is unable to successfully implement new strategic initiatives or if the Companys marketing campaigns do not attract new customers, the Companys competitive
position may be harmed, which could adversely affect the Companys business and results of operations.



Additionally, in a highly competitive industry such as the automobile insurance industry, some of the Companys competitors may fail from time to time. In the
event of a failure of a major insurance company, the Company could be adversely affected, as the Company and other insurance companies would likely be required by state law to absorb the losses of the failed insurer, and as the Company would be
faced with an unexpected surge in new business from the failed insurers former policyholders.



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



Approximately 85% of the Companys direct written premiums for the year ended
December 31, 2005 were generated from personal automobile insurance policies. Adverse developments in the market for personal automobile insurance, or the personal automobile insurance industry in general, whether related to changes in



26



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competition, pricing or regulations, could cause the Companys results of operations to suffer. This industry is also exposed to the risks of severe weather
conditions, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes and, to a lesser degree, explosions, terrorist attacks and riots. The automobile insurance business is also affected by cost trends that impact
profitability. Factors which negatively affect cost trends include inflation in automobile repair costs, automobile parts costs, used car prices and medical care. Increased litigation of claims, particularly those involving allegations of bad faith
or seeking extra contractual and punitive damages, may also adversely affect loss costs.



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



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



Required
Licensing. The Company operates under licenses issued by the Departments of Insurance in the states in which the Company sells insurance. If a regulatory authority denies or delays granting a new license, the Companys ability to enter that
market quickly or offer new insurance products in that market may be substantially impaired.



Transactions Between Insurance Companies and Their Affiliates. Transactions between the Companys insurance subsidiaries and their affiliates (including the Company) generally must be disclosed to state regulators,
and prior approval of the applicable regulator generally is required before any material or extraordinary transaction may be consummated. State regulators may refuse to approve or delay approval of some transactions, which may adversely effect the
Companys ability to innovate or operate efficiently.



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



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



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



| |  |  | the use of non-public consumer information and related privacy issues;
| | - |  | ----------------------------------------------------------------------



| |  |  | the use of credit history in underwriting and rating;
| | - |  | -----------------------------------------------------



| |  |  | limitations on the ability to charge policy fees;
| | - |  | -------------------------------------------------



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| |  |  | limitations on types and amounts of investments;
| | - |  | ------------------------------------------------



| |  |  | the payment of dividends;
| | - |  | -------------------------



| |  |  | the acquisition or disposition of an insurance company or of any company controlling an insurance company;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | reporting with respect to financial condition;
| | - |  | ----------------------------------------------



| |  |  | periodic financial and market conduct examinations performed by state insurance department examiners; and
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | the other regulations discussed in this Annual Report on Form 10-K.
| | - |  | -------------------------------------------------------------------



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



Regulation may become more extensive in the future, which may adversely affect the Companys business and results of operations.



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



Risks Related to the Companys Stock



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



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



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



The Company may raise capital in the future through the issuance and sale of shares of its common stock. The Company cannot predict what effect, if any, such future
sales will have on the market price of its common stock. Sales of substantial amounts of its common stock in the public market could adversely affect the market price of



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the Companys outstanding common stock, and may make it more difficult for shareholders to sell common stock at a time and price that the shareholder deems
appropriate. In addition, the Company has issued options to purchase shares of its common stock. In the event that any options to purchase common stock are exercised, shareholders will suffer dilution in their investment.



Applicable insurance laws may make it difficult to effect a change of control of
the Company or the sale of any of its insurance subsidiaries.



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



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



The Company has
paid cash dividends on a consistent basis since the public offering of its common stock in November 1985. However, future cash dividends will depend upon a variety of factors, including the ability of the insurance subsidiaries to make distributions
to the Company, which may be restricted by financial, regulatory or tax constraints. Also, there can be no assurance that the Company will continue to pay dividends even if the necessary financial and regulatory conditions are met and if sufficient
cash is available for distribution.



Item 1B.    Unresolved
Staff Comments



None



Item 2.    Properties



The home office of the California Companies and the Companys computer facilities
are located in Brea, California in 238,000 square feet of office space owned by the Company.



The Companys executive offices are located in a 36,000 square foot office building in Los Angeles, California, owned by MCC. The Company occupies approximately 95% of the building and leases the remaining office space to
outside parties.



The Company owns a 130,000 square foot office building
in Rancho Cucamonga, California that opened in September 2003. This space is used to support the Companys California operations and future expansion. Any space in the building that is not occupied by the Company may be leased to outside
parties.



During 2005, the Company purchased a 157,000 square foot office
building in St. Petersburg, Florida and a 100,000 square foot office building in Oklahoma City, Oklahoma. These buildings house employees of the Company and several outside tenants. In the future, the Company plans to expand into the spaces occupied
by the outside tenants as their lease terms end.



The Company leases all
of its other office space. Office location is not material to the Companys operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space.



Item 3.    Legal Proceedings



The Company is, from time to time, named as a defendant in various lawsuits incidental
to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages, which are not insurable under



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judicial decisions. The Company has established reserves for lawsuits in cases where the Company is able to estimate its potential exposure and it is probable that the
court will rule against the Company. The Company vigorously defends actions against it, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the
Companys quarterly results of operations, however it is not expected to be material to the Companys financial condition.



As previously reported, following trial and appeal in Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and
California Automobile Insurance Company (Superior Court for the City and County of San Francisco), the Court issued a modified injunction on July 11, 2005 requiring the Company to compensate brokers at the same rate based on volume of
sales, accept applications for insurance from any California licensed broker, remove subjective underwriting requirements from its broker instruction manual and provide guidelines to be used by its field personnel that specifically identify the
standards of broker performance. The Company has implemented changes to its broker relationship to comply with the Courts modified injunction. The Court also stated that some period of review must take place following any changes before a
complete assessment of the brokers relationship with the Company can be made, and that any further judicial review should be undertaken only after further discussions between the parties to the lawsuit and appropriate evidence reflecting the
nature of such broker relationship is fully assessed. These changes must occur during a one year period of review through November 1, 2006 before the Court will reconsider vacating the modified injunction. The Company believes that it is in
compliance with the modified injunction. The Company is not able to estimate the extent to which complying with the modified injunction will impact future trends in earnings or loss ratios.



Sam Donabedian, individually and on behalf of those similarly situated v. Mercury
Insurance Company, filed his original action on April 20, 2001 in the Los Angeles Superior Court, asserting, among other things, a claim that the Companys calculation of persistency discounts to determine premiums is an unfair
business practice, a violation of the California Consumer Legal Remedies Act (CLRA) and a breach of the covenant of good faith and fair dealing. The Company originally prevailed on a Demurrer to the Complaint and the case was
dismissed; however, the California Court of Appeal reversed the trial courts ruling, deciding that the California Insurance Commissioner does not have the exclusive right to review the calculation of insurance rates/premiums. After filing two
additional pleadings, on June 28, 2005, the Plaintiff filed a Fourth Amended Complaint, asserting claims for violation of California Business & Professions Code Section 17200 and breach of the covenant of good faith and fair
dealing (the CLRA claim previously had been dismissed with prejudice). Plaintiff again sought injunctive relief, unspecified restitution and monetary damages as well as punitive damages and attorneys fees and costs. Without leave of court, the
Plaintiff has attempted to state claims for breach of contract and fraud. The Company filed a Demurrer and Motion to Strike certain portions of the Plaintiffs Fourth Amended Complaint. Following the hearing on September 19, 2005, the
Court took the matter under submission. On June 9, 2005, the trial court also permitted a Complaint in Intervention by The Foundation for Taxpayer and Consumer Rights which alleges that the Companys calculation of persistency discounts
constitutes a violation of Insurance Code Section 1861.02(a) and (c) and the Company has filed an answer to that pleading. No trial date has been scheduled and the Plaintiff has not filed a motion to certify the putative class.



The Court agreed to postpone the litigation and to seal its ruling on the
Companys Demurrer and Motion to Strike certain portions of the Fourth Amended Complaint until March 14, 2006 to determine whether the case could be resolved without further litigation. If the case is not resolved by that date or if
progress towards settlement has not been made, the Company expects the Court will unseal its ruling on the Demurrer and Motion to Strike and discovery will commence. The Company is not able to determine the potential outcome of this matter or
potential exposure in the event liability is to be found. The Company intends to vigorously defend this lawsuit.



Noam Hernandez, individually and on behalf of others similarly situated v. Mercury Insurance Company,(Los Angeles Superior Court), originally filed
July 12, 2002, as Dan ODell v. Mercury Insurance Company, involves a dispute over whether the Companys use of certain automated database vendors to help determine the value of total loss claims is proper. The Plaintiff
(along with plaintiffs in other coordinated cases against other insurers) is seeking class certification and unspecified damages for breach of contract and bad faith, including punitive damages,



30



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restitution, an injunction preventing the Company from using valuation software, and unspecified attorneys fees and costs. In 2003, the Court granted the
Companys motion to stay the action pending Plaintiff ODells compliance with a contractual arbitration provision. The arbitration was completed in August 2004 and the award in the Companys favor was confirmed by the Court
in January 2005. In June 2005, based upon the arbitration result and other defenses, the Court granted the Companys Motion to Strike the first amended complaint. While the individual claims of Plaintiff ODell were dismissed
with prejudice, Plaintiffs counsel was given leave to file a second amended complaint, substituting a new Plaintiff, in August of 2005. As with the previous Plaintiff, the Company has filed a motion to compel Plaintiff Hernandez
compliance with a contractual arbitration provision, and has also filed a Motion to Strike portions of the amended complaint on other grounds. The Court is expected to rule on these motions on March 16, 2006. The Company is not able to evaluate
the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of an unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated
proceedings.



In Marissa Goodman, on her own behalf and on behalf of
all others similarly situated v. Mercury Insurance Company (Los Angeles Superior Court), filed June 16, 2002, the Plaintiff is challenging the Companys use of certain automated database vendors to assist in valuing claims for medical
payments. The Plaintiff has filed a motion seeking class action certification to include all of the Companys insureds from 1998 to the present who presented a medical payments claim, had the claim reduced using the computer program and whose
claim did not reach the policy limits for medical payments. No date has been set for this motion. As with the ODell case above, and the other cases in the coordinated proceedings, the Plaintiff alleges that these automated databases
systematically undervalue medical payment claims to the detriment of insureds. The Plaintiff is seeking unspecified actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been
coordinated with two other similar cases, and also with ten other cases relating to total loss claims. The Court denied the Companys Motion for Summary Judgment holding that there is an issue of fact as to whether Ms. Goodman sustained
any damages as a result of the Companys handling of her medical payments claim. A trial date has been set for May 2006. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in
the event of an unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.



Cynthia Markovich and Patricia Carnegie v. Mercury Insurance Services, LLC, a collective action claim filed April 19, 2005
in the United States District Court for the Middle District of Florida, asserts that the Plaintiffs were denied overtime compensation while working as Florida claims adjusters for the Company in violation of the provisions of the Fair Labor
Standards Act. The Plaintiffs are seeking class certification to include all Florida claims adjusters during the three years preceding the filing of this action and recovery of overtime compensation, liquidated damages, attorneys fees, costs
and other compensation. No specific amount of damages has been claimed. The parties to the claim have agreed to give the putative members of the collective action notice and an opportunity to opt-in to determine the potential liability and then
attempt to settle the claim. If a settlement can not be reached, discovery will continue and the case will proceed to trial. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the
event of a settlement or an unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit.



The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. See Item 7. Managements
Discussion and Analysis of Financial Conditions and Results of OperationsGeneral, and Note 6 of Notes to Consolidated Financial Statements.



Item 4.    Submission of Matters to a Vote of Security Holders



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



31



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PART II



Item 5.    Market for the Registrants Common Equity, Related Security Holder Matters and Issuer Purchase of
Equity Securities



Price Range of Common Stock



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



|            |  |      |       |     |   |      
|----------- |  | ---- | ----- | --- | - | -----
|            |  | High |       | Low
|2004        |  |      |       |     |   |      
|1st Quarter |  | $    | 53.24 |     | $ | 46.29
|2nd Quarter |  | $    | 53.40 |     | $ | 47.70
|3rd Quarter |  | $    | 53.27 |     | $ | 46.95
|4th Quarter |  | $    | 60.26 |     | $ | 47.60
|            |  |     
|            |  | High |       | Low
|2005        |  |      |       |     |   |      
|1st Quarter |  | $    | 60.00 |     | $ | 51.80
|2nd Quarter |  | $    | 55.58 |     | $ | 51.16
|3rd Quarter |  | $    | 60.45 |     | $ | 53.50
|4th Quarter |  | $    | 60.45 |     | $ | 56.87



The closing price of the
Companys common stock on February 28, 2006 was $55.90.



Dividends



Since the public offering of its common stock
in November 1985, the Company has paid regular quarterly dividends on its common stock. During 2005 and 2004, the Company paid dividends on its common stock of $1.72 per share and $1.48 per share, respectively. On February 3, 2006, the Board of
Directors declared a $0.48 quarterly dividend payable on March 30, 2006 to shareholders of record on March 15, 2006.



The common stock dividend rate has increased at least once each year since dividends were initiated in January, 1986. For financial statement purposes, the Company
records dividends on the declaration date. The Company expects to continue the payment of quarterly dividends; however, the continued payment and amount of cash dividends will depend upon, among other factors, the Companys operating results,
overall financial condition, capital requirements and general business conditions.



As a holding company, Mercury General is largely dependent upon dividends from its subsidiaries to pay dividends to its shareholders. These subsidiaries are subject to state laws that restrict their ability to distribute
dividends. For example, California state laws permit a casualty insurance company to pay dividends and advances within any 12-month period, without any prior regulatory approval, in an amount up to the greater of 10% of statutory earned surplus at
the preceding December 31, or statutory net income for the calendar year preceding the date the dividend is paid. Under the state restrictions, the direct insurance subsidiaries of the Company are entitled to pay dividends to Mercury General
during 2006 of up to approximately $248 million without prior regulatory approval. See Item 1. BusinessRegulationHolding Company Act, and Note 8 of Notes to Consolidated Financial Statements.



Shareholders of Record



The approximate number of holders of record of the Companys common stock as of February 28, 2006 was 210.



32



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Item 6.    Selected Consolidated Financial Data



|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|-------------------------------------- |  | --------------------------------------------- | --------- | ---- | - | --------- |  | ---- | --------- |  | ---- | --------- | - |  | - | --------- | -
|                                       |  | Year Ended December 31,                       |          
|                                       |  | 2005                                          |           | 2004 |   | 2003      |  | 2002 |           |  | 2001 |          
|                                       |  | (Amounts in thousands, except per share data) |          
|Income Data:                           |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Earned premiums                        |  | $                                             | 2,847,733 |      | $ | 2,528,636 |  | $    | 2,145,047 |  | $    | 1,741,527 |   |  | $ | 1,380,561 |  
|Net investment income                  |  |                                               | 122,582   |      |   | 109,681   |  |      | 104,520   |  |      | 113,083   |   |  |   | 114,511   |  
|Net realized investment gains (losses) |  |                                               | 16,160    |      |   | 25,065    |  |      | 11,207    |  |      | (70,412   | ) |  |   | 6,512     |  
|Other                                  |  |                                               | 5,438     |      |   | 4,775     |  |      | 4,743     |  |      | 2,073     |   |  |   | 5,396     |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Total revenues                         |  | $                                             | 2,991,913 |      |   | 2,668,157 |  |      | 2,265,517 |  |      | 1,786,271 |   |  |   | 1,506,980 |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Losses and loss adjustment expenses    |  |                                               | 1,862,936 |      |   | 1,582,254 |  |      | 1,452,051 |  |      | 1,268,243 |   |  |   | 1,010,439 |  
|Policy acquisition costs               |  |                                               | 618,915   |      |   | 562,553   |  |      | 473,314   |  |      | 378,385   |   |  |   | 301,670   |  
|Other operating expenses               |  |                                               | 150,201   |      |   | 111,285   |  |      | 91,295    |  |      | 74,875    |   |  |   | 62,335    |  
|Interest                               |  |                                               | 7,222     |      |   | 4,222     |  |      | 3,056     |  |      | 4,100     |   |  |   | 7,727     |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Total expenses                         |  |                                               | 2,639,274 |      |   | 2,260,314 |  |      | 2,019,716 |  |      | 1,725,603 |   |  |   | 1,382,171 |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Income before income taxes             |  |                                               | 352,639   |      |   | 407,843   |  |      | 245,801   |  |      | 60,668    |   |  |   | 124,809   |  
|Income tax expense (benefit)           |  |                                               | 99,380    |      |   | 121,635   |  |      | 61,480    |  |      | (5,437    | ) |  |   | 19,470    |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Net income                             |  | $                                             | 253,259   |      | $ | 286,208   |  | $    | 184,321   |  | $    | 66,105    |   |  | $ | 105,339   |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Per Share Data:                        |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Basic earnings per share               |  | $                                             | 4.64      |      | $ | 5.25      |  | $    | 3.39      |  | $    | 1.22      |   |  | $ | 1.94      |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Diluted earnings per share             |  | $                                             | 4.63      |      | $ | 5.24      |  | $    | 3.38      |  | $    | 1.21      |   |  | $ | 1.94      |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Dividends paid                         |  | $                                             | 1.72      |      | $ | 1.48      |  | $    | 1.32      |  | $    | 1.20      |   |  | $ | 1.06      |  
|                                       |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|                                       | 
|                                       |  | December 31,                                  |          
|                                       |  | 2005                                          |           | 2004 |   | 2003      |  | 2002 |           |  | 2001 |          
|                                       |  | (Amounts in thousands, except per share data) |          
|Balance Sheet Data:                    |  |                                               |           |      |   |           |  |      |           |  |      |           |   |  |   |           |  
|Total investments                      |  | $                                             | 3,242,712 |      | $ | 2,921,042 |  | $    | 2,539,514 |  | $    | 2,150,658 |   |  | $ | 1,936,171 |  
|Premiums receivable                    |  |                                               | 310,457   |      |   | 284,690   |  |      | 231,277   |  |      | 186,446   |   |  |   | 143,612   |  
|Total assets                           |  |                                               | 4,041,551 |      |   | 3,622,024 |  |      | 3,134,541 |  |      | 2,664,231 |   |  |   | 2,316,540 |  
|Losses and loss adjustment expenses    |  |                                               | 1,022,603 |      |   | 900,744   |  |      | 797,927   |  |      | 679,271   |   |  |   | 534,926   |  
|Unearned premiums                      |  |                                               | 902,567   |      |   | 799,679   |  |      | 681,745   |  |      | 560,649   |   |  |   | 434,720   |  
|Notes payable                          |  |                                               | 143,540   |      |   | 137,024   |  |      | 139,489   |  |      | 147,794   |   |  |   | 129,513   |  
|Deferred income tax liability (asset)  |  |                                               | 37,456    |      |   | 30,606    |  |      | 17,808    |  |      | (17,004   | ) |  |   | (1,252    | )
|Shareholders equity                   |  |                                               | 1,607,837 |      |   | 1,459,548 |  |      | 1,255,503 |  |      | 1,098,786 |   |  |   | 1,069,711 |  
|Book value per share                   |  |                                               | 29.44     |      |   | 26.77     |  |      | 23.07     |  |      | 20.21     |   |  |   | 19.72     |  



33



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



Overview



Mercury General Corporation and its subsidiaries (collectively, the Company) is headquartered in Los Angeles, California
and operates primarily as a personal automobile insurer selling policies through a network of independent agents and brokers in thirteen states. The Company also offers homeowners insurance, mechanical breakdown insurance, commercial and dwelling
fire insurance, umbrella insurance, commercial automobile and commercial property insurance. Private passenger automobile lines of insurance accounted for approximately 85% of the $3.0 billion of the Companys direct premiums written in 2005,
with approximately 72% of the private passenger automobile premiums written in California.



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



Economic and Industry Wide Factors



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



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



| |  |  | InflationThe largest cost component for automobile insurers are losses which include medical costs and replacement automobile parts and labor repair costs. There has recently been
significant variation in the overall increases in medical cost inflation and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of
certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates are higher or lower than anticipated. The Company currently estimates low single digit inflation rates on bodily injury
coverages for its major California personal automobile lines for the 2005 accident year. The inflation rate for this accident year is the most difficult to estimate because there remain many open claims. Should actual inflation be higher the Company
could be under reserved for its losses and profit margins would be lower.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



34



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| |  |  | Underwriting Cycle and CompetitionThe property and casualty insurance industry is highly cyclical, with periods of rising premium rates and shortages of underwriting capacity
(hard market) followed by periods of substantial price competition and excess capacity (soft market). The Company has historically seen premium growth in excess of 20% during hard markets, whereas premium growth rates during
soft markets have historically been in the single digits. Many of the Companys major competitors announced improved operating results in 2004 and throughout 2005. This typically signals a softening in the market, and consequently, the Company
experienced a decline in the rate of growth of its policies in force in California during 2005.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Revenues, Income and Cash Generation



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



The Company believes that it has a more thorough underwriting process which gives the Company an advantage over its competitors. The Company views its agent
relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins.



The Company also generates revenue from its investment portfolio, which was approximately $3.2 billion at the end of 2005. This
investment portfolio generated nearly $123 million in pre-tax investment income during 2005. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.



The Companys results and growth have allowed it to consistently generate positive
cash flow from operations, which was approximately $490 million in 2005. The Companys cash flow from operations has exceeded $100 million every year since 1994 and has been positive for over 20 years. Cash flow from operations has been used to
pay shareholder dividends and to help support growth.



Opportunities, Challenges and Risks



The Company
currently underwrites personal automobile insurance in thirteen states: Arizona, California, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas and Virginia. The Company expects to continue its growth
by expanding into new states in future years with the objective of achieving greater geographic diversification, so that non-California premiums eventually account for as much as half of the Companys total premiums.



There are, however, challenges and risks involved in entering each new state, including
establishing adequate rates without any operating history in the state, working with a new regulatory regime, hiring and training competent personnel, building adequate systems and finding qualified agents to represent the Company. The Company does
not expect to enter into any new states until its NextGen computer system is successfully implemented. See Technology.



The Company is also subject to risks inherent in its business, which include but are not limited to the following:



| |  |  | A catastrophe, such as a major wildfire, earthquake or hurricane, can cause a significant amount of loss to the Company in a very short period of time.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A major regulatory change could make it more difficult for the Company to generate new business.
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | A sharp upward increase in market interest rates or a downturn in securities markets could cause a significant loss in the value of the Companys investment portfolio.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



35



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Technology



The Company is currently developing a Next Generation (NextGen) computer system to replace its existing underwriting, billings, claims and
commissions legacy systems that currently reside on Hewlett Packard 3000 mainframe computers. The NextGen system is designed to be a multi-state, multi-line system that is expected to enable the Company to enter new states more rapidly, as well as
respond to legislative and regulatory changes more easily than the Companys current systems. The NextGen system is initially being deployed for the personal automobile line of business and has been successfully implemented in one state
(Virginia). The Company expects to implement NextGen in its other states in 2006 and 2007. The Company has currently spent approximately $30 million on NextGen and expects additional costs to be incurred during the implementation period. NextGen is
expected to provide a positive benefit to the Company. As with any large scale technology implementation, risks associated with system implementation can occur that could significantly impact the operations of the Company and increase the expected
costs of the project, although management has expended planning and development efforts to mitigate these risks.



General



The operating results of property and casualty insurance companies are subject to significant fluctuations from quarter-to-quarter and from year-to-year due to the effect of competition on pricing, the frequency and severity of
losses, including the effect of natural disasters on losses, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates and other factors such as changes in tax
laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on
the ability of the Company to grow and retain business. In managements view, 2004 and 2005 were periods of very good results for companies underwriting automobile insurance. As a result, the automobile insurance market is extremely
competitive. The Company expects this trend to continue in 2006.



The
Company operates primarily in the state of California, which was the only state in which it produced business prior to 1990. The Company has since expanded its operations into the following states: Georgia (1990), Illinois (1990), Oklahoma (1996),
Texas (1996), Florida (1998), Virginia (2001), New York (2001), New Jersey (2003), Arizona (2004), Pennsylvania (2004), Michigan (2004) and Nevada (2004).



During 2005, approximately 72% of the Companys total net premiums written were derived from California as compared to 76% in 2004. The decrease was the
result of a greater portion of business written outside of California. The Company has established a diversification goal to produce half of its business outside of California by the end of 2008. There are factors, some of which are outside of the
Companys control, that could prevent the Company from achieving this goal.



The process for implementing rate changes varies by state, with California, Georgia, New York, New Jersey, Pennsylvania and Nevada requiring prior approval from the DOI before a rate can be implemented. Illinois, Texas, Virginia,
Arizona and Michigan only require that rates be filed with the DOI, while Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be excessive, inadequate or unfairly
discriminatory.



During 2005, the Company had no rate increases in
California and implemented automobile rate increases in only three of the twelve non-California states. The Company believes that its rates will remain competitive in the marketplace. During 2005, the Company continued its marketing efforts for name
recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation make the Company very competitive in California and in other states. During 2005,
the Company incurred approximately $34 million in advertising expenses.



The California DOI uses rating factor regulations requiring automobile insurance rates to be determined by (1) driving safety record, (2) miles driven per year, (3) years of driving experience and (4) whatever optional
factors



36



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are determined by the California DOI to have a substantial relationship to the risk of loss and adopted by regulation. The regulations further require that each of the
four factors be applied in decreasing order of importance.



In December
2005, the California Insurance Commissioner introduced new regulations designed to reduce the impact on automobile insurance rates based on where people live. Current regulations allow companies to average the weight of all the optional rating
factors, and the average weight of the optional rating factors must be less than the third statutory factor. The proposed regulation requires each individual optional factor such as territory to have less weight than the third statutory factor. The
California Commissioner expects these regulations to be effective in late 2006 after public hearings and review by the California Office of Administrative Law (OAL). Following the announcement of the effective date of this proposed
regulation, every insurer will have 90 days to submit a class plan which complies with these regulations.



The insurance industry has argued that territory is a useful predictor of risk because it takes into account aspects such as the number of accidents and theft in a
particular area. Many insurers, including the Company, place a higher weight on this optional factor. Certain studies have predicted that reducing the weight of territory in developing automobile insurance rates would likely hurt consumers in the
rural and suburban areas where automobile insurance rates would, on average, increase and help consumers in the urban areas where automobile insurance rates would, on average, decrease. Depending upon the results of the public hearing and the OAL
review, the insurance industry may challenge the California Commissioners proposal in court on the basis that the results of this regulation are unfairly discriminatory.



The outcome of these proposed regulations is not certain at the present time and the Company is unable to determine the impact that
these proposed regulations, if enacted, would have on its business.



Persistency discounts are discounts to consumers based on the number of consecutive years the consumer has had insurance coverage. In 1990, following the enactment of Proposition 103 and its prior approval requirement for insurance premiums
in California, the California DOI issued regulations permitting persistency as a rating factor. The regulations, however, provided no definition of persistency. Following a 1994 market conduct examination of the Company, the California DOI
determined that the Companys persistency discount, awarded only to consumers previously insured by the Company or its agents and brokers (so-called loyalty persistency), was unfairly discriminatory. In response, in 1995 the Company
obtained approval for a persistency discount awarded to insureds with continuous coverage with any insurerwhat has come to be called portable persistency. This discount was consistently reapproved until 2002 when the California
DOI, under then Commissioner Harry Low took the position that only loyalty persistencythat is, the kind of persistency discount the Company awarded prior to 1995was allowable under Proposition 103.



In 2003, the California DOI required all insurers offering persistency discounts to
eliminate their portability. However, Senate Bill 841 (SB 841), enacted in 2003, amended the California Insurance Code to allow portable persistency discounts. SB 841 was challenged in the courts and on September 27, 2005 was
overturned in a decision by the California Court of Appeal in The Foundation for Taxpayer and Consumer Rights, et al. v. Garamendi. The Companys petition for review of this decision was denied by the California Supreme Court in January
2006. Consequently, the Company has filed and received approval for a revenue neutral rate change eliminating persistency which effectively increases the rates charged to some insureds moderately and lowers rates for all others. Since the new rates
went in effect, the Company has seen an increase in the number of new applications. However, it is not yet possible to determine if this will have a material impact on the Company or its operations.



On June 25, 2003, the California State Board of Equalization (SBE)
upheld Notices of Proposed Assessments issued against the Company for tax years 1993 through 1996 in which the Franchise Tax Board (FTB) disallowed a portion of the Companys expenses related to management services provided to its
insurance company subsidiaries on grounds that such expenses were allocable to the Companys tax-deductible dividends from such subsidiaries. The SBE decision also resulted in a smaller disallowance of the Companys interest expense
deductions than was proposed by the FTB in those years. The Company filed a petition for rehearing with the SBE



37



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relating to these franchise tax issues and a rehearing was granted and held on July 1, 2005. At the rehearing, additional briefings were requested before the SBE
would rule on the matter. These briefings were filed with the SBE and another rehearing is scheduled for March 28, 2006.



The potential net exposure on the franchise tax issues for 1993 through 1996, after federal tax benefit, amounts to approximately $15 million, which includes a
potential tax amnesty interest penalty of approximately $4 million. The amnesty penalty relates to a revenue enhancement provision contained in the California Tax Amnesty legislation requiring taxpayers with tax assessments for tax years 2002 and
prior, whether or not disputed, to pay amounts due by March 31, 2005 or risk paying an additional penalty amount equal to 50% of the interest computed on the original assessment for the period beginning with the due date of the return and
ending on March 31, 2005. These amounts would be due should the Company not prevail on the underlying tax issues.



The Company believes that the deduction of the expenses related to management services provided to its insurance company subsidiaries is appropriate. The Company
has established a tax liability of approximately $1 million for the franchise tax issues related to the tax years 1993 through 1996. An unfavorable ruling against the Company in the rehearing may have a material impact on the Companys
quarterly results of operations.



As a result of California Assembly Bill
263 (AB263), the Company paid approximately $3.5 million in California franchise taxes for the tax years 1997 through 2003 during 2005. AB263 resolved an issue raised by the FTB where they interpreted a legal ruling to eliminate a
dividends received deduction (DRD) taken by companies on dividends received from their insurance subsidiaries. AB263 provides for an 80% DRD for tax years 1997 through 2007 and an 85% DRD for tax years after 2007.



The California FTB has audited the 1997 through 2002 tax returns and they accepted the
1997 through 2000 returns to be correct as filed. For the 2001 and 2002 tax returns, the FTB has taken exception to the state apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from
Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company that is excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. Based on this assertion, the FTB issued
notices of proposed tax assessments in January 2006 for the 2001 and 2002 tax years totaling approximately $1 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the SBE. An
unfavorable ruling against the Company may have a material impact on the Companys quarterly results of operations. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that
the Company will prevail on this matter.



The Company is also involved in
proceedings incidental to its insurance business. See Item 3. Legal Proceedings, and Note 10 of Notes to Consolidated Financial Statements.



Critical Accounting Policies



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



The Company performs its own loss reserve analysis and also engages the services of independent actuaries to assist in the estimation of loss reserves. The Company
and the actuaries do not calculate a range of loss reserve



38



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estimates but rather calculate a point estimate. Management reviews the underlying factors and assumptions that serve as the basis for preparing the reserve estimate.
These include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information. At December 31, 2005, the Company recorded its point estimate of
approximately $1,023 million in loss and loss adjustment expense reserves which includes approximately $277 million of incurred but not reported (IBNR) loss reserves. IBNR includes estimates, based upon past experience, of ultimate
developed costs which may differ from case estimates, unreported claims which occurred on or prior to December 31, 2005 and estimated future payments for reopened-claims reserves. Management believes that the liability for losses and loss
adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision.



For the year ended December 31, 2005, the Company had positive
development of approximately $46.5 million on the 2004 and prior year loss and loss adjustment expense reserves which at December 31, 2004 totaled $901 million. The Company attributes more than half of this redundancy to a change in the
inflation rate assumptions used to establish bodily injury coverage reserves for the California automobile insurance lines of business for the 2003 and 2004 accident years. The redundancies, related to changes in bodily injury inflation rate changes
on the 2004 and 2003 accident years, were approximately $23 million and $5 million, respectively.



At December 31, 2004, the Company had estimated California automobile insurance bodily injury inflation rates of approximately 1% on the 2003 and 2004 accident
years. At December 31, 2005, these assumptions were reduced to deflation amounts of approximately negative 1% for the 2003 accident year and approximately negative 4% for the 2004 accident year. The Company changed its inflation assumptions
based on factors that continued to develop throughout 2005. These included a favorable trend in the average amounts paid on closed claims for the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage
of time as more claims from an accident period are closed.



Bodily injury
inflation for the most recent accident years is one of the most difficult components of the Companys reserves to estimate because a large portion of the claims have not yet been settled. As time passes and more claims from an accident year are
settled, the actual inflation rate becomes more certain. Since there are still a significant amount of open bodily injury claims for the 2005 and 2004 accident years, it is possible that inflation rate assumptions will change as more claims are
settled in the future.



In addition, approximately one third of the
positive development on the reserves established at December 31, 2004 relates to a reduction in the loss adjustment expense reserves for the California automobile insurance lines of business. During the year ended December 31, 2005, there
was a decrease in the expenditures to outside legal counsel for the defense of personal automobile claims in California. This led to a reduction in the ultimate expense amount expected to be paid out and therefore a redundancy in the reserves
established at December 31, 2004. The Company believes that many factors could be contributing to the reduction in payments to outside legal counsel. These include cost savings from the usage of more flat fee billing arrangements with outside
counsel, faster closure rates of bodily injury liability cases and a decrease in bodily injury claims frequency due to factors such as improvements made in vehicle safety.



The Company had smaller redundancies and deficiencies in its other coverages offered within its California automobile insurance line
of business, as well as in other lines of business in California and other states. When aggregated, these account for the remainder of the positive reserve development experienced in 2005. The positive development in total was more than offset by
the reserve needs for the current accident year.



For the year ended
December 31, 2004, the Companys loss reserves as estimated at December 31, 2003 produced a redundancy of approximately $58 million which was reflected in the financial statements as a reduction to the 2004 calendar year incurred
losses. The Company attributes most of this redundancy to a change in the inflation rate assumptions used to establish reserves on the bodily injury coverage for California private passenger automobile insurance on the 2002 and 2003 accident years.



39



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At year-end 2003, the Company had assumed bodily injury severity inflation on California private passenger
automobile insurance of 9% on the 2001 accident year, 6% on the 2002 accident year and 7% on the 2003 accident year. At year-end 2004, these assumptions were reduced to 8% for 2001, 1% for 2002 and 1% for 2003. The Company reduced the inflation rate
assumptions based on factors that emerged during 2004 including moderating to decreasing average amounts paid on closed claims in the 2003 and 2004 accident years and increased certainty in reserve amounts that comes through the passage of time as
more claims from an accident period are closed.



The change in these
inflation assumptions accounted for approximately $41 million of the decrease in the expected ultimate loss on the reserves established at December 31, 2003. Each percentage point change in the inflation rate assumption accounts for
approximately $2.5 million of the redundancy on the 2002 accident year losses and approximately $5 million on the 2003 accident year losses.



The remainder of the redundancy for the 2003 accident year primarily occurred in the Companys California homeowners and Florida personal automobile lines of
business. California homeowners had approximately $6 million in reserve redundancy and Florida personal automobile had approximately $8 million in reserve redundancy.



At December 31, 2004, the Company assumed bodily injury inflation rates of approximately 1% on the 2004 accident year for the
California automobile lines of business. The Company estimates that each percentage point change in the inflation rate assumption would impact the 2002 through 2004 accident years by approximately $2.5 million individually with a compounding effect
if adjusted for multiple accident years. For example, if all years were changed to 2%, 2002 would be affected by $2.5 million, 2003 by $5 million and 2004 by $7.5 million for a total of approximately $15 million.



The Company complies with the SFAS No. 60 definition of how insurance enterprises
should recognize revenue on insurance policies written. The Companys insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums
are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition
costs and maintenance costs to related unearned premiums. To the extent that any of the Companys lines of business become substantially unprofitable, then a premium deficiency reserve may be required. The Company does not expect this to occur
on any of its significant lines of business.



The Company carries its
fixed maturity and equity investments at market value as required for securities classified as Available for Sale by Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity
Securities (SFAS No. 115). In most cases, market valuations were drawn from trade data sources. In no case were any valuations made by the Companys management. Equity holdings, including non-sinking fund preferred
stocks, are, with minor exceptions, actively traded on national exchanges or trading markets, and were valued at the last transaction price on the balance sheet date. The Company constantly evaluates its investments for other than temporary declines
and writes them off as realized losses through the consolidated statement of income, as required by SFAS No. 115, when recovery of the net book value appears doubtful. Temporary unrealized investment gains and losses are credited or charged
directly to shareholders equity as part of accumulated other comprehensive income (loss), net of applicable taxes. It is possible that future information will become available about the Companys current investments that would require
accounting for them as realized losses due to other than temporary declines in value. The financial statement effect would be to move the unrealized loss from accumulated other comprehensive income (loss) on the consolidated balance sheet to
realized investment losses on the consolidated statement of income.



The
Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits relating to our business. The Company continually evaluates these
potential liabilities and accrues for them or discloses them in the financial statement footnotes if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the ultimate outcome of contingent
liabilities, management does not expect them to have a material effect on the consolidated operations or financial position.



40



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Results of Operations



Year Ended December 31, 2005 Compared to Year Ended December 31, 2004



Premiums earned in 2005 of $2,847.7 million increased 12.6% from the corresponding period in 2004. Net premiums written in 2005 of
$2,950.5 million increased 11.5% over amounts written in 2004. The premium increases were principally attributable to increased policy sales. During 2005, the Company had no rate increases in California and implemented automobile rate increases in
three of the twelve non-California states.



Net premiums written is a
non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Net premiums written is a statutory measure used to determine production levels. Net premiums earned, the most directly
comparable GAAP measure, represents the portion of premiums written that are recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of
total Company net premiums written to net premiums earned (000s) for the years ended December 31, 2005 and 2004, respectively:



|                              |  |      |           |      |   |          
|----------------------------- |  | ---- | --------- | ---- | - | ---------
|                              |  | 2005 |           | 2004
|Net premiums written          |  | $    | 2,950,523 |      | $ | 2,646,704
|Increase in unearned premiums |  |      | 102,790   |      |   | 118,068  
|                              |  |      |           |      |   |          
|Earned premiums               |  | $    | 2,847,733 |      | $ | 2,528,636
|                              |  |      |           |      |   |          



The loss ratio (GAAP basis) in
2005 (loss and loss adjustment expenses related to premiums earned) was 65.4% in 2005 compared with 62.6% in 2004. Losses from Florida hurricanes negatively impacted the 2005 and 2004 loss ratios by 1 point and 0.9 points, respectively. Positive
development on prior accident years reduced the 2005 loss ratio by 1.6 points compared to a 2.3 point reduction in the 2004 loss ratio.



The expense ratio (GAAP basis) in 2005 (policy acquisition costs and other operating expenses related to premiums earned) was 27.0% compared with 26.6% in 2004.
Increases in advertising, state assessments and consulting costs related to IT initiatives impacted the expense ratio in 2005.



The combined ratio of losses and expenses (GAAP basis) 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; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 92.4% in 2005
compared with 89.2% in 2004.



Net investment income in 2005 was $122.6
million compared with $109.7 million in 2004. The after-tax yield on average investments of $3,058.1 million (cost basis) was 3.5%, compared with 3.6% on average investments of $2,662.2 million (cost basis) in 2004. The effective tax rate on
investment income was 13.8% in 2005, compared to 12.6% in 2004. The higher tax rate in 2005 reflects a shift in the mix of the Companys portfolio from non-taxable to taxable securities. Proceeds from bonds which matured or were called in 2005
totaled $409.5 million, compared to $363.4 million in 2004. Assuming market interest rates remain at current levels, the Company expects approximately $520 million of bonds to mature or be called in 2006. The Company expects to reinvest any proceeds
into securities meeting the Companys investment profile.



Net
realized investment gains in 2005 were $16.2 million, compared with net realized investment gains of $25.1 million in 2004. Included in the net realized investment gains are investment write-downs of $2.2 million in 2005 and $0.9 million in 2004
that the Company considered to be other-than-temporarily impaired.



The
income tax provision of $99.4 million in 2005 represented an effective tax rate of 28.2% compared to an effective tax rate of 29.8% in 2004. The lower rate is primarily attributable to a decreased proportion of underwriting income taxed at the full
corporate rate of 35% in contrast with investment income which includes tax exempt interest and tax sheltered dividend income.



41



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Net income in 2005 was $253.3 million or $4.63 per share (diluted) compared with $286.2 million or $5.24 per share
(diluted) in 2004. Diluted per share results are based on a weighted average of 54.7 million shares in 2005 and 54.6 million shares in 2004. Basic per share results were $4.64 in 2005 and $5.25 in 2004. Included in net income are net
realized investment gains, net of income tax expense, of $0.19 and $0.30 per share (diluted and basic) in 2005 and 2004, respectively.



Year Ended December 31, 2004 Compared to Year Ended December 31, 2003



Premiums earned in 2004 of $2,528.6 million increased 17.9% from the corresponding period in 2003. Net premiums written in 2004 of
$2,646.7 million increased 16.7% over amounts written in 2003. The premium increases were principally attributable to increased policy sales in the California, Florida and New Jersey automobile lines of business and the California homeowners line of
business.



As described above, net premiums written is a non-GAAP
financial measure which represents the premiums charged on policies issued during a fiscal period less any reinsurance. Net premiums written is a statutory measure used to determine production levels. Net premiums earned, the most directly
comparable GAAP measure, represents the portion of premiums written that are recognized as income in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of
total Company net premiums written to net premiums earned (000s) for the years ended December 31, 2004 and 2003, respectively:



|                              |  |      |           |      |   |          
|----------------------------- |  | ---- | --------- | ---- | - | ---------
|                              |  | 2004 |           | 2003
|Net premiums written          |  | $    | 2,646,704 |      | $ | 2,268,778
|Increase in unearned premiums |  |      | 118,068   |      |   | 123,731  
|                              |  |      |           |      |   |          
|Earned premiums               |  | $    | 2,528,636 |      | $ | 2,145,047
|                              |  |      |           |      |   |          



The loss ratio (GAAP basis) in
2004 (loss and loss adjustment expenses related to premiums earned) was 62.6% in 2004 compared with 67.7% in 2003. The lower loss ratio is largely attributable to improved loss frequency on automobile claims and California homeowners claims.
Automobile loss frequencies can be affected by many factors including seasonal travel, weather and fluctuations in gasoline prices. The Florida hurricanes negatively impacted the 2004 loss ratio by 0.9 points compared to the 0.7 points negative
impact that the Southern California firestorms had on the 2003 loss ratio. Furthermore, positive development on prior accident years reduced the 2004 loss ratio by 2.3 points and adverse development on prior accident years increased the 2003 loss
ratio by 0.2 points.



The expense ratio (GAAP basis) in 2004 (policy
acquisition costs and other operating expenses related to premiums earned) was 26.6% compared with 26.3% in 2003. The increase in the expense ratio is primarily due to an increase in advertising expense and profitability related bonuses.



The combined ratio of losses and expenses (GAAP basis) 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; a combined ratio over 100% generally reflects unprofitable underwriting
results. The combined ratio of losses and expenses (GAAP basis) was 89.2% in 2004 compared with 94.0% in 2003.



Net investment income in 2004 was $109.7 million compared with $104.5 million in 2003. The after-tax yield on average investments of $2,662.2 million (cost basis)
was 3.6%, compared with 4.0% on average investments of $2,311.0 million (cost basis) in 2003. The effective tax rate on investment income was 12.6% in 2004, compared to 10.7% in 2003. The higher tax rate in 2004 reflects a shift in the mix of the
Companys portfolio from non-taxable to taxable securities. Proceeds from the sale of bonds which matured or were called in 2004 totaled $363.4 million, compared to $442.5 million in 2003.



Net realized investment gains in 2004 were $25.1 million, compared with net realized
gains of $11.2 million in 2003. Included in the net realized investment gains are investment write-downs of $0.9 million in 2004 and $9.1 million in 2003 that the Company considered to be other-than-temporarily impaired.



42



---

The income tax provision of $121.6 million in 2004 represented an effective tax rate of 29.8% compared to an
effective tax rate of 25.0% in 2003. The higher rate is primarily attributable to an increased proportion of underwriting income taxed at the full corporate rate of 35% in contrast with investment income which includes tax exempt interest and tax
sheltered dividend income.



Net income in 2004 was $286.2 million or
$5.24 per share (diluted) compared with $184.3 million or $3.38 per share (diluted), in 2003. Diluted per share results are based on a weighted average of 54.6 million shares in 2004 and 54.5 million shares in 2003. Basic per share results
were $5.25 in 2004 and $3.39 in 2003. Included in net income are net realized investment gains, net of income tax expense, of $0.30 and $0.13 per share (diluted and basic) in 2004 and 2003, respectively.



Liquidity and Capital Resources



Mercury General is largely dependent upon dividends received from its insurance subsidiaries to pay debt service costs and to make
distributions to its shareholders. Under current insurance law, the Insurance Companies are entitled to pay, without extraordinary approval, dividends of approximately $248 million in 2006. The actual amount of dividends paid from the Insurance
Companies to Mercury General during 2004 was $134 million. As of December 31, 2005, Mercury General also had approximately $31 million in fixed maturity securities, equity securities and cash that could be utilized to satisfy its direct holding
company obligations.



The principal sources of funds for the Insurance
Companies are premiums, sales and maturity of invested assets and dividend and interest income from invested assets. The principal uses of funds for the Insurance Companies are the payment of claims and related expenses, operating expenses,
dividends to Mercury General and the purchase of investments.



Through
the Insurance Companies, the Company has generated positive cash flow from operations for over twenty consecutive years, in excess of $100 million every year since 1994 and over $400 million for each of the past three years. During this same period,
the Company has not been required to liquidate any of its fixed maturity investments to settle claims or other liabilities. Because of the Companys long track record of positive operating cash flows, it does not attempt to match the duration
and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. Combined with cash and short term investments of $355.8 million at
December 31, 2005, the Company believes its cash flows from operations are adequate to satisfy its liquidity requirements without the forced sale of investments. 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, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.



Net cash provided from operating activities in 2005 was $489.8 million, an increase of
$21.2 million over the same period in 2004. This increase was primarily due to the growth in premiums reflecting increases in both policy sales and rates partially offset by an increase in loss and loss adjustment expenses paid in 2005. The Company
has utilized the cash provided from operating activities primarily to increase its investment in fixed maturity securities, the purchase and development of information technology such as the NextGen computer system and the payment of dividends to
its shareholders. Excess cash was invested in short-term cash investments. Funds derived from the sale, redemption or maturity of fixed maturity investments of $1,347.0 million, were primarily reinvested by the Company in high grade fixed maturity
securities.



The market value of all investments held at market as
Available for Sale exceeded amortized cost of $3,140.1 million at December 31, 2005 by $102.6 million. That net unrealized gain, reflected in shareholders equity, net of applicable tax effects, was $66.5 million at
December 31, 2005, compared with $80.5 million at December 31, 2004.



43



---

At December 31, 2005, the average rating of the $2,641.0 million bond portfolio at market (amortized cost
$2,589.3 million) was AA, the same as the average rating at December 31, 2004. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At
December 31, 2005, bond holdings rated below investment grade totaled $51.1 million at market (cost $49.8 million) representing 1.6% of total investments. This compares to approximately $50.4 million at market (cost $48.1 million) representing
1.7% of total investments at December 31, 2004.



The following table
sets forth the composition of the investment portfolio of the Company as of December 31, 2005:



|                                      |  |                        |           |              |   |          
|------------------------------------- |  | ---------------------- | --------- | ------------ | - | ---------
|                                      |  | Amortized cost         |           | Market value
|                                      |  | (Amounts in thousands)
|Fixed maturity securities:            |  |                        |           |              |   |          
|U.S. government bonds and agencies    |  | $                      | 201,456   |              | $ | 199,436  
|Municipal bonds                       |  |                        | 2,042,289 |              |   | 2,098,811
|Mortgage-backed securities            |  |                        | 206,248   |              |   | 203,353  
|Corporate bonds                       |  |                        | 139,275   |              |   | 139,445  
|Redeemable preferred stock            |  |                        | 4,477     |              |   | 4,510    
|                                      |  |                        |           |              |   |          
|                                      |  | $                      | 2,593,745 |              | $ | 2,645,555
|                                      |  |                        |           |              |   |          
|Equity securities:                    |  |                        |           |              |   |          
|Common stock:                         |  |                        |           |              |   |          
|Public utilities                      |  | $                      | 66,023    |              | $ | 102,251  
|Banks, trusts and insurance companies |  |                        | 6,415     |              |   | 8,352    
|Industrial and other                  |  |                        | 103,019   |              |   | 113,366  
|Non-redeemable preferred stock        |  |                        | 49,853    |              |   | 52,139   
|                                      |  |                        |           |              |   |          
|                                      |  | $                      | 225,310   |              | $ | 276,108  
|                                      |  |                        |           |              |   |          
|Short-term cash investments           |  | $                      | 321,049   |              | $ | 321,049  
|                                      |  |                        |           |              |   |          



The following table illustrates
the gross unrealized losses included in the Companys investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized
loss position as of December 31, 2005.



|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|------------------------------------------------------------------------------------- |  | ---------------------- | ------ | ----------------- | - | ---------------- |  | ---------- | ----- | ---------------- | - | ---------- |  | - | ------ |  | - | ---------
|                                                                                      |  | Less than 12 months    |        | 12 months or more |   | Total           
|                                                                                      |  | UnrealizedLosses       |        | Fair Value        |   | UnrealizedLosses |  | Fair Value |       | UnrealizedLosses |   | Fair Value
|                                                                                      |  | (Amounts in thousands)
|U.S. Treasury Securities and obligations of U.S. government corporations and agencies |  | $                      | 1,316  |                   | $ | 147,544          |  | $          | 787   |                  | $ | 48,434     |  | $ | 2,103  |  | $ | 195,978  
|Obligations of states and political subdivisions                                      |  |                        | 3,433  |                   |   | 522,566          |  |            | 3,202 |                  |   | 92,349     |  |   | 6,635  |  |   | 614,915  
|Corporate securities                                                                  |  |                        | 1,670  |                   |   | 111,734          |  |            | 1,537 |                  |   | 46,929     |  |   | 3,207  |  |   | 158,663  
|Mortgage-backed securities                                                            |  |                        | 1,868  |                   |   | 77,425           |  |            | 789   |                  |   | 26,525     |  |   | 2,657  |  |   | 103,950  
|Redeemable preferred stock                                                            |  |                        |       |                   |   |                 |  |            | 9     |                  |   | 1,187      |  |   | 9      |  |   | 1,187    
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|Subtotal, debt securities                                                             |  |                        | 8,287  |                   |   | 859,269          |  |            | 6,324 |                  |   | 215,424    |  |   | 14,611 |  |   | 1,074,693
|Equity securities                                                                     |  |                        | 4,888  |                   |   | 171,816          |  |            | 579   |                  |   | 8,623      |  |   | 5,467  |  |   | 180,439  
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|Total temporarily impaired securities                                                 |  | $                      | 13,175 |                   | $ | 1,031,085        |  | $          | 6,903 |                  | $ | 224,047    |  | $ | 20,078 |  | $ | 1,255,132
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          



44



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The Company monitors its investments closely. If an unrealized loss is determined to be other than temporary it is
written off as a realized loss through the consolidated statement of income. The Companys methodology of assessing other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various
factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and
principal payments, and the Companys intent to hold the investment for a period of time sufficient to allow the Company to recover its costs. The Company recognized $2.2 million and $0.9 million in realized losses as other-than-temporary
declines to its investment securities during 2005 and 2004, respectively.



At December 31, 2005, the Company had a net unrealized gain on all investments of $102.6 million before income taxes which is comprised of unrealized gains of $122.7 million offset by unrealized losses of $20.1 million. Unrealized
losses represent 0.6% of total investments at amortized cost. Of these unrealized losses, approximately $14.6 million relate to fixed maturity investments and the remaining $5.5 million relate to equity securities. Approximately $18.1 million of the
unrealized losses are represented by a large number of individual securities with unrealized losses of less than 20% of each securitys amortized cost. Of these, the most significant unrealized losses relate to one corporate bond and one
municipal bond with unrealized losses of approximately $0.8 million and $0.5 million, respectively, representing market value declines of 6% and 16% of amortized cost. The remaining $2.0 million represents unrealized losses that exceed 20% of
amortized costs, the majority of which have been in an unrealized loss position for less than twelve months. The Company has concluded that the gross unrealized losses of $20.1 million at December 31, 2005 were temporary in nature. However,
facts and circumstances may change which could result in a decline in market value considered to be other than temporary.



The following table presents the aging of pre-tax unrealized losses on investments that exceed 20% of amortized costs as of December 31, 2005:



|                                                 |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|------------------------------------------------ |  | ---------------------- | ----- | -------------------------- | - | ---- | ----------- |  | ------------- | --- | ----- | - | --- |  | - | -----
|                                                 |  |                        |       | Aging of Unrealized Losses
|                                                 |  | AmortizedCost          |       | 0-6 Months                 |   |      | 6-12 Months |  | Over 12Months |     | Total
|                                                 |  | (Amounts in thousands)
|Fixed Maturities:                                |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|Investment grade                                 |  | $                      |      |                            | $ |     |             |  | $             |    |       | $ |    |  | $ |     
|Non-investment grade                             |  |                        | 1,179 |                            |   |     |             |  |               |    |       |   | 371 |  |   | 371  
|Equity securities                                |  |                        | 5,877 |                            |   | 921  |             |  |               | 523 |       |   | 149 |  |   | 1,593
|                                                 |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|                                                 |  | $                      | 7,056 |                            | $ | 921  |             |  | $             | 523 |       | $ | 520 |  | $ | 1,964
|                                                 |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|                                                 |  |                        |       |                            |  
|Aged unrealized losses as a % of amortized cost: |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|                                                 |  |                        |       |                            |  
|Investment grade securities                      |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|20-50% below amortized cost                      |  |                        |       |                            |   | 100  | %           |  |               |     |       |   |     |  |   |      
|Over 50% below amortized cost                    |  |                        |       |                            |   |     |             |  |               |     |       |   |     |  |   |      
|Equity securities                                |  |                        |       |                            |   |      |             |  |               |     |       |   |     |  |   |      
|20-50% below amortized cost                      |  |                        |       |                            |   | 100% |             |  |               |     |       |   |     |  |   |      
|Over 50% below amortized cost                    |  |                        |       |                            |   |     |             |  |               |     |       |   |     |  |   |      



The unrealized losses of $2.0
million in the table above include two municipal bonds with losses of $0.1 million and $0.3 million and four equity securities whose individual losses range from $0.1 million to $0.3 million. Based upon the Companys analysis of these
securities which includes the status of debt servicing for the municipal bonds and third party analyst estimates for the equity securities, the unrealized losses for these securities are treated as temporary declines.



During 2005, the Company recognized approximately $18.3 million in net realized gains
from the disposal (sale, call or maturity) of securities which is comprised of realized gains of $29.3 million offset by realized losses of $11.0 million. These realized losses were derived from the disposal of securities with a total amortized cost
of



45



---

approximately $323.0 million. Of the total realized losses, approximately $4.5 million relates to securities held as of December 2004 with an average realized loss of
approximately $19,000 and no loss on any one individual security exceeding $0.2 million.



On August 7, 2001, the Company completed a public debt offering issuing $125 million of senior notes payable under a $300 million shelf registration filed with the Securities and Exchange Commission in July 2001. The notes
are unsecured, senior obligations of the Company with a 7.25% annual coupon payable on August 15 and February 15 each year commencing February 15, 2002. These notes mature on August 15, 2011. The Company used the proceeds from
the senior notes to retire amounts payable under existing revolving credit facilities, which were terminated. Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on the senior notes for a
floating rate of LIBOR plus 107 basis points. The swap significantly reduced the interest expense in 2005 and 2004 when the effective interest rate was 5.3% and 3.3%, respectively. However, if the LIBOR interest rate increases in the future as it
did during 2004 and 2005, the Company will incur higher interest expense in the future. The swap is designated as a fair value hedge under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and
Hedging Activities (SFAS No. 133). See Item 7A. Quantitative and Qualitative Disclosures About Market Risks.



Under the Companys stock repurchase program, the Company may purchase over a one-year period up to $200 million of Mercury Generals common stock. The
purchases may be made from time to time in the open market at the discretion of management. The program will be funded by dividends received from the Companys insurance subsidiaries that generate cash flow through the sale of lower yielding
tax-exempt bonds and internal cash generation. Since the inception of the program in 1998, the Company has purchased 1,266,100 shares of common stock at an average price of $31.36. The shares purchased were retired. No stock has been purchased since
2000.



The NAIC utilizes a risk-based capital formula for casualty
insurance companies which establishes recommended minimum capital requirements that are compared to the Companys actual capital level. The formula was designed to capture the widely varying elements of risks undertaken by writers of different
lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. The Company
has calculated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2005. Each of the Insurance Companies policyholders statutory surplus exceeded the highest level of minimum required capital.



The Company has no direct investment in real estate that it does not
utilize for operations. In 2005, the Company completed the acquisitions of a 157,000 square foot office building in St. Petersburg, Florida and a 100,000 square foot office building in Oklahoma City, Oklahoma. These buildings house employees of the
Company and several outside tenants. The purchase price of the Florida property included cash in the amount of $13.6 million and the assumption of a secured promissory note in the amount of $11.3 million. The Oklahoma property was acquired for
approximately $7.0 million in cash.



The Company is currently developing
a Next Generation (NextGen) computer system to replace its existing underwriting, billings, claims and commissions legacy systems that currently reside on Hewlett Packard 3000 mainframe computers. The NextGen system is designed to be a
multi-state, multi-line system that is expected to enable the Company to enter new states more rapidly, as well as respond to legislative and regulatory changes more easily than the Companys current systems. The NextGen system is initially
being deployed for the personal automobile line of business and has been successfully implemented in one state (Virginia). The Company expects to implement NextGen in its other states in 2006 and 2007. The Company has currently spent approximately
$30 million on NextGen and expects additional costs to be incurred during the implementation period. NextGen is expected to provide a positive benefit to the Company. As with any large scale technology implementation, risks associated with system
implementation can occur that could significantly impact the operations of the Company and increase the expected costs of the project, although management has expended planning and development efforts to mitigate these risks.



46



---

The Company has obligations to make future payments under contracts and credit-related financial instruments and
commitments. At December 31, 2005, certain long-term aggregate contractual obligations and credit-related commitments are summarized as follows:



|                                    |  |                        |           |               |   |           |  |           |         |               |   |        |  |   |        
|----------------------------------- |  | ---------------------- | --------- | ------------- | - | --------- |  | --------- | ------- | ------------- | - | ------ |  | - | -------
|                                    |  | Payments Due by Period
|Contractual Obligations             |  | Total                  |           | Within 1 year |   | 1-3 years |  | 4-5 years |         | After 5 years
|                                    |  | (Amounts in thousands)
|Debt (including interest)           |  | $                      | 189,016   |               | $ | 9,734     |  | $         | 30,442  |               | $ | 18,125 |  | $ | 130,715
|Lease obligations                   |  |                        | 24,535    |               |   | 7,496     |  |           | 11,968  |               |   | 4,568  |  |   | 503    
|Losses and loss adjustment expenses |  |                        | 1,022,603 |               |   | 662,305   |  |           | 319,277 |               |   | 33,691 |  |   | 7,330  
|                                    |  |                        |           |               |   |           |  |           |         |               |   |        |  |   |        
|Total Contractual Obligations       |  | $                      | 1,236,154 |               | $ | 679,535   |  | $         | 361,687 |               | $ | 56,384 |  | $ | 138,548
|                                    |  |                        |           |               |   |           |  |           |         |               |   |        |  |   |        



Notes to
Contractual Obligations Table:



The amount of interest
included in the Companys debt obligations was calculated using the fixed rate of 7.25% on the senior notes and LIBOR plus 175 basis points or 5.97% at December 31, 2005 on its mortgage note. The Company is party to an interest rate swap
of its fixed rate obligations on its senior notes for a floating rate of six month LIBOR plus 107 basis points. Using the effective annual interest rate of 5.3% in 2005, the total contractual obligations on debt would be $175 million with $7 million
due within 1 year, $26 million due between 1 and 3 years, $13 million due in years 4 and 5 and $129 million due beyond 5 years.



The Companys outstanding debt contains various terms, conditions and covenants which, if violated by the Company, would result in a default
under the debt and could result in the acceleration of the Companys payment obligations thereunder.



Unlike many other forms of contractual obligations, loss and loss adjustment expenses do not have definitive due dates and the ultimate payment
dates are subject to a number of variables and uncertainties. As a result, the total loss and loss adjustment expense payments to be made by period, as shown above, are estimates.



Industry and regulatory guidelines suggest that the ratio of a property and casualty insurers annual net premiums written to
statutory policyholders surplus should not exceed 3.0 to 1. Based on the combined surplus of all of the Insurance Companies of $1,487.6 million at December 31, 2005, and net premiums written for the twelve months ended on that date of
$2,950.5 million, the ratio of premium writings to surplus was approximately 2.0 to 1.



Item 7A.    Quantitative and Qualitative Disclosures about Market Risks



The Company is subject to various market risk exposures including interest rate risk and equity price risk. The following disclosure reflects estimates of future
performance and economic conditions. Actual results may differ.



The
Company invests its assets primarily in fixed maturity investments, which at December 31, 2005 comprised approximately 82% of total investments at market value. Tax-exempt bonds represent 76% of the fixed maturity investments with the remaining
amount consisting of sinking fund preferred stocks and taxable bonds. Equity securities account for approximately 8% of total investments at market value. The remaining 10% of the investment portfolio consists of highly liquid short-term investments
which are primarily short-term money market funds.



The value of the
fixed maturity portfolio is subject to interest rate risk. As market interest rates decrease, the value of the portfolio goes up with the opposite holding true in rising interest rate environments. A common measure of the interest sensitivity of
fixed maturity assets is modified duration, a calculation that utilizes maturity, coupon rate, yield and call terms to calculate an average age of the expected cash flows. The longer the duration, the more sensitive the asset is to market interest
rate fluctuations.



47



---

The Company historically invested in fixed maturity investments with a goal towards maximizing after-tax yields and
holding assets to the maturity or call date. Since assets with longer maturity dates tend to produce higher current yields, the Companys historical investment philosophy resulted in a portfolio with a moderate duration. However, due to the
current interest rate environment, management has taken steps to reduce the duration of the Companys bond portfolio. Bond investments made by the Company typically have call options attached, which further reduce the duration of the asset as
interest rates decline. Consequently, the modified duration of the bond portfolio has declined to 2.9 years at December 31, 2005 compared to 3.2 years and 3.8 years at December 31, 2004 and 2003, respectively. Given a hypothetical parallel
increase of 100 basis points in interest rates, the fair value of the bond portfolio at December 31, 2005 would decrease by approximately $77 million.



At December 31, 2005, the Companys strategy for common equity investments is an active strategy which primarily focuses on current income with a
secondary focus on capital appreciation. The value of the equity investment consists of $224.0 million in common stocks and $52.1 million in non-sinking fund preferred stocks. The common stock equity assets are typically valued for future economic
prospects as perceived by the market. The non-sinking fund preferred stocks are typically valued using credit spreads to U. S. Treasury benchmarks. This causes them to be comparable to fixed income securities in terms of interest rate risk.



At December 31, 2005, the duration on the Companys
non-sinking fund preferred stock portfolio was 13.5 years. This implies that an upward parallel shift in the yield curve by 100 basis points would reduce the asset value at December 31, 2005 by approximately $7 million, with all other factors
remaining constant.



The common equity portfolio, representing
approximately 7% of total investments at market value, consists primarily of public utility and energy sector common stocks. Beta is a measure of a securitys systematic (non-diversifiable) risk, which is the percentage change in an individual
securitys return for a 1% change in the return of the market. The average Beta for the Companys common stock holdings was 0.92. Based on a hypothetical 20% reduction in the overall value of the stock market, the fair value of the common
stock portfolio would decrease by approximately $41 million.



Effective
January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on its $125 million fixed rate senior notes for a floating rate. The interest rate swap has the effect of hedging the fair value of the senior notes.



New Accounting Standards



In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R) that will require compensation costs related to share-based payment transactions to be recognized in the
financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity instrument issued. Compensation cost will be recognized over the period that an employee provides
service in exchange for the award. SFAS No. 123R replaces Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees and its related implementation guidance; the principles that the Company currently employs to account and report its employee stock option awards. On April 14, 2005, the Securities and Exchange Commission issued a Final Rule
amending Regulation S-X to revise the date for compliance with SFAS No. 123R so that each registrant that is not a small business issuer will be required to prepare financial statements in accordance with SFAS No. 123R beginning with the
first interim reporting period of the registrants first fiscal year beginning on or after June 15, 2005. The Company will adopt the provisions of SFAS No. 123R in January 2006. The Company does not believe that the adoption of SFAS
No. 123R will have a material impact on its consolidated financial statements.



In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (SFAS No. 154). SFAS No. 154 establishes, unless impracticable, retrospective
application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to a newly adopted accounting principle. The statement will be effective for the Company for all accounting
changes and any error corrections occurring after January 1, 2006.



48



---

There were no other accounting standards issued as of March 7, 2006 that are expected to have a material impact on
the Companys consolidated financial statements.



Forward-looking statements



Certain statements in this report on Form 10-K that are not
historical fact constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking
statements may address, among other things, our strategy for growth, business development, regulatory approvals, market position, expenditures, financial results and reserves. Forward-looking statements are not guarantees of performance and are
subject to important factors and events that could cause our actual business, prospects and results of operations to differ materially from the historical information contained in this Form 10-K and from those that may be expressed or implied by the
forward-looking statements. Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California automobile insurance markets, our success in expanding our business in states outside
of California, the impact of potential third party bad-faith legislation, changes in laws or regulations, the outcome of tax position challenges by the California FTB, and decisions of courts, regulators and governmental bodies,
particularly in California, our ability to obtain and the timing of the approval of the California DOI for premium rate changes for private passenger automobile policies issued in California and similar rate approvals in other states where we do
business, the level of investment yields we are able to obtain with our investments in comparison to recent yields and the market risk associated with our investment portfolio, the cyclical and general competitive nature of the property and casualty
insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Companys pricing methodologies, uncertainties related to assumptions and projections generally, inflation and changes in
economic conditions, changes in driving patterns and loss trends, acts of war and terrorist activities, court decisions and trends in litigation and health care and auto repair costs, and other uncertainties, and all of which are difficult to
predict and many of which are beyond our control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve
is established for a major contingency. Reported results may therefore appear to be volatile in certain periods. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future
events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Form 10-K or, in the case of any document we incorporate by reference, the date of that document.
Investors also should understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions
underlying our forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but
not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements. Any forward-looking statements should also be considered in
light of the information provided in Item 1A. Risk Factors.



49



---

Quarterly Data



Summarized quarterly financial data for 2005 and 2004 is as follows (in thousands except per share data):



|                             |  |               |         |         |   |          |  |         |         |  |   |        
|---------------------------- |  | ------------- | ------- | ------- | - | -------- |  | ------- | ------- |  | - | -------
|                             |  | Quarter Ended
|                             |  | March 31      |         | June 30 |   | Sept. 30 |  | Dec. 31
|2005                         |  |               |         |         |   |          |  |         |         |  |   |        
|Earned premiums              |  | $             | 684,714 |         | $ | 707,261  |  | $       | 722,899 |  | $ | 732,859
|Income before income taxes   |  | $             | 83,845  |         | $ | 103,649  |  | $       | 104,169 |  | $ | 60,976 
|Net income                   |  | $             | 60,424  |         | $ | 73,602   |  | $       | 73,014  |  | $ | 46,219 
|Basic earnings per share     |  | $             | 1.11    |         | $ | 1.35     |  | $       | 1.34    |  | $ | 0.85   
|Diluted earnings per share   |  | $             | 1.10    |         | $ | 1.35     |  | $       | 1.33    |  | $ | 0.84   
|Dividends declared per share |  | $             | 0.43    |         | $ | 0.43     |  | $       | 0.43    |  | $ | 0.43   
|                             |  |               |         |        
|2004                         |  |               |         |         |   |          |  |         |         |  |   |        
|Earned premiums              |  | $             | 591,937 |         | $ | 620,432  |  | $       | 648,165 |  | $ | 668,102
|Income before income taxes   |  | $             | 96,285  |         | $ | 111,051  |  | $       | 88,875  |  | $ | 111,632
|Net income                   |  | $             | 68,816  |         | $ | 78,134   |  | $       | 65,129  |  | $ | 74,129 
|Basic earnings per share     |  | $             | 1.26    |         | $ | 1.43     |  | $       | 1.20    |  | $ | 1.36   
|Diluted earnings per share   |  | $             | 1.26    |         | $ | 1.43     |  | $       | 1.19    |  | $ | 1.36   
|Dividends declared per share |  | $             | 0.37    |         | $ | 0.37     |  | $       | 0.37    |  | $ | 0.37   



Quarterly results can be
affected by many factors including catastrophes, realized gains and losses related to the timing of the sale or write-down of investments and the establishment of liabilities for loss contingencies that meet probability thresholds as required by
accounting principles generally accepted in the United States of America. For the quarter ended December 31, 2005, net income was negatively impacted by approximately $16 million, net of tax benefit, from losses caused by Hurricane Wilma that struck
Florida on October 24, 2005.



50



---

Item 8.    Financial Statements and Supplementary Data



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                                       |  |     
|---------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                       |  | Page
|Reports of Independent Registered Public Accounting Firm                                                               |  | 52  
|                                                                                                                       | 
|Consolidated Financial Statements:                                                                                     |  |     
|                                                                                                                       | 
|Consolidated Balance Sheets as of December 31, 2005 and 2004                                                           |  | 54  
|                                                                                                                       | 
|Consolidated Statements of Income for Each of the Years in the Three-Year Period Ended December 31, 2005               |  | 55  
|                                                                                                                       | 
|Consolidated Statements of Comprehensive Income for Each of the Years in the Three-Year Period Ended December 31, 2005 |  | 56  
|                                                                                                                       | 
|Consolidated Statements of Shareholders Equity for Each of the Years in the Three-Year Period Ended December 31, 2005 |  | 57  
|                                                                                                                       | 
|Consolidated Statements of Cash Flows for Each of the Years in the Three-Year Period Ended December 31, 2005           |  | 58  
|                                                                                                                       | 
|Notes to Consolidated Financial Statements                                                                             |  | 59  



51



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Mercury
General Corporation:



We have audited the accompanying consolidated
balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, shareholders equity and cash flows for each of the years in the
three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our
audits.



We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General
Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted
accounting principles.



We also have audited, in accordance with the
standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Companys internal control over financial reporting as of December 31, 2005, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 7, 2006 expressed an unqualified opinion on managements assessment of, and the
effective operation of, internal control over financial reporting.



/s/    KPMG LLP



Los Angeles, California

March 7, 2006



52



---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Mercury General Corporation:



We have audited managements assessment, included in the accompanying Managements Report on Internal Control over Financial Reporting as set forth
in Item 9a, that Mercury General Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). Mercury General Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our
audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures
as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.



A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies
or procedures may deteriorate.



In our opinion, managements
assessment that Mercury General Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established inInternal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2005, based on criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).



We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, shareholders
equity and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 7, 2006 expressed an unqualified opinion on those consolidated financial statements.



/s/    KPMG LLP



Los Angeles, California

March 7, 2006



53



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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS



December 31,

Amounts expressed in thousands, except
share amounts



|                                                                                                      |  |      |           |      |   |          
|----------------------------------------------------------------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|ASSETS                                                                                                |  |      |           |     
|                                                                                                      |  | 2005 |           | 2004
|Investments:                                                                                          |  |      |           |      |   |          
|Fixed maturities available for sale (amortized cost $2,593,745 in 2005 and $2,164,955 in 2004)        |  | $    | 2,645,555 |      | $ | 2,245,311
|Equity securities available for sale (cost $225,310 in 2005 and $210,553 in 2004)                     |  |      | 276,108   |      |   | 254,362  
|Short-term cash investments, at cost, which approximates market                                       |  |      | 321,049   |      |   | 421,369  
|                                                                                                      |  |      |           |      |   |          
|Total investments                                                                                     |  |      | 3,242,712 |      |   | 2,921,042
|Cash                                                                                                  |  |      | 34,793    |      |   | 23,714   
|Receivables:                                                                                          |  |      |           |      |   |          
|Premiums receivable                                                                                   |  |      | 310,457   |      |   | 284,690  
|Premium notes                                                                                         |  |      | 27,002    |      |   | 23,702   
|Accrued investment income                                                                             |  |      | 33,051    |      |   | 28,855   
|Other                                                                                                 |  |      | 19,724    |      |   | 30,415   
|                                                                                                      |  |      |           |      |   |          
|Total receivables                                                                                     |  |      | 390,234   |      |   | 367,662  
|Deferred policy acquisition costs                                                                     |  |      | 197,943   |      |   | 174,840  
|Current income tax                                                                                    |  |      | 11,219    |      |   |         
|Fixed assets, net                                                                                     |  |      | 136,779   |      |   | 88,645   
|Other assets                                                                                          |  |      | 27,871    |      |   | 46,121   
|                                                                                                      |  |      |           |      |   |          
|Total assets                                                                                          |  | $    | 4,041,551 |      | $ | 3,622,024
|                                                                                                      |  |      |           |      |   |          
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                  |  |      |           |     
|Losses and loss adjustment expenses                                                                   |  | $    | 1,022,603 |      | $ | 900,744  
|Unearned premiums                                                                                     |  |      | 902,567   |      |   | 799,679  
|Notes payable                                                                                         |  |      | 143,540   |      |   | 137,024  
|Loss drafts payable                                                                                   |  |      | 104,593   |      |   | 82,245   
|Accounts payable and accrued expenses                                                                 |  |      | 137,661   |      |   | 138,836  
|Current income tax                                                                                    |  |      |          |      |   | 10,123   
|Deferred income tax                                                                                   |  |      | 37,456    |      |   | 30,606   
|Other liabilities                                                                                     |  |      | 85,294    |      |   | 63,219   
|                                                                                                      |  |      |           |      |   |          
|Total liabilities                                                                                     |  |      | 2,433,714 |      |   | 2,162,476
|                                                                                                      |  |      |           |      |   |          
|Commitments and contingencies                                                                         |  |      |           |      |   |          
|Shareholders equity:                                                                                 |  |      |           |      |   |          
|Common stock without par value or stated value:                                                       |  |      |           |      |   |          
|Authorized 70,000,000 shares; issued and outstanding 54,605,406 shares in 2005 and 54,514,693 in 2004 |  |      | 63,103    |      |   | 60,206   
|Accumulated other comprehensive income                                                                |  |      | 66,549    |      |   | 80,549   
|Retained earnings                                                                                     |  |      | 1,478,185 |      |   | 1,318,793
|                                                                                                      |  |      |           |      |   |          
|Total shareholders equity                                                                            |  |      | 1,607,837 |      |   | 1,459,548
|                                                                                                      |  |      |           |      |   |          
|Total liabilities and shareholders equity                                                            |  | $    | 4,041,551 |      | $ | 3,622,024
|                                                                                                      |  |      |           |      |   |          



See accompanying notes to
consolidated financial statements.



54



---

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF INCOME



Three years ended December 31,

Amounts expressed in
thousands, except per share data



|                                    |  |      |           |      |   |           |  |   |          
|----------------------------------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|                                    |  | 2005 |           | 2004 |   | 2003     
|Revenues:                           |  |      |           |      |   |           |  |   |          
|Earned premiums                     |  | $    | 2,847,733 |      | $ | 2,528,636 |  | $ | 2,145,047
|Net investment income               |  |      | 122,582   |      |   | 109,681   |  |   | 104,520  
|Net realized investment gains       |  |      | 16,160    |      |   | 25,065    |  |   | 11,207   
|Other                               |  |      | 5,438     |      |   | 4,775     |  |   | 4,743    
|                                    |  |      |           |      |   |           |  |   |          
|Total revenues                      |  |      | 2,991,913 |      |   | 2,668,157 |  |   | 2,265,517
|                                    |  |      |           |      |   |           |  |   |          
|Expenses:                           |  |      |           |      |   |           |  |   |          
|Losses and loss adjustment expenses |  |      | 1,862,936 |      |   | 1,582,254 |  |   | 1,452,051
|Policy acquisition costs            |  |      | 618,915   |      |   | 562,553   |  |   | 473,314  
|Other operating expenses            |  |      | 150,201   |      |   | 111,285   |  |   | 91,295   
|Interest                            |  |      | 7,222     |      |   | 4,222     |  |   | 3,056    
|                                    |  |      |           |      |   |           |  |   |          
|Total expenses                      |  |      | 2,639,274 |      |   | 2,260,314 |  |   | 2,019,716
|                                    |  |      |           |      |   |           |  |   |          
|Income before income taxes          |  |      | 352,639   |      |   | 407,843   |  |   | 245,801  
|Income tax expense                  |  |      | 99,380    |      |   | 121,635   |  |   | 61,480   
|                                    |  |      |           |      |   |           |  |   |          
|Net income                          |  | $    | 253,259   |      | $ | 286,208   |  | $ | 184,321  
|                                    |  |      |           |      |   |           |  |   |          
|Basic earnings per share            |  | $    | 4.64      |      | $ | 5.25      |  | $ | 3.39     
|                                    |  |      |           |      |   |           |  |   |          
|Diluted earnings per share          |  | $    | 4.63      |      | $ | 5.24      |  | $ | 3.38     
|                                    |  |      |           |      |   |           |  |   |          







See accompanying notes to consolidated financial statements.



55



---

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME



Three Years ended December 31,

Amounts expressed in thousands



|                                                                                               |  |      |         |   |      |   |         |      |  |   |         |  
|---------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                               |  | 2005 |         |   | 2004 |   |         | 2003 | 
|Net income                                                                                     |  | $    | 253,259 |   |      | $ | 286,208 |      |  | $ | 184,321 |  
|Other comprehensive income (loss), before tax:                                                 |  |      |         |   |      |   |         |      |  |   |         |  
|Unrealized gains (losses) on securities:                                                       |  |      |         |   |      |   |         |      |  |   |         |  
|Unrealized holding gains (losses) arising during period                                        |  |      | (10,687 | ) |      |   | 14,127  |      |  |   | 71,502  |  
|Less: reclassification adjustment for net gains included in net income                         |  |      | (10,868 | ) |      |   | (20,701 | )    |  |   | (5,790  | )
|                                                                                               |  |      |         |   |      |   |         |      |  |   |         |  
|Other comprehensive income (loss), before tax                                                  |  |      | (21,555 | ) |      |   | (6,574  | )    |  |   | 65,712  |  
|Income tax expense related to unrealized holding gains (losses) arising during period          |  |      | (3,751  | ) |      |   | 4,955   |      |  |   | 25,046  |  
|Income tax benefit related to reclassification adjustment for net gains included in net income |  |      | (3,804  | ) |      |   | (7,245  | )    |  |   | (2,027  | )
|                                                                                               |  |      |         |   |      |   |         |      |  |   |         |  
|Comprehensive income, net of tax                                                               |  | $    | 239,259 |   |      | $ | 281,924 |      |  | $ | 227,014 |  
|                                                                                               |  |      |         |   |      |   |         |      |  |   |         |  







See accompanying notes to consolidated financial statements.



56



---

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY



Three years ended December 31,

Amounts expressed in thousands



|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|----------------------------------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                                  |  | 2005 |           |   | 2004 |   |           | 2003 | 
|Common stock, beginning of year                                   |  | $    | 60,206    |   |      | $ | 57,453    |      |  | $ | 55,933    |  
|Proceeds of stock options exercised                               |  |      | 2,394     |   |      |   | 2,188     |      |  |   | 1,331     |  
|Tax benefit on sales of incentive stock options                   |  |      | 503       |   |      |   | 565       |      |  |   | 189       |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Common stock, end of year                                         |  |      | 63,103    |   |      |   | 60,206    |      |  |   | 57,453    |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Accumulated other comprehensive income, beginning of year         |  |      | 80,549    |   |      |   | 84,833    |      |  |   | 42,140    |  
|Net (decrease) increase in other comprehensive income, net of tax |  |      | (14,000   | ) |      |   | (4,284    | )    |  |   | 42,693    |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Accumulated other comprehensive income, end of year               |  |      | 66,549    |   |      |   | 80,549    |      |  |   | 84,833    |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Retained earnings, beginning of year                              |  |      | 1,318,793 |   |      |   | 1,113,217 |      |  |   | 1,000,713 |  
|Net income                                                        |  |      | 253,259   |   |      |   | 286,208   |      |  |   | 184,321   |  
|Dividends paid to shareholders                                    |  |      | (93,867   | ) |      |   | (80,632   | )    |  |   | (71,817   | )
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Retained earnings, end of year                                    |  |      | 1,478,185 |   |      |   | 1,318,793 |      |  |   | 1,113,217 |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  
|Total shareholders equity                                        |  | $    | 1,607,837 |   |      | $ | 1,459,548 |      |  | $ | 1,255,503 |  
|                                                                  |  |      |           |   |      |   |           |      |  |   |           |  







See accompanying notes to consolidated financial statements.



57



---

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS



Three Years Ended December 31,

Amounts expressed
in thousands



|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|------------------------------------------------------------------------------------------------ |  | ---- | ---------- | - | ---- | - | ---------- | ---- |  | - | -------- | -
|                                                                                                 |  | 2005 |            |   | 2004 |   |            | 2003 | 
|Cash flows from operating activities:                                                            |  |      |            |   |      |   |            |      |  |   |          |  
|Net income                                                                                       |  | $    | 253,259    |   |      | $ | 286,208    |      |  | $ | 184,321  |  
|Adjustments to reconcile net income to net cash provided from operating activities:              |  |      |            |   |      |   |            |      |  |   |          |  
|Depreciation                                                                                     |  |      | 18,781     |   |      |   | 16,192     |      |  |   | 16,126   |  
|Net realized investment gains                                                                    |  |      | (16,160    | ) |      |   | (25,065    | )    |  |   | (11,207  | )
|Bond amortization, net                                                                           |  |      | 11,814     |   |      |   | 7,797      |      |  |   | 2,883    |  
|Increase in premiums receivable                                                                  |  |      | (25,767    | ) |      |   | (53,413    | )    |  |   | (44,831  | )
|Increase in premium notes receivable                                                             |  |      | (3,300     | ) |      |   | (1,082     | )    |  |   | (859     | )
|Increase in deferred policy acquisition costs                                                    |  |      | (23,103    | ) |      |   | (27,889    | )    |  |   | (27,916  | )
|Increase in unpaid losses and loss adjustment expenses                                           |  |      | 121,859    |   |      |   | 102,817    |      |  |   | 118,656  |  
|Increase in unearned premiums                                                                    |  |      | 102,888    |   |      |   | 117,934    |      |  |   | 121,096  |  
|Increase in premiums collected in advance                                                        |  |      | 14,484     |   |      |   | 12,019     |      |  |   | 7,305    |  
|Increase in loss drafts payable                                                                  |  |      | 22,348     |   |      |   | 2,285      |      |  |   | 15,614   |  
|(Increase) decrease in accrued income taxes, excluding deferred tax on change in unrealized gain |  |      | (6,443     | ) |      |   | 13,698     |      |  |   | 16,601   |  
|(Decrease) increase in accounts payable and accrued expenses                                     |  |      | (1,175     | ) |      |   | 39,447     |      |  |   | 38,119   |  
|Other, net                                                                                       |  |      | 20,333     |   |      |   | (22,285    | )    |  |   | 8,544    |  
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|Net cash provided by operating activities                                                        |  |      | 489,818    |   |      |   | 468,663    |      |  |   | 444,452  |  
|Cash flows from investing activities:                                                            |  |      |            |   |      |   |            |      |  |   |          |  
|Fixed maturities available for sale:                                                             |  |      |            |   |      |   |            |      |  |   |          |  
|Purchases                                                                                        |  |      | (1,787,879 | ) |      |   | (1,076,940 | )    |  |   | (854,883 | )
|Sales                                                                                            |  |      | 937,481    |   |      |   | 396,815    |      |  |   | 122,212  |  
|Calls or maturities                                                                              |  |      | 409,520    |   |      |   | 363,372    |      |  |   | 442,465  |  
|Equity securities available for sale:                                                            |  |      |            |   |      |   |            |      |  |   |          |  
|Purchases                                                                                        |  |      | (406,974   | ) |      |   | (247,401   | )    |  |   | (217,681 | )
|Sales                                                                                            |  |      | 401,016    |   |      |   | 278,346    |      |  |   | 228,588  |  
|Decrease (increase) in receivable from securities                                                |  |      | 250        |   |      |   | (716       | )    |  |   | 6,709    |  
|Decrease (increase) in short-term cash investments                                               |  |      | 100,320    |   |      |   | (91,557    | )    |  |   | (43,006  | )
|Purchase of fixed assets                                                                         |  |      | (42,211    | ) |      |   | (26,185    | )    |  |   | (35,015  | )
|Sale of fixed assets                                                                             |  |      | 1,211      |   |      |   | 797        |      |  |   | 1,418    |  
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|Net cash used in investing activities                                                            |  | $    | (387,266   | ) |      | $ | (403,469   | )    |  | $ | (349,193 | )
|Cash flows from financing activities:                                                            |  |      |            |   |      |   |            |      |  |   |          |  
|Dividends paid to shareholders                                                                   |  | $    | (93,867    | ) |      | $ | (80,632    | )    |  | $ | (71,817  | )
|Proceeds from stock options exercised                                                            |  |      | 2,394      |   |      |   | 2,188      |      |  |   | 1,331    |  
|Payments on ESOP loan                                                                            |  |      |           |   |      |   |           |      |  |   | (1,000   | )
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|Net cash used in financing activities                                                            |  |      | (91,473    | ) |      |   | (78,444    | )    |  |   | (71,486  | )
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|Net increase (decrease) in cash                                                                  |  |      | 11,079     |   |      |   | (13,250    | )    |  |   | 23,773   |  
|Cash:                                                                                            |  |      |            |   |      |   |            |      |  |   |          |  
|Beginning of the year                                                                            |  |      | 23,714     |   |      |   | 36,964     |      |  |   | 13,191   |  
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  
|End of the year                                                                                  |  | $    | 34,793     |   |      | $ | 23,714     |      |  | $ | 36,964   |  
|                                                                                                 |  |      |            |   |      |   |            |      |  |   |          |  



See accompanying notes to
consolidated financial statements.



58



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



December
31, 2005 and 2004



(1)    Significant Accounting Policies



Principles of Consolidation and Presentation



The Company operates as a private passenger automobile insurer selling policies
through a network of independent agents and brokers in thirteen states. The Company also offers homeowners insurance, commercial automobile and property insurance, mechanical breakdown insurance, commercial and dwelling fire insurance and umbrella
insurance. The private passenger automobile lines of insurance exceeded 85% of the Companys net premiums written in 2005, 2004 and 2003, with approximately 73%, 76% and 84% of the private passenger automobile premiums written in the state of
California during 2005, 2004 and 2003, respectively.



The consolidated
financial statements include the accounts of Mercury General Corporation (the Company) and its wholly-owned subsidiaries, Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General
Underwriters Insurance Company, Inc., Mercury Insurance Company of Georgia, Mercury Insurance Company of Illinois, Mercury Insurance Company of Florida, Mercury Indemnity Company of Georgia, Mercury National Insurance Company, Mercury Indemnity
Company of America, Mercury Insurance Services, LLC (MISLLC), American Mercury Insurance Company (AMIC), Mercury Select Management Company, Inc. (MSMC), American Mercury Lloyds Insurance Company (AML)
and Mercury County Mutual Insurance Company (MCM). American Mercury MGA, Inc. (AMMGA), is a wholly-owned subsidiary of AMIC. AML is not owned by the Company, but is controlled by the Company through its attorney-in-fact,
MSMC. MCM is not owned by the Company, but is controlled through a management contract and therefore its results are included in the consolidated financial statements. The consolidated financial statements also include Concord Insurance Services,
Inc. (Concord), a Texas insurance agency owned by the Company. All of the subsidiaries as a group, including AML and MCM, but excluding MSMC, AMMGA, MISLLC and Concord, are referred to as the Insurance Companies. The consolidated
financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All
significant intercompany balances and transactions have been eliminated.



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 and disclosures of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The most significant assumptions in the preparation of these consolidated financial statements relate to loss and loss adjustment
expenses. Actual results could differ from those estimates.



Investments



Fixed maturities available for sale include
those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. Fixed maturities available for sale,
which include bonds and sinking fund preferred stocks, are carried at market. Investments in equity securities, which include common stocks and non-redeemable preferred stocks, are carried at market. Short-term cash investments are carried at cost,
which approximates market.



In most cases, the market valuations were
drawn from standard trade data sources. In no case was any valuation made by the Companys management. Fixed maturities are amortized using first call date and are adjusted for anticipated prepayments. Mortgage-backed securities at amortized
cost are adjusted for anticipated prepayment using the prospective method. Equity holdings, including non-sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges and were valued at the last transaction price
on the balance sheet date.



59



---

MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



Temporary unrealized investment gains and losses on securities available for sale are credited or charged
directly to shareholders equity as accumulated other comprehensive income, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the
consolidated statements of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method.



The Company writes covered call options through listed exchanges and over-the-counter. When the Company writes an option, an amount
equal to the premium received by the Company is recorded as a liability and is subsequently adjusted to the current fair value of the option written. Premiums received from writing options that expire unexercised are treated by the Company on
the expiration date as realized gains from investments. If a call option is exercised, the premium is added to the proceeds from the sale of the underlying security or currency in determining whether the Company has realized a gain or loss. The
Company, as writer of an option, bears the market risk of an unfavorable change in the price of the security underlying the written option.



Fair Value of Financial Instruments



Under Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS
No. 115), the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair
value. The carrying amounts and fair values for investment securities are disclosed in Note 2 of the Notes to Consolidated Financial Statements and were drawn from standard trade data sources such as market and broker quotes. The carrying value of
receivables, accounts payable and other liabilities is equivalent to the estimated fair value of those items. The notes payable are carried at their fair value which was determined using quoted market price. The carrying value of the Companys
interest rate swap is based on current settlement value. The terms of the note and interest rate swap are discussed in Note 5 of the Notes to Consolidated Financial Statements.



Goodwill and Other Intangible Assets



Goodwill and other intangible assets represent the excess of the purchase price of acquired businesses over the fair value of net assets acquired using the
purchase method of accounting. Included in the Companys consolidated balance sheets are goodwill of $7.3 million and other intangible assets of $5.2 million. The goodwill and other intangible assets were determined to have an indefinite useful
life and in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets are not amortized, but tested for impairment annually or more frequently if circumstances indicate potential
impairment. The fair values of goodwill and other intangibles are measured annually based upon projected discounted operating cash flows using a market rate of interest to discount the cash flows. No impairment was recorded during the three years
ended December 31, 2005.



Premium Income Recognition



Insurance premiums are recognized as income ratably over the term
of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums are computed on a monthly pro rata basis. Unearned premiums are stated gross of reinsurance deductions, with the reinsurance deduction recorded
in other assets and other receivables.



Net premiums written during 2005,
2004 and 2003 were $2,950,523,000, $2,646,704,000 and $2,268,778,000, respectively.



60



---

MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



One broker produced direct premiums written of approximately 14%, 14% and 16% of the Companys total
direct premiums written during 2005, 2004 and 2003, respectively. No other agent or broker accounted for more than 2% of direct premiums written.



Premium Notes



Premium notes receivable represent the balance due to the Company from policyholders who elect to finance their premiums over the policy term. The Company requires
both a down payment and monthly payments as part of its financing program. Premium finance fees are charged to policyholders who elect to finance premiums. The fees are charged at rates that vary with the amount of premium financed. Premium finance
fees are recognized over the term of the premium note based upon the effective yield.



Deferred Policy Acquisition Costs



Acquisition costs related to unearned premiums, which consist of commissions, premium taxes and certain other underwriting costs, and which vary directly with and are directly related to the production of business, are deferred and
amortized to expense ratably over the terms of the policies. Deferred acquisition costs are limited to the amount which 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 the premiums are earned. The Company does not defer advertising expenses.



Losses and Loss Adjustment Expenses



The liability for losses and loss adjustment expenses is based upon the accumulation of individual case estimates for losses reported prior to the close of the
accounting period, plus estimates, based upon past experience, of ultimate developed costs which may differ from case estimates and of unreported claims. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of
reinsurance recoverable is included in other receivables.



Estimating
loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the regulatory and legal environment, results of litigation, medical
costs, the cost of repair materials and labor rates can all impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the occurrence of a loss and the payment or settlement of
the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims. Management believes that the liability for
losses and loss adjustment expenses is adequate to cover the ultimate net cost of losses and loss adjustment expenses incurred to date. Since the provisions for loss reserves are necessarily based upon estimates, the ultimate liability may be more
or less than such provisions.



Depreciation



Buildings and furniture and equipment are stated at cost and depreciated over 30-year
and 3-year to 10-year periods, respectively, on a combination of straight-line and accelerated methods. Automobiles are depreciated over 5 years, using an accelerated method. Capitalized software is capitalized in accordance with Statement of
Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use and amortized on a straight-line method over the estimated useful life of the software, generally not exceeding five years. Leasehold
improvements are stated at cost and amortized over the life of the associated lease.



61



---

MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



Earnings per Share



Earnings per share is presented in accordance with the provisions of Statement of Financial Accounting Standards No. 128,
Earnings per Share, which requires presentation of basic and diluted earnings per share for all publicly traded companies. Note 13 of the Notes to Consolidated Financial Statements contains the required disclosures which make up the
calculation of basic and diluted earnings per share.



Segment
Reporting



Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way information about operating segments is reported in financial statements. The Company does not have any operations that require
separate disclosure as operating segments.



Income Taxes



The Company recognizes deferred tax assets and liabilities for
temporary differences between the financial reporting basis and the tax basis of the Companys assets and liabilities and expected benefits of utilizing net operating loss and tax credit carry forwards. 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 impact on deferred taxes of changes in tax rates and laws, if any, are applied to the
years during which temporary differences are expected to be settled and reflected in the financial statements in the period enacted.



Reinsurance



Liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The
ceded amounts are immaterial and are carried in other receivables. Earned premiums are stated net of deductions for ceded reinsurance.



The Insurance Companies, as primary insurers, will be required to pay losses in their entirety in the event that the reinsurers are unable to discharge their
obligations under the reinsurance agreements.



Supplemental Cash Flow
Information



Interest paid during 2005, 2004 and 2003, was
$5,649,000, $3,329,000 and $3,087,000, respectively. Income taxes paid were $105,811,000 in 2005, $107,277,000 in 2004 and $44,697,000 in 2003.



The tax benefit realized on stock options exercised and included in cash provided from operations in 2005, 2004 and 2003 was $503,000, $565,000 and $189,000,
respectively.



In 2003, notes payable with a discounted value of
$4,315,000 was canceled in accordance with terms of a Purchase and Sale Agreement between the Company and Employers Reinsurance Corporation.



In 2005, the Company assumed a mortgage note payable of $11,250,000 in connection with the acquisition of an office building in Florida.



Reclassifications



Certain reclassifications have been made to the prior year balances to conform to the current year presentation.



62



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



Stock-Based Compensation



The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board
(APB) Opinion No. 25 Accounting for Stock Issued to Employees, as allowed by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123)
and amended by SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure.



The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition of SFAS No. 123:



|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                           |  | Year Ended December 31,                  |        
|                                                                                                                                           |  | 2005                                     |         |   | 2004 |   |         | 2003 | 
|                                                                                                                                           |  | (Amounts in thousands, except per share) |        
|Net income, as reported                                                                                                                    |  | $                                        | 253,259 |   |      | $ | 286,208 |      |  | $ | 184,321 |  
|Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax
effect |  |                                          | (726    | ) |      |   | (549    | )    |  |   | (560    | )
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|Pro forma net income                                                                                                                       |  | $                                        | 252,533 |   |      | $ | 285,659 |      |  | $ | 183,761 |  
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|Earnings per share:                                                                                                                        |  |                                          |         |   |      |   |         |      |  |   |         |  
|Basicas reported                                                                                                                          |  | $                                        | 4.64    |   |      | $ | 5.25    |      |  | $ | 3.39    |  
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|Basicpro forma                                                                                                                            |  | $                                        | 4.63    |   |      | $ | 5.24    |      |  | $ | 3.38    |  
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|Dilutedas reported                                                                                                                        |  | $                                        | 4.63    |   |      | $ | 5.24    |      |  | $ | 3.38    |  
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  
|Dilutedpro forma                                                                                                                          |  | $                                        | 4.62    |   |      | $ | 5.23    |      |  | $ | 3.37    |  
|                                                                                                                                           |  |                                          |         |   |      |   |         |      |  |   |         |  



Calculations of the fair value
under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2005, 2004 and 2003: dividend yield of 3.0% in 2005, 2.5% in 2004 and 2.8% for
2003, expected volatility of 26.4% in 2005, 29.4% in 2004 and 35.0% in 2003 and expected lives of 6 years for all years. The risk-free interest rates used were 4.0% for options granted in 2005, 3.9% for options granted during 2004 and 3.2% for the
options granted during 2003.



Recently Issued Accounting Standards



In December 2004, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R) that will require compensation costs related to share-based payment transactions to
be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity instrument issued. Compensation cost will be recognized over the period that an
employee provides service in exchange for the award. SFAS No. 123R replaces Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting
for Stock Issued to Employees and its related implementation guidance; the principles that the Company currently employs to account and report its employee stock option awards. On April 14, 2005, the Securities and Exchange Commission
issued a Final Rule amending Regulation S-X to revise the date for compliance with SFAS No. 123R so that each registrant that is not a small business issuer will be required to prepare financial statements in accordance with SFAS No. 123R
beginning with the first interim reporting period of the registrants first fiscal year beginning on or after June 15, 2005. The Company will adopt the provisions of SFAS No. 123R in January 2006. The Company does not believe that the
adoption of SFAS No. 123R will have a material impact on its consolidated financial statements.



63



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, Accounting Changes
and Error Corrections (SFAS No. 154). SFAS No. 154 establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition
requirements specific to a newly adopted accounting principle. The statement will be effective for the Company for all accounting changes and any error corrections occurring after January 1, 2006.



There were no other accounting standards issued as of March 7, 2006 that are expected
to have a material impact on the Companys consolidated financial statements.



(2)    Investments and Investment Income



A summary of net investment income is shown in the following table:



|                                           |  |                         |         |      |   |         |  |   |        
|------------------------------------------ |  | ----------------------- | ------- | ---- | - | ------- |  | - | -------
|                                           |  | Year ended December 31,
|                                           |  | 2005                    |         | 2004 |   | 2003   
|                                           |  | (Amounts in thousands) 
|Interest and dividends on fixed maturities |  | $                       | 100,403 |      | $ | 95,340  |  | $ | 87,586 
|Dividends on equity securities             |  |                         | 10,149  |      |   | 10,963  |  |   | 14,752 
|Interest on short-term cash investments    |  |                         | 13,827  |      |   | 4,796   |  |   | 3,339  
|                                           |  |                         |         |      |   |         |  |   |        
|Total investment income                    |  |                         | 124,379 |      |   | 111,099 |  |   | 105,677
|Investment expense                         |  |                         | 1,797   |      |   | 1,418   |  |   | 1,157  
|                                           |  |                         |         |      |   |         |  |   |        
|Net investment income                      |  | $                       | 122,582 |      | $ | 109,681 |  | $ | 104,520
|                                           |  |                         |         |      |   |         |  |   |        



A summary of net realized
investment gains (losses) is as follows:



|                                        |  |                         |        |   |      |   |        |      |  |   |       
|--------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------
|                                        |  | Year ended December 31,
|                                        |  | 2005                    |        |   | 2004 |   |        | 2003
|                                        |  | (Amounts in thousands) 
|Net realized investment gains (losses): |  |                         |        |   |      |   |        |      |  |   |       
|Fixed maturities                        |  | $                       | (280   | ) |      | $ | (82    | )    |  | $ | 3,198 
|Equity securities                       |  |                         | 16,440 |   |      |   | 25,147 |      |  |   | 8,009 
|                                        |  |                         |        |   |      |   |        |      |  |   |       
|                                        |  | $                       | 16,160 |   |      | $ | 25,065 |      |  | $ | 11,207
|                                        |  |                         |        |   |      |   |        |      |  |   |       



Gross gains and losses realized
on the sales of investments (excluding calls and other than temporarily impaired securities) are shown below:



|                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                      |  | Year ended December 31, |       
|                                      |  | 2005                    |        |   | 2004 |   |        | 2003 | 
|                                      |  | (Amounts in thousands)  |       
|Fixed maturities available for sale:  |  |                         |        |   |      |   |        |      |  |   |        |  
|Gross realized gains                  |  | $                       | 604    |   |      | $ | 474    |      |  | $ | 4,529  |  
|Gross realized losses                 |  |                         | (1,539 | ) |      |   | (1,316 | )    |  |   | (1,161 | )
|                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Net                                   |  | $                       | (935   | ) |      | $ | (842   | )    |  | $ | 3,368  |  
|                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Equity securities available for sale: |  |                         |        |   |      |   |        |      |  |   |        |  
|Gross realized gains                  |  | $                       | 26,799 |   |      | $ | 29,863 |      |  | $ | 15,216 |  
|Gross realized losses                 |  |                         | (8,330 | ) |      |   | (4,259 | )    |  |   | (4,128 | )
|                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Net                                   |  | $                       | 18,469 |   |      | $ | 25,604 |      |  | $ | 11,088 |  
|                                      |  |                         |        |   |      |   |        |      |  |   |        |  



64



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



A summary of the net increase (decrease) in unrealized investment gains and losses less applicable income tax
expense (benefit), is as follows:



|                                                                       |  |                         |         |   |      |   |        |      |  |   |       
|---------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------
|                                                                       |  | Year ended December 31,
|                                                                       |  | 2005                    |         |   | 2004 |   |        | 2003
|                                                                       |  | (Amounts in thousands) 
|Net increase (decrease) in net unrealized investment gains and losses: |  |                         |         |   |      |   |        |      |  |   |       
|Fixed maturities available for sale                                    |  | $                       | (28,546 | ) |      | $ | (8,869 | )    |  | $ | 22,114
|Income tax (benefit) expense                                           |  |                         | (9,990  | ) |      |   | (3,104 | )    |  |   | 7,740 
|                                                                       |  |                         |         |   |      |   |        |      |  |   |       
|                                                                       |  | $                       | (18,556 | ) |      | $ | (5,765 | )    |  | $ | 14,374
|                                                                       |  |                         |         |   |      |   |        |      |  |   |       
|Equity securities                                                      |  | $                       | 6,988   |   |      | $ | 2,530  |      |  | $ | 43,598
|Income tax expense                                                     |  |                         | 2,432   |   |      |   | 876    |      |  |   | 15,279
|                                                                       |  |                         |         |   |      |   |        |      |  |   |       
|                                                                       |  | $                       | 4,556   |   |      | $ | 1,654  |      |  | $ | 28,319
|                                                                       |  |                         |         |   |      |   |        |      |  |   |       



Accumulated unrealized gains and
losses on securities available for sale are as follows:



|                                      |  |                        |         |   |      |   |         |  
|------------------------------------- |  | ---------------------- | ------- | - | ---- | - | ------- | -
|                                      |  | December 31,           |        
|                                      |  | 2005                   |         |   | 2004 |  
|                                      |  | (Amounts in thousands) |        
|Fixed maturities available for sale:  |  |                        |         |   |      |   |         |  
|Unrealized gains                      |  | $                      | 66,421  |   |      | $ | 89,175  |  
|Unrealized losses                     |  |                        | (14,611 | ) |      |   | (8,819  | )
|Tax effect                            |  |                        | (18,134 | ) |      |   | (28,124 | )
|                                      |  |                        |         |   |      |   |         |  
|                                      |  | $                      | 33,676  |   |      | $ | 52,232  |  
|                                      |  |                        |         |   |      |   |         |  
|Equity securities available for sale: |  |                        |         |   |      |   |         |  
|Unrealized gains                      |  | $                      | 56,041  |   |      | $ | 46,039  |  
|Unrealized losses                     |  |                        | (5,467  | ) |      |   | (2,474  | )
|Tax effect                            |  |                        | (17,701 | ) |      |   | (15,248 | )
|                                      |  |                        |         |   |      |   |         |  
|                                      |  | $                      | 32,873  |   |      | $ | 28,317  |  
|                                      |  |                        |         |   |      |   |         |  



The amortized costs and
estimated market values of investments in fixed maturities available for sale as of December 31, 2005 are as follows:



|                                                                                      |  |                        |           |                      |   |                       |  |                       |        |  |   |          
|------------------------------------------------------------------------------------- |  | ---------------------- | --------- | -------------------- | - | --------------------- |  | --------------------- | ------ |  | - | ---------
|                                                                                      |  | AmortizedCost          |           | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | EstimatedMarket Value
|                                                                                      |  | (Amounts in thousands)
|U.S. Treasury securities and obligations of U.S. government corporations and agencies |  | $                      | 201,456   |                      | $ | 82                    |  | $                     | 2,102  |  | $ | 199,436  
|Obligations of states and political subdivisions                                      |  |                        | 2,042,289 |                      |   | 63,158                |  |                       | 6,636  |  |   | 2,098,811
|Mortgage-backed securities                                                            |  |                        | 206,248   |                      |   | 312                   |  |                       | 3,207  |  |   | 203,353  
|Corporate securities                                                                  |  |                        | 139,275   |                      |   | 2,827                 |  |                       | 2,657  |  |   | 139,445  
|Redeemable preferred stock                                                            |  |                        | 4,477     |                      |   | 42                    |  |                       | 9      |  |   | 4,510    
|                                                                                      |  |                        |           |                      |   |                       |  |                       |        |  |   |          
|Totals                                                                                |  | $                      | 2,593,745 |                      | $ | 66,421                |  | $                     | 14,611 |  | $ | 2,645,555
|                                                                                      |  |                        |           |                      |   |                       |  |                       |        |  |   |          



65



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



The amortized costs and estimated market values of investments in fixed maturities available for sale as of
December 31, 2004 are as follows:



|                                                                                      |  |                        |           |                      |   |                       |  |                       |       |  |   |          
|------------------------------------------------------------------------------------- |  | ---------------------- | --------- | -------------------- | - | --------------------- |  | --------------------- | ----- |  | - | ---------
|                                                                                      |  | AmortizedCost          |           | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | EstimatedMarket Value
|                                                                                      |  | (Amounts in thousands)
|U.S. Treasury securities and obligations of U.S. government corporations and agencies |  | $                      | 153,770   |                      | $ | 446                   |  | $                     | 632   |  | $ | 153,584  
|Obligations of states and political subdivisions                                      |  |                        | 1,637,514 |                      |   | 82,121                |  |                       | 4,147 |  |   | 1,715,488
|Mortgage-backed securities                                                            |  |                        | 253,408   |                      |   | 1,172                 |  |                       | 3,617 |  |   | 250,963  
|Corporate securities                                                                  |  |                        | 112,170   |                      |   | 5,311                 |  |                       | 323   |  |   | 117,158  
|Redeemable preferred stock                                                            |  |                        | 8,093     |                      |   | 125                   |  |                       | 100   |  |   | 8,118    
|                                                                                      |  |                        |           |                      |   |                       |  |                       |       |  |   |          
|Totals                                                                                |  | $                      | 2,164,955 |                      | $ | 89,175                |  | $                     | 8,819 |  | $ | 2,245,311
|                                                                                      |  |                        |           |                      |   |                       |  |                       |       |  |   |          



The Company monitors its
investments closely. If an unrealized loss is determined to be other than temporary it is written off as a realized loss through the consolidated statements of income. The Companys methodology of assessing other-than-temporary impairments is
based on security-specific analysis as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been less than the cost, the financial condition and the near term prospects of
the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Companys intent to hold the investment for a period of time sufficient to allow the Company to recover its costs.



The following table illustrates the gross unrealized losses included in the
Companys investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized loss position as of December 31, 2005.



|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|------------------------------------------------------------------------------------- |  | ---------------------- | ------ | ----------------- | - | ---------------- |  | ---------- | ----- | ---------------- | - | ---------- |  | - | ------ |  | - | ---------
|                                                                                      |  | Less than 12 months    |        | 12 months or more |   | Total           
|                                                                                      |  | UnrealizedLosses       |        | Fair Value        |   | UnrealizedLosses |  | Fair Value |       | UnrealizedLosses |   | Fair Value
|                                                                                      |  | (Amounts in thousands)
|U.S. Treasury Securities and obligations of U.S. government corporations and agencies |  | $                      | 1,315  |                   | $ | 147,544          |  | $          | 787   |                  | $ | 48,434     |  | $ | 2,102  |  | $ | 195,978  
|Obligations of states and political subdivisions                                      |  |                        | 3,434  |                   |   | 522,566          |  |            | 3,202 |                  |   | 92,349     |  |   | 6,636  |  |   | 614,915  
|Corporate securities                                                                  |  |                        | 1,670  |                   |   | 111,734          |  |            | 1,537 |                  |   | 46,929     |  |   | 3,207  |  |   | 158,663  
|Mortgage-backed securities                                                            |  |                        | 1,868  |                   |   | 77,425           |  |            | 789   |                  |   | 26,525     |  |   | 2,657  |  |   | 103,950  
|Redeemable preferred stock                                                            |  |                        |       |                   |   |                 |  |            | 9     |                  |   | 1,187      |  |   | 9      |  |   | 1,187    
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|Subtotal, debt securities                                                             |  |                        | 8,287  |                   |   | 859,269          |  |            | 6,324 |                  |   | 215,424    |  |   | 14,611 |  |   | 1,074,693
|Equity securities                                                                     |  |                        | 4,888  |                   |   | 171,816          |  |            | 579   |                  |   | 8,623      |  |   | 5,467  |  |   | 180,439  
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          
|Total temporarily impaired securities                                                 |  | $                      | 13,175 |                   | $ | 1,031,085        |  | $          | 6,903 |                  | $ | 224,047    |  | $ | 20,078 |  | $ | 1,255,132
|                                                                                      |  |                        |        |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |          



At December 31, 2005, the
Company had a net unrealized gain on all investments of $102.6 million before income taxes, which is comprised of unrealized gains of $122.7 million offset by unrealized losses of $20.1 million. Unrealized losses represent 0.6% of total investments
at amortized cost. The Companys investment portfolio includes approximately 600 securities in a gross unrealized loss position. Of these unrealized losses, approximately



66



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



$14.6 million relate to fixed maturity investments and the remaining $5.5 million relate to equity securities. Approximately $18.1 million of the unrealized losses are
represented by a large number of individual securities with unrealized losses of less than 20% of each securitys amortized cost. Of these, the most significant unrealized losses relate to one corporate bond and one municipal bond with
unrealized losses of approximately $0.8 million and $0.5 million, respectively, representing market value declines of 6% and 16% of amortized cost, the majority of which have been in an unrealized loss position for less than twelve months. The
remaining $2.0 million represents unrealized losses that exceed 20% of amortized costs. Based upon the Companys analysis of these securities which includes the status of debt servicing for the municipal bonds and third party analyst estimates
for the equity securities, the Company has concluded that the gross unrealized losses of $20.1 million at December 31, 2005 are temporary in nature. However, facts and circumstances may change which could result in a decline in market value
considered to be other than temporary.



The following table illustrates
the gross unrealized losses included in the Companys investment portfolio and the fair value of those securities, aggregated by investment category. The table also illustrates the length of time that they have been in a continuous unrealized
loss position as of December 31, 2004.



|                                                                                      |  |                        |       |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |        
|------------------------------------------------------------------------------------- |  | ---------------------- | ----- | ----------------- | - | ---------------- |  | ---------- | ----- | ---------------- | - | ---------- |  | - | ------ |  | - | -------
|                                                                                      |  | Less than 12 months    |       | 12 months or more |   | Total           
|                                                                                      |  | UnrealizedLosses       |       | Fair Value        |   | UnrealizedLosses |  | Fair Value |       | UnrealizedLosses |   | Fair Value
|                                                                                      |  | (Amounts in thousands)
|U.S. Treasury Securities and obligations of U.S. government corporations and agencies |  | $                      | 632   |                   | $ | 103,672          |  | $          |      |                  | $ |           |  | $ | 632    |  | $ | 103,672
|Obligations of states and political subdivisions                                      |  |                        | 2,202 |                   |   | 294,441          |  |            | 1,945 |                  |   | 30,322     |  |   | 4,147  |  |   | 324,763
|Corporate securities                                                                  |  |                        | 286   |                   |   | 34,560           |  |            | 37    |                  |   | 4,167      |  |   | 323    |  |   | 38,727 
|Mortgage-backed securities                                                            |  |                        | 3,559 |                   |   | 178,676          |  |            | 58    |                  |   | 3,869      |  |   | 3,617  |  |   | 182,545
|Redeemable preferred stock                                                            |  |                        | 8     |                   |   | 1,230            |  |            | 92    |                  |   | 1,008      |  |   | 100    |  |   | 2,238  
|                                                                                      |  |                        |       |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |        
|Subtotal, debt securities                                                             |  |                        | 6,687 |                   |   | 612,579          |  |            | 2,132 |                  |   | 39,366     |  |   | 8,819  |  |   | 651,945
|Equity securities                                                                     |  |                        | 1,554 |                   |   | 86,640           |  |            | 920   |                  |   | 10,014     |  |   | 2,474  |  |   | 96,654 
|                                                                                      |  |                        |       |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |        
|Total temporarily impaired securities                                                 |  | $                      | 8,241 |                   | $ | 699,219          |  | $          | 3,052 |                  | $ | 49,380     |  | $ | 11,293 |  | $ | 748,599
|                                                                                      |  |                        |       |                   |   |                  |  |            |       |                  |   |            |  |   |        |  |   |        



At December 31, 2005, bond
holdings rated below investment grade were 1.6% of total investments. The average Standard and Poors rating of the bond portfolio was AA. The amortized cost and estimated market value of fixed maturities available for sale at December 31,
2005 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



|                                       |  |                        |           |                       |   |          
|-------------------------------------- |  | ---------------------- | --------- | --------------------- | - | ---------
|                                       |  | AmortizedCost          |           | EstimatedMarket Value
|                                       |  | (Amounts in thousands)
|Fixed maturities available for sale:   |  |                        |           |                       |   |          
|Due in one year or less                |  | $                      | 63,699    |                       | $ | 63,404   
|Due after one year through five years  |  |                        | 257,969   |                       |   | 257,963  
|Due after five years through ten years |  |                        | 706,509   |                       |   | 720,240  
|Due after ten years                    |  |                        | 1,356,134 |                       |   | 1,397,549
|Mortgage-backed securities             |  |                        | 209,434   |                       |   | 206,399  
|                                       |  |                        |           |                       |   |          
|                                       |  | $                      | 2,593,745 |                       | $ | 2,645,555
|                                       |  |                        |           |                       |   |          



67



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



(3)    Fixed Assets



A summary of fixed assets follows:



|                              |  |                        |          |   |      |   |         |  
|----------------------------- |  | ---------------------- | -------- | - | ---- | - | ------- | -
|                              |  | December 31,           |         
|                              |  | 2005                   |          |   | 2004 |  
|                              |  | (Amounts in thousands) |         
|Land                          |  | $                      | 14,502   |   |      | $ | 12,232  |  
|Buildings                     |  |                        | 81,939   |   |      |   | 49,782  |  
|Furniture and equipment       |  |                        | 93,198   |   |      |   | 81,882  |  
|Capitalized software          |  |                        | 46,894   |   |      |   | 28,772  |  
|Leasehold improvements        |  |                        | 2,636    |   |      |   | 2,104   |  
|                              |  |                        |          |   |      |   |         |  
|                              |  |                        | 239,169  |   |      |   | 174,772 |  
|Less accumulated depreciation |  |                        | (102,390 | ) |      |   | (86,127 | )
|                              |  |                        |          |   |      |   |         |  
|Net fixed assets              |  | $                      | 136,779  |   |      | $ | 88,645  |  
|                              |  |                        |          |   |      |   |         |  



Depreciation expense, including
amortization of leasehold improvements, during 2005, 2004 and 2003 was $18,781,000, $16,192,000 and $16,126,000, respectively.



(4)    Deferred Policy Acquisition Costs



Policy acquisition costs incurred and amortized are as follows:



|                                |  |                         |          |   |      |   |          |      |  |   |          |  
|------------------------------- |  | ----------------------- | -------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                |  | Year ended December 31, |         
|                                |  | 2005                    |          |   | 2004 |   |          | 2003 | 
|                                |  | (Amounts in thousands)  |         
|Balance, beginning of year      |  | $                       | 174,840  |   |      | $ | 146,951  |      |  | $ | 119,035  |  
|Costs deferred during the year  |  |                         | 642,018  |   |      |   | 590,442  |      |  |   | 501,230  |  
|Amortization charged to expense |  |                         | (618,915 | ) |      |   | (562,553 | )    |  |   | (473,314 | )
|                                |  |                         |          |   |      |   |          |      |  |   |          |  
|Balance, end of year            |  | $                       | 197,943  |   |      | $ | 174,840  |      |  | $ | 146,951  |  
|                                |  |                         |          |   |      |   |          |      |  |   |          |  



(5)    Notes Payable



Notes Payable consists of the following:



|                       |  |                        |         |      |   |        
|---------------------- |  | ---------------------- | ------- | ---- | - | -------
|                       |  | December 31,          
|                       |  | 2005                   |         | 2004
|                       |  | (Amounts in thousands)
|Unsecured senior notes |  | $                      | 132,290 |      | $ | 137,024
|Mortgage note          |  |                        | 11,250  |      |   |       
|                       |  |                        |         |      |   |        
|                       |  | $                      | 143,540 |      | $ | 137,024
|                       |  |                        |         |      |   |        



On August 7, 2001, the
Company issued $125 million of senior notes payable under a $300 million shelf registration filed with the Securities and Exchange Commission in July 2001. The notes are unsecured, senior obligations of the Company with a 7.25% annual coupon payable
on August 15 and February 15 each year. The notes mature on August 15, 2011. The Company incurred debt issuance costs of approximately $1.3 million, inclusive of underwriters fees. These costs are deferred and then amortized as
a component of interest expense over the term of the notes. The notes were issued at a slight discount at 99.723%, making the effective annualized interest rate including debt issuance costs approximately 7.44%.



68



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



Effective January 2, 2002, the Company entered into an interest rate swap of its fixed rate obligation on
the senior notes for a floating rate of LIBOR plus 107 basis points. The swap agreement terminates on August 15, 2011 and includes an early termination option exercisable by either party on the fifth anniversary or each subsequent anniversary
by providing sufficient notice, as defined. The swap significantly reduced interest expense in 2003, 2004 and 2005, but does expose the Company to higher interest expense in future periods should LIBOR rates increase. The effective annualized
interest rate was 5.3% and 3.3% in 2005 and 2004, respectively. The swap is designated as a fair value hedge and qualifies for the shortcut method under Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities because the hedge is deemed to have no ineffectiveness. The fair value of the interest rate swap was $7,516,000 and $12,281,000 at December 31, 2005 and 2004, respectively, and has been
recorded in other assets in the consolidated balance sheets with a corresponding increase to notes payable. The interest rate swap was determined to be highly effective and no amount of ineffectiveness was recorded in earnings during the periods
ending December 31, 2005 and 2004.



In January 2005, as part of the
acquisition of an office building in St. Petersburg, Florida, the Company assumed a secured promissory note in the amount of $11,250,000. Under the terms of the note, interest only is payable quarterly at a rate of LIBOR plus 1.75%. The terms of the
note also contain restrictions on prepayment which include penalties for partial or complete prepayment. The note matures on August 1, 2008, at which time the principal and any outstanding interest is due and payable.



The aggregated maturities for notes payable are: 2006$0; 2007$0;
2008$11,250,000; 2009$0; 2010$0; thereafter$125,000,000.



(6)    Income Taxes



The Company and
its subsidiaries file a consolidated Federal income tax return. The provision for income tax expense consists of the following components:



|         |  |                         |        |      |   |         |  |   |       
|-------- |  | ----------------------- | ------ | ---- | - | ------- |  | - | ------
|         |  | Year ended December 31,
|         |  | 2005                    |        | 2004 |   | 2003   
|         |  | (Amounts in thousands) 
|Federal  |  |                         |        |      |   |         |  |   |       
|Current  |  | $                       | 82,509 |      | $ | 101,259 |  | $ | 49,299
|Deferred |  |                         | 13,520 |      |   | 9,916   |  |   | 11,606
|         |  |                         |        |      |   |         |  |   |       
|         |  | $                       | 96,029 |      | $ | 111,175 |  | $ | 60,905
|         |  |                         |        |      |   |         |  |   |       
|State    |  |                         |        |      |   |         |  |   |       
|Current  |  | $                       | 2,463  |      | $ | 5,257   |  | $ | 374   
|Deferred |  |                         | 888    |      |   | 5,203   |  |   | 201   
|         |  |                         |        |      |   |         |  |   |       
|         |  | $                       | 3,351  |      | $ | 10,460  |  | $ | 575   
|         |  |                         |        |      |   |         |  |   |       
|Total    |  |                         |        |      |   |         |  |   |       
|Current  |  | $                       | 84,972 |      | $ | 106,516 |  | $ | 49,673
|Deferred |  |                         | 14,408 |      |   | 15,119  |  |   | 11,807
|         |  |                         |        |      |   |         |  |   |       
|Total    |  | $                       | 99,380 |      | $ | 121,635 |  | $ | 61,480
|         |  |                         |        |      |   |         |  |   |       



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



The income tax provision reflected in the consolidated statements of income is less than the expected federal
income tax on income before income taxes as shown in the table below:



|                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                      |  | Year ended December 31, |        
|                                                                                                      |  | 2005                    |         |   | 2004 |   |         | 2003 | 
|                                                                                                      |  | (Amounts in thousands)  |        
|Computed tax expense at 35%                                                                           |  | $                       | 123,424 |   |      | $ | 142,745 |      |  | $ | 86,030  |  
|Tax-exempt interest income                                                                            |  |                         | (28,187 | ) |      |   | (26,288 | )    |  |   | (26,967 | )
|Dividends received deduction                                                                          |  |                         | (2,333  | ) |      |   | (2,509  | )    |  |   | (2,734  | )
|Reduction of losses incurred deduction for 15% of income on securities purchased after August 7, 1986 |  |                         | 4,474   |   |      |   | 4,193   |      |  |   | 4,322   |  
|Other, net                                                                                            |  |                         | 2,002   |   |      |   | 3,494   |      |  |   | 829     |  
|                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  
|Income tax expense                                                                                    |  | $                       | 99,380  |   |      | $ | 121,635 |      |  | $ | 61,480  |  
|                                                                                                      |  |                         |         |   |      |   |         |      |  |   |         |  



The temporary differences that
give rise to a significant portion of the deferred tax asset (liability) relate to the following:



|                                                                                      |  |                        |          |   |      |   |          |  
|------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | -------- | -
|                                                                                      |  | December 31,           |         
|                                                                                      |  | 2005                   |          |   | 2004 |  
|                                                                                      |  | (Amounts in thousands) |         
|Deferred tax assets                                                                   |  |                        |          |   |      |   |          |  
|20% of net unearned premium                                                           |  | $                      | 67,579   |   |      | $ | 59,400   |  
|Discounting of loss reserves and salvage and subrogation recoverable for tax purposes |  |                        | 14,578   |   |      |   | 15,681   |  
|Write-down of impaired investments                                                    |  |                        | 4,683    |   |      |   | 6,466    |  
|Capital loss carryforwards                                                            |  |                        |         |   |      |   | 3,814    |  
|Other deferred tax assets                                                             |  |                        | 2,553    |   |      |   | 1,830    |  
|                                                                                      |  |                        |          |   |      |   |          |  
|Total gross deferred tax assets                                                       |  |                        | 89,393   |   |      |   | 87,191   |  
|                                                                                      |  |                        |          |   |      |   |          |  
|Deferred tax liabilities                                                              |  |                        |          |   |      |   |          |  
|Deferred acquisition costs                                                            |  |                        | (69,280  | ) |      |   | (61,194  | )
|Tax liability on net unrealized gain on securities carried at market value            |  |                        | (35,824  | ) |      |   | (43,363  | )
|Tax depreciation in excess of book depreciation                                       |  |                        | (13,045  | ) |      |   | (5,715   | )
|Accretion on bonds                                                                    |  |                        | (315     | ) |      |   | (447     | )
|Undistributed earnings of insurance subsidiaries                                      |  |                        | (3,606   | ) |      |   | (3,250   | )
|Other deferred tax liabilities                                                        |  |                        | (4,779   | ) |      |   | (3,828   | )
|                                                                                      |  |                        |          |   |      |   |          |  
|Total gross deferred tax liabilities                                                  |  |                        | (126,849 | ) |      |   | (117,797 | )
|                                                                                      |  |                        |          |   |      |   |          |  
|Net deferred tax liabilities                                                          |  | $                      | (37,456  | ) |      | $ | (30,606  | )
|                                                                                      |  |                        |          |   |      |   |          |  



Realization of deferred tax
assets is dependent on generating sufficient taxable income prior to their expiration. Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized.



As a result of California Assembly Bill 263 (AB263) the Company paid
approximately $3.5 million in California franchise taxes for the tax years 1997 through 2003 during 2005. This expense was reflected in the 2004 current state income tax provision. AB263 resolved an issue raised by the Franchise Tax Board
(FTB) where they



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



interpreted a legal ruling to eliminate a dividends received deduction (DRD) taken by companies on dividends received from their insurance subsidiaries.
AB263 provides for an 80% DRD for tax years 1997 through 2007 and an 85% DRD for tax years after 2007.



On June 25, 2003, the California State Board of Equalization (SBE) upheld Notices of Proposed Assessments issued against the Company for tax years
1993 through 1996 in which the FTB disallowed a portion of the Companys expenses related to management services provided to its insurance company subsidiaries on grounds that such expenses were allocable to the Companys tax-deductible
dividends from such subsidiaries. The SBE decision also resulted in a smaller disallowance of the Companys interest expense deductions than was proposed by the FTB in those years. The Company filed a petition for rehearing with the SBE
relating to these franchise tax issues and a rehearing was granted and held on July 1, 2005. At the rehearing, additional briefings were requested before the SBE would rule on the matter. These briefings were filed with the SBE and another
rehearing is scheduled for March 28, 2006.



The potential net
exposure on the franchise tax issues for 1993 through 1996, after federal tax benefit, amounts to approximately $15 million, which includes a potential tax amnesty interest penalty of approximately $4 million. The amnesty penalty relates to a
revenue enhancement provision contained in the California Tax Amnesty legislation requiring taxpayers with tax assessments for tax years 2002 and prior, whether or not disputed, to pay amounts due by March 31, 2005 or risk paying an additional
penalty amount equal to 50% of the interest computed on the original assessment for the period beginning with the due date of the return and ending on March 31, 2005. These amounts would be due should the Company not prevail on the underlying
tax issues.



The Company believes that the deduction of the expenses
related to management services provided to its insurance company subsidiaries is appropriate. The Company has established a tax liability of approximately $1 million for the franchise tax issues related to the tax years 1993 through 1996. An
unfavorable ruling against the Company in the rehearing may have a material impact on the Companys quarterly results of operations.



The California FTB has audited the 1997 through 2002 tax returns and they accepted the 1997 through 2000 returns to be correct as filed. For the 2001 and 2002 tax
returns, the FTB has taken exception to the state apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company that is
excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. Based on this assertion, the FTB issued notices of proposed tax assessments in January 2006 for the 2001 and 2002 tax
years totaling approximately $1 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the SBE. An unfavorable ruling against the Company may have a material impact on the
Companys quarterly results of operations. Management believes that the issue will ultimately be resolved in favor of the Company. However, there can be no assurance that the Company will prevail in this matter.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



(7)    Reserves for Losses and Loss Adjustment Expenses



Activity in the reserves for losses and loss adjustment expenses is summarized as
follows:



|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|--------------------------------------------------------------------------- |  | ----------------------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                                            |  | Year ended December 31, |          
|                                                                            |  | 2005                    |           |   | 2004 |   |           | 2003 | 
|                                                                            |  | (Amounts in thousands)  |          
|Gross reserves for losses and loss adjustment expenses at beginning of year |  | $                       | 900,744   |   |      | $ | 797,927   |      |  | $ | 679,271   |  
|Less reinsurance recoverable                                                |  |                         | (14,137   | ) |      |   | (11,771   | )    |  |   | (14,382   | )
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Net reserves, beginning of year                                             |  |                         | 886,607   |   |      |   | 786,156   |      |  |   | 664,889   |  
|Incurred losses and loss adjustment expenses related to:                    |  |                         |           |   |      |   |           |      |  |   |           |  
|Current year                                                                |  |                         | 1,909,453 |   |      |   | 1,640,197 |      |  |   | 1,447,986 |  
|Prior years                                                                 |  |                         | (46,517   | ) |      |   | (57,943   | )    |  |   | 4,065     |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Total incurred losses and loss adjustment expenses                          |  |                         | 1,862,936 |   |      |   | 1,582,254 |      |  |   | 1,452,051 |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Loss and loss adjustment expense payments related to:                       |  |                         |           |   |      |   |           |      |  |   |           |  
|Current year                                                                |  |                         | 1,218,784 |   |      |   | 1,020,154 |      |  |   | 892,658   |  
|Prior years                                                                 |  |                         | 525,125   |   |      |   | 461,649   |      |  |   | 438,126   |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Total payments                                                              |  |                         | 1,743,909 |   |      |   | 1,481,803 |      |  |   | 1,330,784 |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Net reserves for losses and loss adjustment expenses at end of year         |  |                         | 1,005,634 |   |      |   | 886,607   |      |  |   | 786,156   |  
|Reinsurance recoverable                                                     |  |                         | 16,969    |   |      |   | 14,137    |      |  |   | 11,771    |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  
|Gross reserves, end of year                                                 |  | $                       | 1,022,603 |   |      | $ | 900,744   |      |  | $ | 797,927   |  
|                                                                            |  |                         |           |   |      |   |           |      |  |   |           |  



The decrease in the provision
for insured events of prior years in 2005 and 2004 relates largely to a decrease in the estimated inflation rates for prior accident years on bodily injury coverage for California automobile insurance. In addition, a decrease in the expenditures to
outside legal counsel for defense of personal automobile claims in California during 2005 has led to a reduction in the loss adjustment expense reserve established at December 31, 2004. For 2003, the increase largely relates to an increase in the
ultimate liability for bodily injury, physical damage and collision claims over what was originally estimated. The increases in these claims relate to increased severity over what was originally recorded and are the result of inflationary trends in
health care costs, auto parts and body shop labor costs.



The increase in
prior year loss and loss adjustment expense payments in 2005 and 2004 is related to the recent growth in the Companys business.



During 2005, the state of Florida was struck by several hurricanes. The Company estimated that its pre-tax losses resulting from these hurricanes is approximately
$27 million. The estimate is based upon the total number of claims reported and the number of unreported claims anticipated as a result of the hurricanes. This compares with the pre-tax losses of approximately $22 million incurred from hurricanes in
2004.



(8)    Dividend Restrictions



The Insurance Companies are subject to the financial capacity guidelines established
by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For 2006, the direct insurance subsidiaries of the Company are permitted to
pay approximately $248 million in dividends to the Company without the prior approval of the Department of



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



Insurance (DOI) of the state of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay
dividends. During 2005 and 2004, the Insurance Companies paid dividends to Mercury General Corporation of $134.0 million and $99.0 million, respectively.



(9)    Statutory Balances and Accounting Practices



The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance
departments. Prescribed statutory accounting practices include primarily those published as statements of Statutory Accounting Principles by the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations,
and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 2005, there were no material permitted statutory accounting practices utilized by the Insurance
Companies.



The Insurance Companies statutory net income, as
reported to regulatory authorities, was $253,810,000, $270,466,000 and $168,118,000 for the years ended December 31, 2005, 2004 and 2003, respectively. The statutory policyholders surplus of the Insurance Companies, as reported to
regulatory authorities, as of December 31, 2005 and 2004 was $1,487,574,000 and $1,361,072,000, respectively.



The Company has estimated the risk-based capital requirements of each of the Insurance Companies as of December 31, 2005 according to the formula issued by the
NAIC. Each of the Insurance Companies policyholders surplus exceeded the highest level of minimum required capital.



(10)    Commitments and Contingencies



The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year
2012. For leases that contain predetermined escalations of the minimum rentals, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the
leases as deferred rent in other liabilities. At December 31, 2005 and 2004, this liability amounted to approximately $1,000,000 and $500,000, respectively. Total rent expense under these lease agreements was $7,175,000, $6,921,000 and
$6,150,000 for the years ended December 31, 2005, 2004 and 2003, respectively.



The annual rental commitments, expressed in thousands, are shown as follows:



|           |  |              |      
|---------- |  | ------------ | -----
|Year       |  | Rent Expense
|2006       |  | $            | 6,963
|2007       |  |              | 6,733
|2008       |  |              | 4,733
|2009       |  |              | 2,843
|2010       |  |              | 1,725
|Thereafter |  |              | 503  



During 2005, the Florida DOI
conducted a market conduct examination of the Companys private passenger automobile and homeowners insurance lines of business. In February 2006, in connection with this examination, the Company responded to a Proposed Consent Order (the
Order) received from the Florida DOI. The Order details preliminary findings from the market conduct examination. As of December 31, 2005, the Company has accrued for those items that it believes will have a financial impact. In
addition, the Order proposes a fine for an



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



unspecified amount of money. The Company has established an accrual for a potential fine; however, it is possible that the actual fine could be greater or less than
the amount accrued. The Company believes that the fine, if any, should not have a material effect on the Companys operations or financial condition.



The Company is, from time to time, named as a defendant in various lawsuits relating to its insurance business. In most of these actions, plaintiffs assert claims
for punitive damages, which are not insurable under judicial decisions. The Company has established reserves for lawsuits in cases where the Company is able to estimate its potential exposure and it is probable that the court will rule against the
Company. The Company vigorously defends actions against it, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Companys quarterly
results of operations, however it is not expected to be material to the Companys financial condition.



In Robert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company
(Superior Court for the City and County of San Francisco), the Court issued a modified injunction on July 11, 2005 requiring the Company to compensate brokers at the same rate based on volume of sales, accept applications for insurance from any
California licensed broker, remove subjective underwriting requirements from its broker instruction manual and provide guidelines to be used by its field personnel that specifically identify the standards of broker performance. The Company has
implemented changes to its broker relationship to comply with the Courts modified injunction. The Court also stated that some period of review must take place following any changes before a complete assessment of the brokers relationship
with the Company can be made, and that any further judicial review should be undertaken only after further discussions between the parties to the lawsuit and appropriate evidence reflecting the nature of such broker relationship is fully assessed.
These changes must occur in a one year period of review through November 1, 2006 before the Court will reconsider vacating the modified injunction. The Company believes that it is in compliance with the modified injunction. The Company is not
able to estimate the extent to which complying with the modified injunction will impact future trends in earnings or loss ratios.



In February 2004, the California DOI issued a Notice of Non-Compliance (NNC) based on the trial court ruling in the Robert Krumme litigation. The
NNC alleges that the Company willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumers insurance broker. The Company filed a Notice of Defense which
is based on the same grounds that formed the Companys defense in the Robert Krumme case as well as what the San Francisco Superior Court appeared to regard as the California DOIs acquiescence in our practices. The Company does not
believe that it has done anything to warrant a monetary penalty from the California DOI. If a monetary penalty is imposed, the Company is unable to estimate the ultimate amount of any monetary penalty, and therefore no reserve for the potential
monetary penalty has been established in the consolidated financial statements.



Sam Donabedian, individually and on behalf of those similarly situated v. Mercury Insurance Company, filed his original action on April 20, 2001 in the Los Angeles Superior Court, asserting, among other things, a claim that the
Companys calculation of persistency discounts to determine premiums is an unfair business practice, a violation of the California Consumer Legal Remedies Act (CLRA) and a breach of the covenant of good faith and fair
dealing. The Company originally prevailed on a Demurrer to the Complaint and the case was dismissed; however, the California Court of Appeal reversed the trial courts ruling, deciding that the California Insurance Commissioner does not
have the exclusive right to review the calculation of insurance rates/premiums. After filing two additional pleadings, on June 28, 2005, the Plaintiff filed a Fourth Amended Complaint, asserting claims for violation of California
Business & Professions Code Section 17200 and breach of the covenant of good faith and fair dealing (the CLRA claim previously had been dismissed with prejudice). Plaintiff again sought injunctive relief,



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MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



unspecified restitution and monetary damages as well as punitive damages and attorneys fees and costs. Without leave of court, the Plaintiff has attempted to
state claims for breach of contract and fraud. The Company filed a Demurrer and Motion to Strike certain portions of the Plaintiffs Fourth Amended Complaint. Following the hearing on September 19, 2005, the Court took the matter under
submission. On June 9, 2005, the trial court also permitted a Complaint in Intervention by The Foundation for Taxpayer and Consumer Rights which alleges that the Companys calculation of persistency discounts constitutes a violation of
Insurance Code Section 1861.02(a) and (c) and the Company has filed an answer to that pleading. No trial date has been scheduled and the Plaintiff has not filed a motion to certify the putative class.



The Court agreed to postpone the litigation and to seal its ruling on the
Companys Demurrer and Motion to Strike certain portions of the Fourth Amended Complaint until March 14, 2006 to determine whether the case could be resolved without further litigation. If the case is not resolved by that date or if
progress towards settlement has not been made, the Company expects the Court will unseal its ruling on the Demurrer and Motion to Strike and discovery will commence. The Company is not able to determine the potential outcome of this matter or
potential exposure in the event liability is to be found. The Company intends to vigorously defend this lawsuit.



Noam Hernandez, individually and on behalf of others similarly situated v. Mercury Insurance Company,(Los Angeles Superior Court), originally filed
July 12, 2002, as Dan ODell v. Mercury Insurance Company, involves a dispute over whether the Companys use of certain automated database vendors to help determine the value of total loss claims is proper. The Plaintiff
(along with plaintiffs in other coordinated cases against other insurers) is seeking class certification and unspecified damages for breach of contract and bad faith, including punitive damages, restitution, an injunction preventing the Company from
using valuation software, and unspecified attorneys fees and costs. In 2003, the Court granted the Companys motion to stay the action pending Plaintiff ODells compliance with a contractual arbitration provision. The
arbitration was completed in August 2004 and the award in the Companys favor was confirmed by the Court in January 2005. In June 2005, based upon the arbitration result and other defenses, the Court granted the Companys Motion to
Strike the first amended complaint. While the individual claims of Plaintiff ODell were dismissed with prejudice, Plaintiffs counsel was given leave to file a second amended complaint, substituting a new Plaintiff, in August of
2005. As with the previous Plaintiff, the Company has filed a motion to compel Plaintiff Hernandez compliance with a contractual arbitration provision, and has also filed a Motion to Strike portions of the amended complaint on other
grounds. The Court is expected to rule on these motions on March 16, 2006. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of an unfavorable outcome at the
present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.



In Marissa Goodman, on her own behalf and on behalf of all others similarly situated v. Mercury Insurance Company (Los Angeles Superior Court), filed
June 16, 2002, the Plaintiff is challenging the Companys use of certain automated database vendors to assist in valuing claims for medical payments. The Plaintiff has filed a motion seeking class action certification to include all of the
Companys insureds from 1998 to the present who presented a medical payments claim, had the claim reduced using the computer program and whose claim did not reach the policy limits for medical payments. No date has been set for this motion. As
with the ODell case above, and the other cases in the coordinated proceedings, the Plaintiff alleges that these automated databases systematically undervalue medical payment claims to the detriment of insureds. The Plaintiff is seeking
unspecified actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with two other similar cases, and also with ten other cases relating to total loss claims. The
Court denied the Companys Motion for Summary Judgment holding that there is an issue of fact as to whether Ms. Goodman sustained any damages as a result of the Companys handling of her medical payments claim. A trial



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



date has been set for May 2006. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of
an unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.



Cynthia Markovich and Patricia Carnegie v. Mercury Insurance Services, LLC, a collective action claim filed April 19, 2005
in the United States District Court for the Middle District of Florida, asserts that the Plaintiffs were denied overtime compensation while working as claims adjusters for the Company in violation of the provisions of the Fair Labor Standards Act.
The Plaintiffs are seeking class certification to include all claims adjusters during the three years preceding the filing of this action and recovery of overtime compensation, liquidated damages, attorneys fees, costs and other compensation.
No specific amount of damages has been claimed. The parties to the claim have agreed to give the putative members of the collective action notice and an opportunity to opt-in to determine the potential liability and then attempt to settle the claim.
If a settlement can not be reached, discovery will continue and the case will proceed to trial. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of a settlement or an
unfavorable outcome at the present time. The Company intends to vigorously defend this lawsuit.



The Company is also involved in proceedings relating to assessments and rulings made by the California Franchise Tax Board. See Note 6 of Notes to Consolidated
Financial Statements.



(11)    Profit Sharing Plan



The Company, at the option of the Board of Directors, may make annual contributions
to an employee Profit Sharing Plan (the Plan). The contributions are not to exceed the greater of the Companys net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed
an amount equal to 15% of the compensation paid or accrued during the year to all participants under the Plan. The annual contribution was $1,850,000, $1,700,000 and $1,500,000 for plan years ended December 31, 2005, 2004 and 2003,
respectively.



The Plan includes an option for employees to make salary
deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $3,861,000, $2,841,000 and $2,235,000 for the plan years ended December 31, 2005, 2004 and 2003,
respectively.



The Plan also includes an employee stock ownership plan
(ESOP) that covers substantially all employees. The Board of Directors authorized the Plan to purchase $1.1 million of the Companys common stock in the open market for allocation to the Plan participants. The Company recognized
$1,100,000, $1,000,000 and $1,000,000 as compensation expense in 2005, 2004 and 2003, respectively.



(12)    Common Stock



Dividends paid per-share in 2005, 2004 and 2003 were $1.72, $1.48 and $1.32, respectively and dividends paid in total in 2005, 2004 and 2003 were $93,867,000, $80,632,000 and $71,817,000, respectively.



In May 1995, the Company adopted the 1995 Equity Participation Plan (the 1995
Plan) which succeeded a prior plan. Under the 1995 Plan, 5,400,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards.
During 1995, the Company granted incentive stock options under both the 1995 Plan and the prior plan. The options granted become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date
of the grant. The options expire in 10 years.



76



---

MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



In May 2005, the Company adopted the 2005 Equity Incentive Award Plan (the 2005 Plan) which
succeeds the 1995 Plan. Under the 2005 Plan, 5,400,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. During 2005, the
Company granted incentive stock options under both the 2005 Plan and the 1995 Plan. The options granted become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date of the grant. The
options expire in 10 years. At December 31, 2005 no awards other than options have been granted.



A summary of the status of the Companys plans as of December 31, 2005, 2004 and 2003 and changes during the years ending on those dates is presented
below:



|                                                               |  |        |         |      |                              |      |        |  |   |                              |   |        |   |        |                              |   |         |   |  |   |       
|-------------------------------------------------------------- |  | ------ | ------- | ---- | ---------------------------- | ---- | ------ |  | - | ---------------------------- | - | ------ | - | ------ | ---------------------------- | - | ------- | - |  | - | ------
|                                                               |  | 2005   |         | 2004 |                              | 2003
|                                                               |  | Shares |         |      | WeightedAverageExercisePrice |      | Shares |  |   | WeightedAverageExercisePrice |   | Shares |   |        | WeightedAverageExercisePrice
|Outstanding at beginning of year                               |  |        | 506,665 |      |                              | $    | 36.118 |  |   | 547,970                      |   |        | $ | 32.662 |                              |   | 582,950 |   |  | $ | 31.118
|Granted during the year                                        |  |        | 126,500 |      |                              |      | 55.760 |  |   | 54,500                       |   |        |   | 51.412 |                              |   | 32,500  |   |  |   | 39.856
|Exercised during the year                                      |  |        | (90,713 | )    |                              |      | 26.385 |  |   | (90,565                      | ) |        |   | 24.158 |                              |   | (62,480 | ) |  |   | 21.307
|Canceled or expired                                            |  |        |        |      |                              |      |       |  |   | (5,240                       | ) |        |   | 40.452 |                              |   | (5,000  | ) |  |   | 41.335
|                                                               |  |        |         |      |                              |      |        |  |   |                              |   |        |   |        |                              |   |         |   |  |   |       
|Outstanding at end of year                                     |  |        | 542,452 |      |                              |      | 42.326 |  |   | 506,665                      |   |        |   | 36.118 |                              |   | 547,970 |   |  |   | 32.662
|                                                               |  |        |         |      |                              |      |        |  |   |                              |   |        |   |        |                              |   |         |   |  |   |       
|Options exercisable at year-end                                |  |        | 299,952 |      |                              |      |        |  |   | 320,365                      |   |        |   |        |                              |   | 331,090 |   |  |   |       
|Weighted-average fair value of options granted during the year |  | $      | 12.98   |      |                              |      |        |  | $ | 13.80                        |   |        |   |        |                              | $ | 11.40   |   |  |   |       



The following table summarizes
information regarding the stock options outstanding at December 31, 2005:



|                         |  |                              |  |                                      |  |                           |        |                              |         |                           |   |       
|------------------------ |  | ---------------------------- |  | ------------------------------------ |  | ------------------------- | ------ | ---------------------------- | ------- | ------------------------- | - | ------
|Range of Exercise Prices |  | NumberOutstandingat 12/31/05 |  | WeightedAvg.RemainingContractualLife |  | WeightedAvg.ExercisePrice |        | NumberExercisableat 12/31/05 |         | WeightedAvg.ExercisePrice
|$21.75 to 29.77          |  | 91,752                       |  | 3.42                                 |  | $                         | 24.948 |                              | 91,752  |                           | $ | 24.948
|$31.22 to 58.8312        |  | 450,700                      |  | 6.89                                 |  | $                         | 45.86  |                              | 208,200 |                           | $ | 40.462
|                         |  |                              |  |                                      |  |                           |        |                              |         |                           |   |       
|$21.75 to 58.8312        |  | 542,452                      |  | 6.31                                 |  | $                         | 42.326 |                              | 299,952 |                           | $ | 35.717
|                         |  |                              |  |                                      |  |                           |        |                              |         |                           |   |       



77



---

MERCURY GENERAL CORPORATION AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



December 31, 2005 and 2004



(13)    Earnings Per Share



A reconciliation of the numerator and denominator used in the basic and diluted earnings per share calculation is presented below:



|                                                                  |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     
|----------------------------------------------------------------- |  | ----------------- | ------- | ---------------------------- | ------ | --------------- | - | ----------------- |  | ---------------------------- | ------- | --------------- | ------ | ----------------- | - | ---------------------------- |  | --------------- | ------- |  | ------ |  | - | ----
|                                                                  |  | 2005              |         | 2004                         |        | 2003           
|                                                                  |  | (000s)           |         | (000s)                      |        |                 |   | (000s)           |  | (000s)                      |         |                 |        | (000s)           |   | (000s)                      |  |                
|                                                                  |  | Income(Numerator) |         | WeightedShares(Denomi-nator) |        | Per-ShareAmount |   | Income(Numerator) |  | WeightedShares(Denomi-nator) |         | Per-ShareAmount |        | Income(Numerator) |   | WeightedShares(Denomi-nator) |  | Per-ShareAmount
|Basic EPS                                                         |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     
|Income available to common stockholders                           |  | $                 | 253,259 |                              | 54,566 |                 | $ | 4.64              |  | $                            | 286,208 |                 | 54,471 |                   | $ | 5.25                         |  | $               | 184,321 |  | 54,402 |  | $ | 3.39
|Effect of dilutive securities:                                    |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     
|Options                                                           |  |                   |        |                              | 151    |                 |   |                   |  |                              |        |                 | 162    |                   |   |                              |  |                 |        |  | 145    |  |   |     
|                                                                  |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     
|Diluted EPS                                                       |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     
|Income available to common stockholders after assumed conversions |  | $                 | 253,259 |                              | 54,717 |                 | $ | 4.63              |  | $                            | 286,208 |                 | 54,633 |                   | $ | 5.24                         |  | $               | 184,321 |  | 54,547 |  | $ | 3.38
|                                                                  |  |                   |         |                              |        |                 |   |                   |  |                              |         |                 |        |                   |   |                              |  |                 |         |  |        |  |   |     



The diluted weighted shares
excludes incremental shares of 19,000, 8,000 and 133,000 for 2005, 2004 and 2003, respectively. These shares are excluded due to their antidilutive effect.



78



---

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



Item 9A.    Controls and Procedures



Evaluation of Disclosure Controls and Procedures



The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the Companys reports filed under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to
the Companys management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in
evaluating the cost benefit relationship of possible controls and procedures.



As required by Securities and Exchange Commission Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Companys management, including the Companys Chief Executive Officer
and the Companys Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective at the reasonable assurance level.



Changes in Internal Control over Financial Reporting



There has been no change in the Companys internal controls over financial reporting during the Companys most recent fiscal quarter that has
materially affected, or is reasonably likely to materially affect the Companys internal controls over financial reporting. The Companys process for evaluating controls and procedures is continuous and encompasses constant improvement of
the design and effectiveness of established controls and procedures and the remediation of any deficiencies which may be identified during this process.



Managements Report on Internal Control over Financial Reporting



The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Companys internal
control system was designed to provide reasonable assurance to the Companys management and board of directors regarding the preparation and fair presentation of published financial statements.



All internal control systems, no matter how well designed, have inherent limitations.
Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.



The Companys management assessed the effectiveness of the Companys internal control over financial reporting as of December 31, 2005. In making
this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control  Integrated Framework.Based upon its assessment, the Companys management believes
that, as of December 31, 2005, the Companys internal control over financial reporting is effective based on these criteria.



The Companys independent auditors have issued an attestation report on managements assessment of the Companys internal control over financial
reporting. This report appears on page 53.



Item 9B.    Other
Information



None.



79



---

PART III



Item 10.    Directors and Executive Officers of the Registrant



Item 11.    Executive Compensation



Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Item 13.    Certain Relationships and Related Transactions



Item 14.    Principal Accountant Fees and Services



Information regarding executive officers of the Company is included
in Part I. For this and other information called for by Items 10, 11, 12, 13 and 14 reference is made to the Companys definitive proxy statement for its Annual Meeting of Shareholders, to be held on May 10, 2006, which will be filed with
the Securities and Exchange Commission within 120 days after December 31, 2005 and which is incorporated herein by reference.



PART IV



Item 15.    Exhibits and Financial Statement Schedules



(a) The following documents are filed as a part of this report:



| | 1. |  | Financial Statements: The Consolidated Financial Statements for the year ended December 31, 2005 are contained herein as listed in the Index to Consolidated Financial Statements on page
51.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. |  | Financial Statement Schedules:
| | -- |  | ------------------------------



Title

Report of Independent Registered Public Accounting Firm

Schedule ISummary of InvestmentsOther than Investments in Related Parties

Schedule IICondensed Financial Information of Registrant

Schedule IVReinsurance



All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or Notes
thereto.



| | 3. |  | Exhibits
| | -- |  | --------



|         |  |                                                                                                                                                                                                                         
|-------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         | 
|3.1(1)   |  | Articles of Incorporation of the Company, as amended to date.                                                                                                                                                           
|         | 
|3.2(2)   |  | By-laws of the Company, as amended to date.                                                                                                                                                                             
|         | 
|4.1(3)   |  | Shareholders Agreement dated as of October 7, 1985 among the Company, George Joseph and Gloria Joseph.                                                                                                                 
|         | 
|4.2(4)   |  | Indenture between the Company and Bank One Trust Company, N.A., as Trustee dated as of June 1, 2001.                                                                                                                    
|         | 
|4.3(5)   |  | Officers Certificate establishing the Companys 7.25% Senior Notes due 2011 as a series of securities under the Indenture dated as of June
1, 2001 between Mercury General Corporation and Bank One Trust Company, N.A.
|         | 
|10.1(1)  |  | Form of Agency Contract.                                                                                                                                                                                                
|         | 
|10.2(6)* |  | Profit Sharing Plan, as Amended and Restated as of March 11, 1994.                                                                                                                                                      
|         | 
|10.3(7)* |  | Amendment 1994-I to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                



80



---

|           |  |                                                                                                                                                                                                                                                                                                                                                                                                                                  
|---------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           | 
|10.4(7)*   |  | Amendment 1994-II to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                        
|           | 
|10.5(8)*   |  | Amendment 1996-I to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.6(8)*   |  | Amendment 1997-I to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.7(1)*   |  | Amendment 1998-I to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.8(9)*   |  | Amendment 1999-I and Amendment 1999-II to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                   
|           | 
|10.9(12)*  |  | Amendment 2001-I to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.10(13)* |  | Amendment 2002-1 to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.11(13)* |  | Amendment 2002-2 to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.12(2)*  |  | Amendment 2003-1 to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.13(2)*  |  | Amendment 2004-1 to the Mercury General Corporation Profit Sharing Plan.                                                                                                                                                                                                                                                                                                                                                         
|           | 
|10.14(10)* |  | The 1995 Equity Participation Plan.                                                                                                                                                                                                                                                                                                                                                                                              
|           | 
|10.15(11)  |  | Management agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Casualty Company, Mercury Insurance Company,
California Automobile Insurance Company and California General Underwriters Insurance Company.                                                                                                                                                                                    
|           | 
|10.16(11)  |  | Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and American Mercury Insurance Company.                                                                                                                                                                                                                                                                                                    
|           | 
|10.17(11)  |  | Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Insurance Company of Georgia.                                                                                                                                                                                                                                                                                                  
|           | 
|10.18(11)  |  | Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Indemnity Company of Georgia.                                                                                                                                                                                                                                                                                                  
|           | 
|10.19(11)  |  | Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Insurance Company of Illinois.                                                                                                                                                                                                                                                                                                 
|           | 
|10.20(11)  |  | Management Agreement effective January 1, 2001 between Mercury Insurance Services LLC and Mercury Indemnity Company of Illinois.                                                                                                                                                                                                                                                                                                 
|           | 
|10.21(12)  |  | Management Agreement effective January 1, 2002 between Mercury Insurance Services LLC and Mercury Insurance Company of Florida and Mercury Indemnity
Company of Florida.                                                                                                                                                                                                                                                         
|           | 
|10.22(14)* |  | Director Compensation Arrangements.                                                                                                                                                                                                                                                                                                                                                                                              
|           | 
|10.23(15)* |  | Mercury General Corporation 2005 Equity Incentive Award Plan.                                                                                                                                                                                                                                                                                                                                                                    
|           | 
|10.24(16)* |  | Incentive Stock Option Agreement under the Mercury General Corporation 2005 Equity Incentive Award Plan.                                                                                                                                                                                                                                                                                                                         
|           | 
|21.1(2)    |  | Subsidiaries of the Company.                                                                                                                                                                                                                                                                                                                                                                                                     
|           | 
|23.1       |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                                                                                                                                        
|           | 
|31.1       |  | Certification of Registrants Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                  
|           | 
|31.2       |  | Certification of Registrants Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                  
|           | 
|32.1       |  | Certification of Registrants Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of
2002. This certification is being furnished solely to accompany this Annual Report on Form 10-K and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any
filing of the Company.
|           | 
|32.2       |  | Certification of Registrants Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of
2002. This certification is being furnished solely to accompany this Annual Report on Form 10-K and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any
filing of the Company.



81



---

---

|(1) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 1997, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 2004, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | This document was filed as an exhibit to Registrants Registration Statement on Form S-1, File No. 33-899, and is incorporated herein by this reference.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) |  | This document was filed as an exhibit to Registrants Form S-3 filed with the Securities and Exchange Commission on June 4, 2001, and is incorporated herein by this reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) |  | This document was filed as an exhibit to Registrants Form 8-K filed with the Securities and Exchange Commission on August 6, 2001, and is incorporated herein by this reference.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 1993, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 1994, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 1996, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 1999, and is incorporated herein by this reference.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) |  | This document was filed as an exhibit to Registrants Form S-8 filed with the Securities and Exchange Commission on March 8, 1996, and is incorporated herein by this reference.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 2000, and is incorporated herein by this reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 2001, and is incorporated herein by this reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) |  | This document was filed as an exhibit to Registrants Form 10-K for the fiscal year ended December 31, 2002, and is incorporated herein by this reference.
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) |  | This document was filed as an exhibit to Registrants Form 8-K filed with the Securities and Exchange Commission on February 3, 2005, and is incorporated herein by this reference.
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) |  | This document was filed as an exhibit to the Companys Definitive Proxy Statement on Schedule 14A (File No. 001-12257) filed with the Securities and Exchange Commission on
April 5, 2005.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(16) |  | This document was filed as an exhibit to Registrants Form 8-K filed with the Securities and Exchange Commission on May 16, 2005, and is incorporated herein by this reference.
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|* |  | Denotes management contract or compensatory plan or arrangement.
|- |  | ----------------------------------------------------------------



82



---

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.



MERCURY GENERAL CORPORATIONBy

/s/    GEORGE JOSEPHGeorge Joseph Chairman of the Board and Chief Executive Officer




March 7, 2006



Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.



|                                              |  |                                                                                                           |  |              
|--------------------------------------------- |  | --------------------------------------------------------------------------------------------------------- |  | -------------
|Signature                                     |  | Title                                                                                                     |  | Date         
|                                              |  |                                                                                                          
|/s/     GEORGE JOSEPHGeorge Joseph            |  | Chairman of the Board and Chief Executive Officer (Principal Executive Officer)                           |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    GABRIEL TIRADORGabriel Tirador         |  | President and Chief Operating Officer Director                                                            |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    THEODORE R. STALICKTheodore R. Stalick |  | Vice President and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    NATHAN BESSINNathan Bessin             |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    BRUCE A. BUNNERBruce A. Bunner         |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    MICHAEL D. CURTIUSMichael D. Curtius   |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    RICHARD E. GRAYSONRichard E. Grayson   |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    CHARLES
MCCLUNGCharles
McClung         |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    DONALD P. NEWELLDonald P. Newell       |  | Director                                                                                                  |  | March 7, 2006
|                                              |  |                                                                                                          
|/s/    DONALD R. SPUEHLERDonald R. Spuehler   |  | Director                                                                                                  |  | March 7, 2006



83



---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Mercury General Corporation:



Under date of March 7, 2006, we reported on the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2005 and
2004, and the related consolidated statements of income, comprehensive income, shareholders equity and cash flows for each of the years in the three-year period ended December 31, 2005, as contained in the annual report on Form 10-K for
the year 2005. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed under Item 15(a)2. These financial statement schedules are the
responsibility of the Companys management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.



In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in
all material respects, the information set forth therein.



/s/    KPMG LLP



Los
Angeles, California

March 7, 2006



S-1



---

SCHEDULE I



MERCURY GENERAL CORPORATION



SUMMARY OF INVESTMENTS

OTHER THAN INVESTMENTS IN RELATED
PARTIES



December 31, 2005



|                                           |  |                      |           |       |   |                                         |  |   |          
|------------------------------------------ |  | -------------------- | --------- | ----- | - | --------------------------------------- |  | - | ---------
|Type of Investment                         |  | Cost                 |           | Value |   | Amount atwhich shownin thebalance sheet
|                                           |  | Amounts in thousands
|Fixed maturities available for sale        |  |                      |           |       |   |                                         |  |   |          
|Bonds:                                     |  |                      |           |       |   |                                         |  |   |          
|U.S. government                            |  | $                    | 201,456   |       | $ | 199,436                                 |  | $ | 199,436  
|States, municipalities                     |  |                      | 2,042,289 |       |   | 2,098,811                               |  |   | 2,098,811
|All other corporate bonds                  |  |                      | 139,275   |       |   | 139,445                                 |  |   | 139,445  
|Mortgage-backed securities                 |  |                      | 206,248   |       |   | 203,353                                 |  |   | 203,353  
|Redeemable preferred stock                 |  |                      | 4,477     |       |   | 4,510                                   |  |   | 4,510    
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total fixed maturities available for sale  |  |                      | 2,593,745 |       |   | 2,645,555                               |  |   | 2,645,555
|                                           |  |                      |           |       |   |                                         |  |   |          
|Equity securities:                         |  |                      |           |       |   |                                         |  |   |          
|Common stocks:                             |  |                      |           |       |   |                                         |  |   |          
|Public utilities                           |  |                      | 66,023    |       |   | 102,251                                 |  |   | 102,251  
|Banks, trust and insurance companies       |  |                      | 6,415     |       |   | 8,352                                   |  |   | 8,352    
|Industrial, miscellaneous and all other    |  |                      | 103,019   |       |   | 113,366                                 |  |   | 113,366  
|Nonredeemable preferred stocks             |  |                      | 49,853    |       |   | 52,139                                  |  |   | 52,139   
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total equity securities available for sale |  |                      | 225,310   |       |   | 276,108                                 |  |   | 276,108  
|                                           |  |                      |           |       |   |                                         |  |   |          
|Short-term investments                     |  |                      | 321,049   |       |   |                                         |  |   | 321,049  
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total investments                          |  | $                    | 3,140,104 |       |   |                                         |  | $ | 3,242,712
|                                           |  |                      |           |       |   |                                         |  |   |          



S-2



---

SCHEDULE I



MERCURY GENERAL CORPORATION



SUMMARY OF INVESTMENTS

OTHER THAN INVESTMENTS IN RELATED
PARTIES(Continued)



December 31, 2004



|                                           |  |                      |           |       |   |                                         |  |   |          
|------------------------------------------ |  | -------------------- | --------- | ----- | - | --------------------------------------- |  | - | ---------
|Type of Investment                         |  | Cost                 |           | Value |   | Amount atwhich shownin thebalance sheet
|                                           |  | Amounts in thousands
|Fixed maturities available for sale        |  |                      |           |       |   |                                         |  |   |          
|Bonds:                                     |  |                      |           |       |   |                                         |  |   |          
|U.S. government                            |  | $                    | 153,770   |       | $ | 153,584                                 |  | $ | 153,584  
|States, municipalities                     |  |                      | 1,637,514 |       |   | 1,715,488                               |  |   | 1,715,488
|All other corporate bonds                  |  |                      | 112,170   |       |   | 117,158                                 |  |   | 117,158  
|Mortgage-backed securities                 |  |                      | 253,408   |       |   | 250,963                                 |  |   | 250,963  
|Redeemable preferred stock                 |  |                      | 8,093     |       |   | 8,118                                   |  |   | 8,118    
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total fixed maturities available for sale  |  |                      | 2,164,955 |       |   | 2,245,311                               |  |   | 2,245,311
|                                           |  |                      |           |       |   |                                         |  |   |          
|Equity securities:                         |  |                      |           |       |   |                                         |  |   |          
|Common stocks:                             |  |                      |           |       |   |                                         |  |   |          
|Public utilities                           |  |                      | 74,106    |       |   | 102,616                                 |  |   | 102,616  
|Banks, trust and insurance companies       |  |                      | 14,286    |       |   | 17,865                                  |  |   | 17,865   
|Industrial, miscellaneous and all other    |  |                      | 69,096    |       |   | 77,590                                  |  |   | 77,590   
|Nonredeemable preferred stocks             |  |                      | 53,065    |       |   | 56,291                                  |  |   | 56,291   
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total equity securities available for sale |  |                      | 210,553   |       |   | 254,362                                 |  |   | 254,362  
|                                           |  |                      |           |       |   |                                         |  |   |          
|Short-term investments                     |  |                      | 421,369   |       |   |                                         |  |   | 421,369  
|                                           |  |                      |           |       |   |                                         |  |   |          
|Total investments                          |  | $                    | 2,796,877 |       |   |                                         |  | $ | 2,921,042
|                                           |  |                      |           |       |   |                                         |  |   |          



S-3



---

SCHEDULE II



MERCURY GENERAL CORPORATION



CONDENSED FINANCIAL INFORMATION OF REGISTRANT



BALANCE SHEETS



December 31,



|                                                                                       |  |                      |           |      |   |          
|-------------------------------------------------------------------------------------- |  | -------------------- | --------- | ---- | - | ---------
|                                                                                       |  | 2005                 |           | 2004
|                                                                                       |  | Amounts in thousands
|ASSETS                                                                                 |  |                      |           |      |   |          
|Investments:                                                                           |  |                      |           |      |   |          
|Fixed maturities available for sale (amortized cost $1,615 in 2005 and $1,900 in 2004) |  | $                    | 1,668     |      | $ | 1,999    
|Equity securities, available for sale (cost $13,847 in 2005 and $14,537 in 2004)       |  |                      | 15,923    |      |   | 16,718   
|Short-term cash investments, at cost, which approximates market                        |  |                      | 13,106    |      |   | 12,467   
|Investment in subsidiaries                                                             |  |                      | 1,680,782 |      |   | 1,554,925
|                                                                                       |  |                      |           |      |   |          
|Total investments                                                                      |  |                      | 1,711,479 |      |   | 1,586,109
|Cash                                                                                   |  |                      | 3,316     |      |   | 415      
|Income taxes                                                                           |  |                      | 22,019    |      |   |         
|Other assets                                                                           |  |                      | 8,993     |      |   | 13,995   
|                                                                                       |  |                      |           |      |   |          
|Total assets                                                                           |  | $                    | 1,745,807 |      | $ | 1,600,519
|                                                                                       |  |                      |           |      |   |          
|LIABILITIES AND SHAREHOLDERS EQUITY                                                   |  |                      |           |      |   |          
|Notes payable                                                                          |  | $                    | 132,290   |      | $ | 137,024  
|Accounts payable and accrued expenses                                                  |  |                      | 2,705     |      |   | 1,937    
|Amounts payable to affiliates                                                          |  |                      | 88        |      |   | 77       
|Income taxes                                                                           |  |                      |          |      |   | 1,797    
|Other liabilities                                                                      |  |                      | 2,887     |      |   | 136      
|                                                                                       |  |                      |           |      |   |          
|Total liabilities                                                                      |  |                      | 137,970   |      |   | 140,971  
|                                                                                       |  |                      |           |      |   |          
|Shareholders equity:                                                                  |  |                      |           |      |   |          
|Common stock                                                                           |  |                      | 63,103    |      |   | 60,206   
|Accumulated other comprehensive income                                                 |  |                      | 66,549    |      |   | 80,549   
|Retained earnings                                                                      |  |                      | 1,478,185 |      |   | 1,318,793
|                                                                                       |  |                      |           |      |   |          
|Total shareholders equity                                                             |  |                      | 1,607,837 |      |   | 1,459,548
|                                                                                       |  |                      |           |      |   |          
|Total liabilities and shareholders equity                                             |  | $                    | 1,745,807 |      | $ | 1,600,519
|                                                                                       |  |                      |           |      |   |          





See accompanying notes to condensed financial information.



S-4



---

SCHEDULE II



MERCURY GENERAL CORPORATION



CONDENSED FINANCIAL INFORMATION OF REGISTRANT(Continued)



STATEMENTS OF INCOME



Three years ended December 31,



|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------------------------- |  | -------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                  |  | 2005                 |         |   | 2004 |   |         | 2003 | 
|                                                                  |  | Amounts in thousands |        
|Revenues:                                                         |  |                      |         |   |      |   |         |      |  |   |         |  
|Net investment income                                             |  | $                    | 1,914   |   |      | $ | 1,451   |      |  | $ | 2,097   |  
|Other                                                             |  |                      | 1,600   |   |      |   | 3,721   |      |  |   | 876     |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Total revenues                                                    |  |                      | 3,514   |   |      |   | 5,172   |      |  |   | 2,973   |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Expenses:                                                         |  |                      |         |   |      |   |         |      |  |   |         |  
|Other operating expenses                                          |  |                      | 2,905   |   |      |   | 2,502   |      |  |   | 2,490   |  
|Interest                                                          |  |                      | 6,717   |   |      |   | 4,222   |      |  |   | 3,056   |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Total expenses                                                    |  |                      | 9,622   |   |      |   | 6,724   |      |  |   | 5,546   |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Loss before income taxes and equity in net income of subsidiaries |  |                      | (6,108  | ) |      |   | (1,552  | )    |  |   | (2,573  | )
|Income tax (benefit) expense                                      |  |                      | (609    | ) |      |   | 2,590   |      |  |   | (2,276  | )
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Loss before equity in net income of subsidiaries                  |  |                      | (5,499  | ) |      |   | (4,142  | )    |  |   | (297    | )
|Equity in net income of subsidiaries                              |  |                      | 258,758 |   |      |   | 290,350 |      |  |   | 184,618 |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  
|Net income                                                        |  | $                    | 253,259 |   |      | $ | 286,208 |      |  | $ | 184,321 |  
|                                                                  |  |                      |         |   |      |   |         |      |  |   |         |  







See accompanying notes to condensed financial information.



S-5



---

SCHEDULE II



MERCURY GENERAL CORPORATION



CONDENSED FINANCIAL INFORMATION OF REGISTRANT(Continued)



STATEMENTS OF CASH FLOWS



Three years ended December 31,



|                                                        |  |                      |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------- |  | -------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                        |  | 2005                 |         |   | 2004 |   |         | 2003 | 
|                                                        |  | Amounts in thousands |        
|Cash flows from operating activities:                   |  |                      |         |   |      |   |         |      |  |   |         |  
|Net cash (used in) provided by operating activities     |  | $                    | (26,695 | ) |      | $ | 629     |      |  | $ | (3,985  | )
|Cash flows from investing activities:                   |  |                      |         |   |      |   |         |      |  |   |         |  
|Capital contribution to controlled entities             |  |                      | (15,000 | ) |      |   | (22,000 | )    |  |   | (11,500 | )
|Dividends from subsidiaries                             |  |                      | 134,000 |   |      |   | 99,000  |      |  |   | 76,000  |  
|Fixed maturities, at market:                            |  |                      |         |   |      |   |         |      |  |   |         |  
|Purchases                                               |  |                      |        |   |      |   |        |      |  |   |        |  
|Sales                                                   |  |                      |        |   |      |   |        |      |  |   | 2,860   |  
|Calls or maturities                                     |  |                      | 303     |   |      |   | 282     |      |  |   | 8       |  
|Equity securities:                                      |  |                      |         |   |      |   |         |      |  |   |         |  
|Purchases                                               |  |                      | (85,445 | ) |      |   | (21,252 | )    |  |   | (3,619  | )
|Sales                                                   |  |                      | 87,849  |   |      |   | 24,901  |      |  |   | 8,595   |  
|Calls                                                   |  |                      |        |   |      |   | 1,250   |      |  |   | 1,450   |  
|Decrease (increase) in short term cash investments, net |  |                      | (639    | ) |      |   | (3,968  | )    |  |   | 754     |  
|                                                        |  |                      |         |   |      |   |         |      |  |   |         |  
|Net cash provided by investing activities               |  |                      | 121,068 |   |      |   | 78,213  |      |  |   | 74,548  |  
|Cash flows from financing activities:                   |  |                      |         |   |      |   |         |      |  |   |         |  
|Dividends paid to shareholders                          |  |                      | (93,867 | ) |      |   | (80,632 | )    |  |   | (71,817 | )
|Stock options exercised                                 |  |                      | 2,394   |   |      |   | 2,188   |      |  |   | 1,331   |  
|                                                        |  |                      |         |   |      |   |         |      |  |   |         |  
|Net cash used in financing activities                   |  |                      | (91,473 | ) |      |   | (78,444 | )    |  |   | (70,486 | )
|Net increase in cash                                    |  |                      | 2,900   |   |      |   | 398     |      |  |   | 77      |  
|Cash:                                                   |  |                      |         |   |      |   |         |      |  |   |         |  
|Beginning of the year                                   |  |                      | 416     |   |      |   | 18      |      |  |   | (59     | )
|                                                        |  |                      |         |   |      |   |         |      |  |   |         |  
|End of the year                                         |  | $                    | 3,316   |   |      | $ | 416     |      |  | $ | 18      |  
|                                                        |  |                      |         |   |      |   |         |      |  |   |         |  





See accompanying notes to condensed financial information.



S-6



---

SCHEDULE II



MERCURY GENERAL CORPORATION



CONDENSED FINANCIAL INFORMATION OF REGISTRANT(Continued)



NOTES TO CONDENSED FINANCIAL INFORMATION



December 31, 2005 and 2004



The accompanying condensed financial information should be read in conjunction with the consolidated financial statements and notes included in this statement.



Reclassifications



Certain reclassifications have been made to prior year balances to conform to the current year presentation.



Dividends Received From Subsidiaries



Dividends of $134,000,000, $99,000,000 and $76,000,000 were received by the Company
from its wholly-owned subsidiaries in 2005, 2004 and 2003, respectively, and are recorded as a reduction to Investment in Subsidiaries.



Capitalization of Subsidiaries



Capital contributions of $15,000,000 and $22,000,000 were made by the Company to its insurance subsidiaries during 2005 and 2004, respectively.



Statements of Cash Flow



In 2003, notes payable with a discounted value of $4,315,000 was canceled in accordance with terms of a Purchase and Sale Agreement
between the Company and Employers Reinsurance Corporation.



S-7



---

SCHEDULE IV



MERCURY GENERAL CORPORATION



REINSURANCE



Three years ended December 31,



|                                                 |  |                      |           |                        |   |         |  |            |       |  |   |          
|------------------------------------------------ |  | -------------------- | --------- | ---------------------- | - | ------- |  | ---------- | ----- |  | - | ---------
|                                                 |  | Directamount         |           | Ceded toothercompanies |   | Assumed |  | Net amount
|                                                 |  | Amounts in thousands
|Property and Liability insurance earned premiums |  |                      |           |                        |   |         |  |            |       |  |   |          
|2005                                             |  | $                    | 2,856,598 |                        | $ | 10,085  |  | $          | 1,220 |  | $ | 2,847,733
|2004                                             |  | $                    | 2,534,307 |                        | $ | 6,743   |  | $          | 1,072 |  | $ | 2,528,636
|2003                                             |  | $                    | 2,151,598 |                        | $ | 7,650   |  | $          | 1,099 |  | $ | 2,145,047



S-8