SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.  20549
 
 FORM
10-Q
 
 QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT
 OF
1934
 
 For the
Quarter Ended September 30, 2008
 
 Commission
File No. 001-12257
 
 MERCURY
GENERAL CORPORATION
 (Exact
name of registrant as specified in its charter)
 
 
 California
              95-2211612(State
      or other jurisdiction
              (I.R.S.
      Employerof
      incorporation or organization)
              Identification
      No.)
 
 4484
      Wilshire Boulevard, Los Angeles, California
              90010(Address
      of principal executive offices)
              (Zip
      Code)
 
 Registrant's
telephone number, including area code:(323) 937-1060
 
 Indicate
by check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 
 Yes T                                No
£
 
 Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer,” “accelerated filer,” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 Large
accelerated filer T                                                                                                                     Accelerated
filer £
 Non-accelerated
filer £
(Do not check if a smaller reporting
company)                                                                                                                                          Smaller
reporting company £
 
 Indicate
by check mark whether the Registrant is a shell company (as defined in the Rule
12b-2 of the Exchange Act).
 
 Yes £                                No
T
 
 At
October 31, 2008, the Registrant had issued and outstanding an aggregate of
54,763,713 shares of its Common Stock.
 
 
  
  
 PART
I - FINANCIAL INFORMATION
 
 Item
      1.
              Financial
      Statements
 
 MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands, except share data)
 (unaudited)
 
 
 September 30,
              
              December 31,2008
              
              2007ASSETSInvestments:Fixed
      maturities available for sale, at fair value (amortized cost:
      $2,860,455)
              
              $
              -
              
              
              $
              2,887,760Fixed
      maturities trading, at fair value (amortized cost:
    $2,766,072)
              
              
              2,601,669
              
              
              
              -Equity
      securities available for sale, at fair value (cost:
    $317,869)
              
              
              -
              
              
              
              413,123Equity
      securities trading, at fair value (cost: $402,047;
$13,126)
              
              
              366,738
              
              
              
              15,114Short-term
      investments, at fair value (amortized cost: $252,860;
      $272,678)
              
              
              249,516
              
              
              
              272,678Total
      investments
              
              
              3,217,923
              
              
              
              3,588,675Cash
              
              
              33,761
              
              
              
              48,245Receivables:Premiums
      receivable
              
              
              284,565
              
              
              
              294,663Premium
      notes
              
              
              28,923
              
              
              
              27,577Accrued
      investment income
              
              
              37,824
              
              
              
              36,436Other
              
              
              7,875
              
              
              
              9,010Total
      receivables
              
              
              359,187
              
              
              
              367,686Current
      income taxes
              
              
              13,161
              
              
              
              -Deferred
      income taxes
              
              
              92,476
              
              
              
              -Deferred
      policy acquisition costs
              
              
              205,768
              
              
              
              209,805Fixed
      assets, net
              
              
              189,477
              
              
              
              172,357Other
      assets
              
              
              38,497
              
              
              
              27,728Total
      assets
              
              $
              4,150,250
              
              
              $
              4,414,496LIABILITIES
      AND SHAREHOLDERS' EQUITYLosses
      and loss adjustment expenses
              
              $
              1,049,241
              
              
              $
              1,103,915Unearned
      premiums
              
              
              918,141
              
              
              
              938,370Notes
      payable
              
              
              154,956
              
              
              
              138,562Accounts
      payable and accrued expenses
              
              
              129,232
              
              
              
              125,755Current
      income taxes
              
              
              -
              
              
              
              3,150Deferred
      income taxes
              
              
              -
              
              
              
              30,852Other
      liabilities
              
              
              203,908
              
              
              
              211,894Total
      liabilities
              
              
              2,455,478
              
              
              
              2,552,498Commitments
      and contingenciesShareholders'
      equity:Common
      stock without par value or stated value (Authorized 70,000,000 shares;
      issued and outstanding 54,759,713 shares in 2008 and 54,729,913 shares in
      2007)
              
              
              71,111
              
              
              
              69,369Accumulated
      other comprehensive income
              
              
              54
              
              
              
              80,557Retained
      earnings
              
              
              1,623,607
              
              
              
              1,712,072Total
      shareholders' equity
              
              
              1,694,772
              
              
              
              1,861,998Total
      liabilities and shareholders’ equity
              
              $
              4,150,250
              
              
              $
              4,414,496
 
 See
accompanying notes to the consolidated financial statements.
 
  2
  MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except share and per share data)
 (unaudited)
 
 Three
      Months Ended September 30,2008
              
              
              2007Revenues:Earned
      premiums
              
              $
              696,605
              
              
              $
              748,798Net
      investment income
              
              
              38,086
              
              
              
              39,216Net
      realized investment (losses) gains
              
              
              (276,973
              )
              
              
              2,049Other
              
              
              1,313
              
              
              
              1,324Total
      revenues
              
              
              459,031
              
              
              
              791,387Expenses:Losses
      and loss adjustment expenses
              
              
              511,806
              
              
              
              497,791Policy
      acquisition costs
              
              
              154,530
              
              
              
              166,496Other
      operating expenses
              
              
              44,350
              
              
              
              41,289Interest
              
              
              1,663
              
              
              
              2,136Total
      expenses
              
              
              712,349
              
              
              
              707,712(Loss)
      income before income taxes
              
              
              (253,318
              )
              
              
              83,675Provision
      for income tax (benefit) expense
              
              
              (112,779
              )
              
              
              20,397Net
      (loss) income
              
              $
              (140,539
              )
              
              $
              63,278BASIC
      EARNINGS PER SHARE (weighted average shares outstanding 54,748,101 in 2008
      and 54,720,110 in 2007)
              
              $
              (2.57
              )
              
              $
              1.16DILUTED
      EARNINGS PER SHARE (weighted average shares 54,748,101 in 2008 and
      54,850,536 as adjusted by 130,426 for the dilutive effect of options in
      2007) (1)
              
              $
              (2.57
              )
              
              $
              1.15Dividends
      declared per share
              
              $
              0.58
              
              
              $
              0.52
 
 (1)
      The dilutive impact of incremental shares for 2008 is excluded from loss
      position in accordance with U.S. generally accepted accounting
      principles.
 
 See
accompanying notes to the consolidated financial statements.
 
  3
  MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except share and per share data)
 (unaudited)
 
 Nine
      Months Ended September 30,2008
              
              
              2007Revenues:Earned
      premiums
              
              $
              2,128,725
              
              
              $
              2,258,626Net
      investment income
              
              
              116,380
              
              
              
              122,156Net
      realized investment (losses) gains
              
              
              (332,614
              )
              
              
              10,996Other
              
              
              3,809
              
              
              
              3,896Total
      revenues
              
              
              1,916,300
              
              
              
              2,395,674Expenses:Losses
      and loss adjustment expenses
              
              
              1,484,824
              
              
              
              1,511,928Policy
      acquisition costs
              
              
              472,112
              
              
              
              497,392Other
      operating expenses
              
              
              131,834
              
              
              
              119,292Interest
              
              
              3,659
              
              
              
              6,771Total
      expenses
              
              
              2,092,429
              
              
              
              2,135,383(Loss)
      income before income taxes
              
              
              (176,129
              )
              
              
              260,291Provision
      for income tax (benefit) expense
              
              
              (102,355
              )
              
              
              67,051Net
      (loss) income
              
              $
              (73,774
              )
              
              $
              193,240BASIC
      EARNINGS PER SHARE (weighted average shares outstanding 54,737,337 in 2008
      and 54,697,145 in 2007)
              
              $
              (1.35
              )
              
              $
              3.53DILUTED
      EARNINGS PER SHARE (weighted average shares 54,737,337 in 2008 and
      54,829,878 as adjusted by 132,733 for the dilutive effect of options in
      2007) (1)
              
              $
              (1.35
              )
              
              $
              3.52Dividends
      declared per share
              
              $
              1.74
              
              
              $
              1.56
 
 (1)
      The dilutive impact of incremental shares for 2008 is excluded from loss
      position in accordance with U.S. generally accepted accounting
      principles.
 
 See
accompanying notes to the consolidated financial statements.
 
  4
  MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
 (in
thousands)
 (unaudited)
 
 Three
      Months Ended September 30,2008
              
              
              2007Net
      (loss) income
              
              $
              (140,539
              )
              
              $
              63,278Other
      comprehensive (loss) income, before tax:Net
      unrealized gains on available-for-sale securities
              
              
              -
              
              
              
              32,240Losses
      on cash flow hedge
              
              
              (186
              )
              
              
              -Other
      comprehensive (loss) income, before tax
              
              
              (186
              )
              
              
              32,240Income
      tax expense related to net unrealized gains on available-for-sale
      securities
              
              
              -
              
              
              
              11,284Income
      tax benefit related to losses on cash flow hedge
              
              
              (65
              )
              
              
              -Comprehensive
      (loss) income, net of tax
              
              $
              (140,660
              )
              
              $
              84,234
 
 See
accompanying notes to the consolidated financial statements.
 
  5
  MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
 (in
thousands)
 (unaudited)
 
 Nine
      Months Ended September 30,2008
              
              
              2007Net
      (loss) income
              
              $
              (73,774
              )
              
              $
              193,240Other
      comprehensive income, before tax:Net
      unrealized gains on available-for-sale securities
              
              
              -
              
              
              
              17,037Gains
      on cash flow hedge
              
              
              83
              
              
              
              -Other
      comprehensive income, before tax
              
              
              83
              
              
              
              17,037Income
      tax expense related to net unrealized gains on available-for-sale
      securities
              
              
              -
              
              
              
              5,963Income
      tax expense related to gains on cash flow hedge
              
              
              29
              
              
              
              -Comprehensive
      (loss) income, net of tax
              
              $
              (73,720
              )
              
              $
              204,314
 
 See
accompanying notes to the consolidated financial statements.
 
  6
  MERCURY
GENERAL CORPORATION AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
 (unaudited)
 
 Nine
      Months Ended September 30,2008
              
              
              2007Cash
      flows from operating activities:Net
      (loss) income
              
              $
              (73,774
              )
              
              $
              193,240Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
              
              
              19,918
              
              
              
              19,486Net
      realized investment losses (gains)
              
              
              332,614
              
              
              
              (10,996
              )Bond
      amortization, net
              
              
              5,711
              
              
              
              4,264Excess
      tax benefit from exercise of stock options
              
              
              (133
              )
              
              
              (203
              )Decrease
      (increase) in premiums receivable
              
              
              10,098
              
              
              
              (14,506
              )Increase
      in premium notes receivable
              
              
              (1,346
              )
              
              
              (1,737
              )Decrease
      (increase) in deferred policy acquisition costs
              
              
              4,037
              
              
              
              (5,867
              )(Decrease)
      increase in unpaid losses and loss adjustment expenses
              
              
              (54,674
              )
              
              
              8,856(Decrease)
      increase in unearned premiums
              
              
              (20,229
              )
              
              
              23,455Increase
      in accounts payable and accrued expenses
              
              
              3,477
              
              
              
              5,562Decrease
      in liability for taxes
              
              
              (139,535
              )
              
              
              (8,879
              )Net
      decrease (increase) in securities held for trading, net of realized gains
      and losses
              
              
              2,042
              
              
              
              (6,064
              )Share-based
      compensation
              
              
              489
              
              
              
              388(Decrease)
      increase in other payables
              
              
              (11,867
              )
              
              
              314Other,
      net
              
              
              (4,216
              )
              
              
              (872
              )Net
      cash provided by operating activities
              
              
              72,612
              
              
              
              206,441Cash
      flows from investing activities:Fixed
      maturities available for sale in nature:Purchases
              
              
              (521,102
              )
              
              
              (1,419,283
              )Sales
              
              
              423,031
              
              
              
              1,163,314Calls
      or maturities
              
              
              184,913
              
              
              
              261,920Equity
      securities available for sale in nature:Purchases
              
              
              (336,636
              )
              
              
              (413,946
              )Sales
              
              
              247,545
              
              
              
              376,903Increase
      in payable for securities, net
              
              
              2,973
              
              
              
              4,085Net
      decrease (increase) in short-term investments
              
              
              19,818
              
              
              
              (49,698
              )Purchase
      of fixed assets
              
              
              (37,787
              )
              
              
              (32,437
              )Sale
      of fixed assets
              
              
              1,115
              
              
              
              924Other,
      net
              
              
              5,029
              
              
              
              (3,499
              )Net
      cash used in investing activities
              
              $
              (11,101
              )
              
              $
              (111,717
              )Cash
      flows from financing activities:Dividends
      paid to shareholders
              
              $
              (95,248
              )
              
              $
              (85,342
              )Proceeds
      from bank loan
              
              
              18,000
              
              
              
              -Proceeds
      from stock options exercised
              
              
              1,120
              
              
              
              1,979Mortgage
      loan pay-off
              
              
              -
              
              
              
              (11,250
              )Excess
      tax benefit from exercise of stock options
              
              
              133
              
              
              
              203Net
      cash used in financing activities
              
              
              (75,995
              )
              
              
              (94,410
              )Net
      (decrease) increase in cash
              
              
              (14,484
              )
              
              
              314Cash:Beginning
      of the period
              
              
              48,245
              
              
              
              47,606End
      of the period
              
              $
              33,761
              
              
              $
              47,920Supplemental
      disclosures of cash flow information:Interest
      paid during the period
              
              $
              5,595
              
              
              $
              8,618Income
      taxes paid during the period
              
              $
              36,823
              
              
              $
              76,311Net
      realized gains from sale of investments
              
              $
              10,197
              
              
              $
              18,875
 
 See
accompanying notes to the consolidated financial statements.
  7
  MERCURY
GENERAL CORPORATION & SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (unaudited)
 
 1.
              Basis
      of Presentation
 
 The preparation of financial statements
in conformity with U.S. generally accepted accounting principles (“GAAP”)
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of contingent liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. The most significant assumptions in the
preparation of these consolidated financial statements relate to losses, loss
adjustment expenses and valuation allowance on deferred tax assets. Actual
results could differ materially from those estimates (See Note 1 “Significant
Accounting Policies” of Notes to Consolidated Financial Statements in the
Company’s Annual Report on Form 10-K for the year ended December 31,
2007).
 
 The financial data of Mercury General
Corporation and its subsidiaries (collectively, the “Company”) included herein
have been prepared without audit. In the opinion of management, all material
adjustments of a normal recurring nature necessary to present fairly the
Company’s financial position at September 30, 2008 and the results of
operations, comprehensive income and cash flows for the periods presented have
been made. Operating results and cash flows for the nine months ended September
30, 2008 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2008.
 
 Certain
reclassifications have been made to the prior-period balances to conform to the
current-period presentation.
 
 2.
              Recently
      Adopted Accounting Standards
 
 Effective January 1, 2008, the Company
adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair
Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a single definition
of fair value, together with a framework for measuring it, and requires
additional disclosure about the use of fair value to measure assets and
liabilities. SFAS No. 157 emphasizes that fair value is a market-based
measurement, not an entity-specific measurement, and sets out a fair value
hierarchy with the highest priority being quoted prices in active markets. The
adoption of SFAS No. 157 did not have a material impact on the Company’s
consolidated financial statements.
 
 Effective January 1, 2008, the Company
adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities - Including an Amendment of FASB Statement No. 115” (“SFAS No.
159”). SFAS No. 159 permits an entity to measure certain financial assets and
financial liabilities at fair value. Entities that elect the fair value option
will report unrealized gains and losses in earnings at each subsequent reporting
date. The Company elected to apply the fair value option of SFAS No. 159 to all
short-term investments and all available-for-sale fixed maturity and equity
securities existing at the time of adoption and similar securities acquired
subsequently unless otherwise noted at the time when the eligible item is first
recognized, including hybrid financial instruments with embedded derivatives
that would otherwise need to be bifurcated. The primary reasons for electing the
fair value option were simplification and cost-benefit considerations as well as
expansion of use of fair value measurement consistent with the long-term
measurement objectives of the Financial Accounting Standards Board (“FASB”) for
accounting for financial instruments.
 
 The transition adjustment to beginning
retained earnings related to the adoption of SFAS No. 159 was a gain of $80.5
million, net of deferred taxes of $43.3 million, all of which related to
applying the fair value option to fixed maturity and equity securities available
for sale. This adjustment was reflected as a reclassification of accumulated
other comprehensive income to retained earnings. Both the fair value and
carrying value of such securities were $3.3 billion on January 1, 2008,
immediately prior to the adoption of the fair value option.
 
 3.
              Fair
      Value of Financial Instruments
 
 The following table presents losses due
to changes in fair value for items measured at fair value pursuant to election
of the fair value option under SFAS No. 159:
 
 Three
      Months Ended
              
              Nine
      Months EndedSeptember
      30, 2008
              
              September 30,
      2008(in
      thousands)Short-term
      investments
              
              $
              (3,031
              )
              
              $
              (3,344
              )Fixed
      maturity securities
              
              
              (121,852
              )
              
              
              (191,709
              )Equity
      securities
              
              
              (129,238
              )
              
              
              (129,781
              )Total
              
              $
              (254,121
              )
              
              $
              (324,834
              )
 
  8
  The losses due to changes in fair value
for items measured at fair value pursuant to election of the fair value option
are included in net realized investment gains (losses) in the Company’s
consolidated statements of operations, while the interest and dividend income on
the investment holdings are recognized on an accrual basis on each measurement
date and are included in net investment income in the Company’s consolidated
statements of operations.
 
 In February 2006, the FASB issued SFAS
No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS No. 155”).
SFAS No. 155 permits hybrid financial instruments that contain an embedded
derivative that would otherwise require bifurcation to irrevocably be accounted
for at fair value, with changes in fair value recognized in the statement of
operations. The Company adopted SFAS No. 155 on January 1, 2007. Since SFAS No.
159 incorporates accounting and disclosure requirements that are similar to
those of SFAS No. 155, effective January 1, 2008, SFAS No. 159 rather than SFAS
No. 155 is applied to the Company’s fair value elections for hybrid financial
instruments.
 
 4.
              Fair
      Value Measurement
 
 SFAS No. 157 establishes a fair value
hierarchy that prioritizes the inputs to valuation techniques used to measure
fair value. The fair value of a financial instrument is the amount that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date (the exit
price). Accordingly, when market observable data is not readily available, the
Company’s own assumptions are set to reflect those that market participants
would be presumed to use in pricing the asset or liability at the measurement
date. The Company uses prices and inputs that are current as of the measurement
date, including during periods of market disruption. In periods of market
disruption, the ability to observe prices and inputs may be reduced for many
instruments. This condition could cause an instrument to be reclassified from
Level 1 to Level 2, or from Level 2 to Level 3.
 
 Financial
assets and financial liabilities recorded on the consolidated balance sheets at
fair value are categorized based on the reliability of inputs to the valuation
techniques as follows:
 Level
1   Financial assets and financial liabilities whose
values are based on unadjusted quoted prices for identical assets or liabilities
in active markets that the Company can access.
 
 Level
2   Financial assets and financial liabilities whose
values are based on the following:
 
 a) Quoted prices for similar assets or
liabilities in active markets;
 b) Quoted prices for identical or
similar assets or liabilities in non-active markets; or
 c) Valuation models whose inputs are
observable, directly or indirectly, for substantially the full term of the asset
or liability.
 
 Level
3   Financial assets and financial liabilities whose
values are based on prices or valuation techniques that require inputs that are
both unobservable and significant to the overall fair value measurement. These
inputs reflect the Company’s estimates of the assumptions that market
participants would use in valuing the financial assets and financial
liabilities.
 The availability of observable inputs
varies by instrument. In situations where fair value is based on internally
developed pricing models or inputs that are unobservable in the market, the
determination of fair value requires more judgment. The degree of judgment
exercised by the Company in determining fair value is typically greatest for
instruments categorized in Level 3. In certain cases, the inputs used to measure
fair value may fall into different levels of the fair value hierarchy. In such
cases, the level in the fair value hierarchy within which the fair value
measurement in its entirety falls has been determined based on the lowest level
input that is significant to the fair value measurement in its entirety. The
Company’s assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment, and considers factors specific to
the asset or liability.
 
 Summary of Significant Valuation
Techniques for Financial Assets and Financial Liabilities
 
 The Company primarily utilizes
independent pricing services to obtain fair values on its portfolio except for
1.4% where unadjusted broker quotes are obtained.
 
 Level
1 Measurements
 
 U.S. government bonds and
agencies: U.S. treasuries and agencies are priced using unadjusted quoted
market prices for identical assets in active markets.
 
 Common stock; Other:
Comprised of actively traded, exchange listed U.S. and international equity
securities and valued based on unadjusted quoted prices for identical assets in
active markets.
 
 Short-term
investments: Comprised of actively traded short-term bonds and money
market funds that have daily quoted net asset values for identical
assets.
 
  9
  
 Derivative contracts:
Comprised of free-standing exchange listed derivatives that are actively traded
and valued based on quoted prices for identical instruments in active
markets.
 
 Level
2 Measurements
 
 Obligations of states and
political subdivisions: Municipal bonds are valued based on models or
matrices using inputs including quoted prices for identical or similar assets in
active markets.
 
 Mortgage-backed
securities: Valued based on models or matrices using multiple observable
inputs, such as benchmark yields, reported trades and broker/dealer quotes, for
identical or similar assets in active markets.
 
 Corporate securities:
Valued based on a multi-dimensional model using multiple observable inputs, such
as benchmark yields, reported trades, broker/dealer quotes and issue spreads,
for identical or similar assets in active markets.
 
 Redeemable and
Non-redeemable preferred stock: Valued based on observable inputs, such
as underlying and common stock of same issuer and appropriate spread over a
comparable U.S. Treasury security, for identical or similar assets in active
markets.
 
 Derivative contracts; Notes
payable: Comprised of interest rate swaps that are valued based on models
using inputs, such as interest rate yield curves, observable for substantially
the full term of the contract.
 
 Level
3 Measurements
 
 Obligations of states and
political subdivisions: Comprised of certain distressed municipal
securities for which valuation is based on models that are widely accepted in
the financial services industry and require projections of future cash flows
that are not market observable. Included in this category are $4.7 million of
auction rate securities (“ARS”). ARS are valued based on a discounted cash flow
model with certain inputs that are significant to the valuation, but are not
market observable.
 
 The Company’s total financial
instruments at fair value are reflected in the consolidated balance sheets on a
trade-date basis. Related unrealized gains or losses are recognized in net
realized investment gains (losses) in the consolidated statements of operations.
Fair value measurements are not adjusted for transaction costs.
 
  10
  The following table presents
information about the Company’s assets and liabilities measured at fair value on
a recurring basis as of September 30, 2008, and indicates the fair value
hierarchy of the valuation techniques utilized by the Company to determine such
fair value:
 Quoted
      Prices in Active Markets for Identical Assets
                
                
                Significant
      Other Observable Inputs
                
                
                Significant
      Unobservable Inputs
                
                
                Balance
      as of September 30,(Level
      1)
                
                
                (Level
      2)
                
                
                (Level
      3)
                
                
                2008(in
      thousands)AssetsFixed
      maturity securities:U.S.
      government bonds and agencies
                
                $
                19,672
                
                
                $
                -
                
                
                $
                -
                
                
                $
                19,672Obligations
      of states and political subdivisions
                
                
                -
                
                
                
                2,269,668
                
                
                
                4,705
                
                
                
                2,274,373Mortgage-backed
      securities
                
                
                -
                
                
                
                212,801
                
                
                
                -
                
                
                
                212,801Corporate
      securities
                
                
                -
                
                
                
                93,935
                
                
                
                -
                
                
                
                93,935Redeemable
      preferred stock
                
                
                -
                
                
                
                888
                
                
                
                -
                
                
                
                888Equity
      securities:Common
      stock:Public
      utilities
                
                
                43,942
                
                
                
                -
                
                
                
                -
                
                
                
                43,942Banks,
      trusts and insurance companies
                
                
                17,275
                
                
                
                -
                
                
                
                -
                
                
                
                17,275Industrial
      and other
                
                
                293,564
                
                
                
                -
                
                
                
                -
                
                
                
                293,564Non-redeemable
      preferred stock
                
                
                -
                
                
                
                11,957
                
                
                
                -
                
                
                
                11,957Short-term
      investments
                
                
                249,516
                
                
                
                -
                
                
                
                -
                
                
                
                249,516Derivative
      contracts
                
                
                973
                
                
                
                7,748
                
                
                
                -
                
                
                
                8,721Total
      assets at fair value
                
                $
                624,942
                
                
                $
                2,596,997
                
                
                $
                4,705
                
                
                $
                3,226,644LiabilitiesNotes
      payable
                
                
                -
                
                
                
                132,539
                
                
                
                -
                
                
                
                132,539Derivative
      contracts
                
                
                2,211
                
                
                
                -
                
                
                
                -
                
                
                
                2,211Other
                
                
                3,465
                
                
                
                -
                
                
                
                -
                
                
                
                3,465Total
      liabilities at fair value
                
                $
                5,676
                
                
                $
                132,539
                
                
                $
                -
                
                
                $
                138,215
 As
required by SFAS No. 157, when the inputs used to measure fair value fall
within different levels of the hierarchy, the level within which the fair value
measurement is categorized is based on the lowest level input that is
significant to the fair value measurement in its entirety. Thus, a Level 3
fair value measurement may include inputs that are observable (Level 1 or Level
2) and unobservable (Level 3).
 
 The
following table provides a summary of changes in fair value during the
three–month and nine-month periods ended September 30, 2008 of Level 3
financial assets and financial liabilities held at fair value on a recurring
basis at September 30, 2008:
 
 Three
      months ended September 30, 2008Fixed
      Maturities(in
      thousands)Fair
      value at June 30, 2008
              
              $
              -Transfers
      in
              
              
              4,705Fair
      value at September 30, 2008
              
              $
              4,705Nine
      months ended September 30, 2008Fixed
      Maturities(in
      thousands)Fair
      value at December 31, 2007
              
              $
              -Transfers
      in
              
              
              4,705Fair
      value at September 30, 2008
              
              $
              4,705
 
 There were no purchases, sales or
realized gains (losses) associated with Level 3 securities during the three and
nine months ended September 30, 2008. The transfer into Level 3 is the result of
adverse changes in the observability of significant inputs to the valuation
model used.
  11
  
 5.
              Share-Based
      Compensation
 
 The
Company accounts for share-based compensation in accordance with SFAS No. 123
(revised 2004), “Share-Based Payment” (“SFAS No. 123R”), using the modified
prospective transition method. Under this transition method, share-based
compensation expense includes compensation expense for all share-based
compensation awards granted prior to, but not yet vested as of, January 1, 2006,
based on the grant-date fair value estimated in accordance with the original
provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.”
Share-based compensation expense for all share-based payment awards granted or
modified on or after January 1, 2006 is based on the grant-date fair value
estimated in accordance with the provisions of SFAS No. 123R. The Company
recognizes these compensation costs on a straight-line basis over the requisite
service period of the award, which is the option vesting term of four or five
years, for only those shares expected to vest. The fair value of stock option
awards is estimated using the Black-Scholes option pricing model with the
grant-date assumptions and weighted-average fair values.
 
 6.
              Income
      Taxes
 
 The Company accounts for uncertainty in
income taxes in accordance with the FASB Interpretation No. 48,“Accounting for
Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN
No. 48”). FIN No. 48 provides guidance on financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return
related to uncertainties in income taxes. FIN No. 48 prescribes a
“more-likely-than-not” recognition threshold that must be met before a tax
benefit can be recognized in the financial statements. For a tax position that
meets the recognition threshold, the largest amount of tax benefit that is
greater than 50 percent likely of being realized upon ultimate settlement is
recognized in the financial statements.
 
 The
Company and its subsidiaries file income tax returns in the U.S. federal
jurisdiction and various states. Tax years that remain subject to examination by
major taxing jurisdictions are 2005 through 2007 for federal taxes and 2001
through 2007 for California state taxes.
 
 There were no material changes to the
total amount of unrecognized tax benefits related to tax uncertainties during
the nine months ended September 30, 2008. The Company does not expect any
changes in such unrecognized tax benefits within the next 12 months to have any
significant impact on its consolidated financial statements. The Company
recognizes interest and assessed penalties related to unrecognized tax benefits
as part of income taxes.
 
 On July
1, 2008, the California Superior Court ruled in favor of Mercury General
Corporation in a case filed against the California Franchise Tax Board (“FTB”)
for tax years 1993 through 1996 entitling the Company to a tax refund of $24.5
million, including interest.  The time period for appeal of the
decision has passed and the Company received the full amount on August 15, 2008.
After providing for federal taxes, the Company recognized a net tax benefit of
$17.5 million in the third quarter 2008.
 
 The Company is under examination by the
FTB for tax years 2001 through 2004. The taxing authority has proposed
significant adjustments to the Company’s California tax
liabilities. Management does not believe that the ultimate outcome of this
examination will have a material impact on the Company's financial
position. However, an unfavorable outcome may have a material impact on the
Company’s results of operations in the period of such resolution.
 
 At September 30, 2008, the Company’s
deferred income taxes were in a net asset position, compared to a net liability
position at December 31, 2007. The movement to net asset position is due
primarily to a decrease in the market value of investment securities.
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.
 
 7.
              Recently
      Issued Accounting Standards
 
 In March 2008, the FASB issued SFAS No.
161, “Disclosures about Derivative Instruments and Hedging Activities-an
amendment of FASB Statement No. 133” (“SFAS No. 161”). SFAS No. 161 amends SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS
No. 133”) by requiring expanded disclosures about an entity’s derivative
instruments and hedging activities, but does not change the scope of accounting
of SFAS No. 133. SFAS No. 161 requires increased qualitative disclosures such as
how and why an entity is using a derivative instrument; how the entity is
accounting for its derivative instrument and hedged items under SFAS No. 133 and
its related interpretations; and how the instrument affects the entity’s
financial position, financial performance, and cash flows. Quantitative
disclosures should include information about the fair value of the derivative
instruments, including gains and losses, and should contain more detailed
information about the location of the derivative instrument in the entity’s
financial statements. Credit-risk disclosures should include information about
the existence and nature of credit-risk-related contingent features included in
derivative instruments. Credit-risk-related contingent features can be defined
as those that require entities, upon the occurrence of a credit event such as a
credit rating downgrade, to settle derivative instruments or post collateral.
SFAS No. 161 is effective on January 1, 2009 for the Company. The Company is
currently assessing the impact of adopting SFAS No. 161 on its consolidated
financial statement disclosures.
 
  12
  
 In May 2008, the FASB issued SFAS No.
162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No.
162”). SFAS No. 162 identifies the sources of accounting principles and the
framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with GAAP (“GAAP hierarchy”). The current GAAP hierarchy, as set
forth in the American Institute of Certified Public Accountants (“AICPA”)
Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles,” has been criticized
because (1) it is directed to the auditor rather than the entity, (2) it is
complex, and (3) it ranks FASB Statements of Financial Accounting Concepts,
which are subject to the same level of due process as FASB Statements of
Financial Accounting Standards, below industry practices that are widely
recognized as generally accepted but that are not subject to due process. SFAS
No. 162 shall be effective 60 days following the Securities and Exchange
Commission’s approval of the Public Company Accounting Oversight Board
amendments to U.S. Auditing Standards Section 411, “The Meaning of Present
Fairly in Conformity With Generally Accepted Accounting Principles.” SFAS No.
162 is not expected to have a material impact on the Company’s consolidated
financial statements.
  In December 2007, the FASB issued SFAS
No. 141 (revised 2007), “Business Combinations” ("SFAS
No. 141R").  SFAS No. 141R will significantly change the
accounting for business combinations in a number of areas including the
treatment of contingent consideration, contingencies, and acquisition
costs  In addition, under SFAS No. 141R, changes in deferred tax asset
valuation allowances and acquired income tax uncertainties in a business
combination after the measurement period will impact income tax expense. 
The provisions of SFAS No. 141R will be effective for the Company on
January 1, 2009.  The Company is currently evaluating the impact
of adopting SFAS No. 141R on its consolidated financial
statements.
  8.
              Subsequent
      Event
 
 On
October 10, 2008, Mercury Casualty Company, a California corporation
(“MCC”), the primary insurance subsidiary of the Company, entered into a Stock
Purchase Agreement (the “Purchase Agreement”) with Aon Corporation, a Delaware
corporation, and Aon Services Group, Inc., a Delaware corporation. Pursuant
to the terms of the Purchase Agreement, in the first quarter of 2009, MCC
anticipates to acquire all of the issued and outstanding capital stock of AIS
Management Corporation, a California corporation, which is the parent company of
Auto Insurance Specialists, Incorporated, a California corporation (“AIS”). AIS
is a major producer of automobile insurance in the state of California and the
Company’s largest independent broker producing over $400 million of direct
premiums written, which represented approximately 14% of the Company’s direct
premiums written during 2007.
 
 The
purchase price of $120 million is payable at closing. Additional contingent
consideration of up to $34.7 million may be payable over the two-year period
following the transaction closing date, depending upon growth in AIS premium
volume during the two-year period. The Company intends to finance the
acquisition through a bank credit facility.
 
  13
  
 Item
      2.
              Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
 
 General
 
 The operating results of property and
casualty insurance companies are subject to significant quarter-to-quarter and
year-to-year fluctuations due to the effect of competition on pricing, the
frequency and severity of losses, natural disasters, 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. Additionally, with the adoption of SFAS No.
159, changes in the fair value of the investment portfolio are reflected in the
consolidated statement of operations, which may result in volatility of
earnings, particularly in times of high volatility in the capital
markets.
 
 The Company utilizes standard industry
measures to report operating results that may not be presented in accordance
with GAAP. Included within Management’s Discussion and Analysis of Financial
Condition and Results of Operations are non-GAAP financial measures, net
premiums written, which represents the premiums charged on policies issued
during a fiscal period less any reinsurance, and operating income, which
represents net income excluding realized investment gains and losses, net of
tax. These measures are not intended to replace, and should be read in
conjunction with, the Company’s GAAP financial results and are reconciled to the
most directly comparable GAAP measures, earned premiums and net income,
respectively, below in Results of Operations.
 
 The Company is headquartered in Los
Angeles, California and operates primarily as a personal automobile insurer,
selling policies through a network of independent producers.  The
Company also offers homeowners insurance, mechanical breakdown insurance,
commercial and dwelling fire insurance, umbrella insurance, commercial
automobile insurance and commercial property insurance. Private passenger
automobile lines of insurance accounted for approximately 84% of the Company’s
$2,109 million of net written premiums in the first nine months of
2008.
 
 The Company operates primarily in
California, the only state in which it operated prior to 1990. The Company has
since expanded its operations into the following states: Georgia and Illinois
(1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001),
New Jersey (2003), and Arizona, Pennsylvania, Michigan and Nevada (2004).
California accounted for approximately 78% and 77% of the Company’s net written
premiums during the nine months ended September 30, 2008 and 2007,
respectively.
 
 In February 2008, the Company acquired
an 88,300 square foot office building in Folsom, California for approximately
$18.4 million. The building will be used to house the Company’s northern
California employees when the existing lease expires in January 2009 on the
building that they currently occupy. The Company financed the transaction
through an $18 million unsecured bank loan. The loan matures on March 1, 2013
with interest payable quarterly at an annual floating rate of LIBOR plus 50
basis points. On March 3, 2008, the Company entered into an interest rate swap
of its floating LIBOR rate plus 50 basis points on the loan for a fixed rate of
4.25%. The swap agreement terminates on March 1, 2013.
 
  14
  Regulatory
and Litigation Matters
 
 The Department of Insurance (“DOI”) in
each state in which the Company operates conducts periodic financial and market
conduct examinations of the Company’s insurance subsidiaries domiciled within
the respective state. The following table provides a summary of current
financial and market conduct examinations:
 State
                Exam Type
                Period Under Review
                StatusCA
                Financial
                2004
      to 2007
                Fieldwork
      has been completed. Awaiting final reportCA
                Rating
      & Underwriting
                2004
      to 2006
                Fieldwork
      has been completed. Awaiting preliminary reportNJ
                Market
      Conduct
                Sept
      2007 to Aug 2008
                Fieldwork
      begins in November 2008GA
                Financial
                2004
      to 2006
                Fieldwork
      has been completed. Awaiting final reportOK
                Financial
                2005
      to 2007
                Fieldwork
      began in October 2008IL
                Market
      Conduct
                2007
                Report
      was issued in August 2008
 No material findings have been noted in
the financial and market conduct examinations above.
 
 On July 14, 2006, the California Office
of Administrative Law (“OAL”) approved proposed regulations by the California
DOI that effectively reduce the weight that insurers can place on a person’s
residence when establishing automobile insurance rates.  Insurance
companies in California are required to file rating plans with the California
DOI that comply with the new regulations. There is a two year phase-in period
for insurers to fully implement those plans. The Company made a rate filing in
August 2006 that reduced the territorial impact of its rates and requested a
small overall rate increase. The California DOI approved the August 2006 filing
in January 2008, which resulted in a small rate increase for two of the
California insurance subsidiaries and a small decrease for a third, for a total
net rate reduction of approximately 2.5%. The newly approved rates went into
effect in April 2008. In July 2008, the Company made an additional rate filing
to bring its rates into full compliance with the new regulations. However, the
Company cannot predict whether the California DOI will determine that the
Company’s rates are in full compliance with the new regulations as a result of
this filing. In general, the Company expects that the regulations will cause
rates for urban drivers to decrease and those for non-urban drivers to increase.
These rate changes are likely to increase consumer shopping for insurance which
could affect the volume and the retention rates of the Company’s business. It is
the Company’s intention to maintain its competitive position in the marketplace
while complying with the new regulations.
 
 In April 2007, regulations became
effective that generally tighten the existing Proposition 103 prior approval
ratemaking regime primarily by establishing a maximum allowable rate of return
of what it defines as the “risk-free rate” (that is, the average of short,
intermediate and long-term T-bill rates) plus six percent and a minimum
allowable rate of return of negative 6 percent of surplus. The new regulations
also allow for the California DOI to grant a number of variances based on loss
prevention, business mix, service to underserved communities, and other factors.
In October 2007, the California DOI invited comments from consumer groups and
the insurance industry in an effort to set appropriate standards for granting or
denying specific variances and to provide sufficient instruction regarding what
information or data to submit when an insurer is applying for a specific
variance. The comment period ended on November 16, 2007. The California DOI then
published proposed amendments to its regulations and held an informal workshop
on them on April 7, 2008. On April 29, 2008, the Commissioner issued a new
notice reflecting slight modifications to the proposed regulations and
superseding the prior version. The proposed changes were approved as emergency
regulations by the OAL on May 16, 2008 and became effective as of that
date.
 
 In March 2006, the California DOI
issued an Amended Notice of Non-Compliance (“NNC”) to the NNC originally issued
in February 2004 alleging that the Company charged rates in violation of the
California Insurance Code, willfully permitted its agents to charge broker fees
in violation of California law, and willfully misrepresented the actual price
insurance consumers could expect to pay for insurance by the amount of a fee
charged by the consumer’s insurance broker. Through this action, the California
DOI seeks to impose a fine for each policy in which the Company allegedly
permitted an agent to charge a broker fee, which the California DOI contends is
the use of an unapproved rate, rating plan or rating system. Further, the
California DOI seeks to impose a penalty for each and every date on which the
Company allegedly used a misleading advertisement alleged in the
NNC.  Finally, based upon the conduct alleged, the California DOI also
contends that the Company acted fraudulently in violation of Section 704(a) of
the California Insurance Code, which permits the California Commissioner of
Insurance to suspend certificates of authority for a period of one year. The
Company filed a Notice of Defense in response to the NNC. The Company does not
believe that it has done anything to warrant a monetary penalty from the
California DOI. The San Francisco Superior Court, in Robert Krumme, On Behalf Of The
General Public v. Mercury Insurance Company, Mercury Casualty Company, and
California Automobile Insurance Company, denied plaintiff’s requests for
restitution or any other form of retrospective monetary relief based on the same
facts and legal theory. The matter is currently in discovery and a hearing
before the administrative law judge has been continued and is scheduled to start
on March 16, 2009.
 
 The Company is not able to determine
the impact of any of the regulatory matters described above. It is possible that
the impact of some of the changes could adversely affect the Company and its
operating results, however, the ultimate outcome is not expected to be material
to the Company’s financial position.
  15
  
 On July 1, 2008, the California
Superior Court ruled in favor of Mercury General Corporation in a case filed
against the California Franchise Tax Board (“FTB”) for tax years 1993 through
1996 entitling the Company to a tax refund of $24.5 million, including
interest.  The time period for appeal of the decision has passed and
the Company received the full amount on August 15, 2008. After providing for
federal taxes, the Company recognized a net tax benefit of $17.5 million in the
third quarter 2008.
 
 The FTB has audited the 1997 through
2002 and 2004 tax returns and accepted the 1997 through 2000 returns to be
correct as filed. The Company received a notice of examination for the 2003 tax
return from the FTB in January 2008. For the Company’s 2001, 2002, and 2004 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 are excluded from the Mercury General Corporation
California Franchise tax return, should be included in the California
apportionment factors. In addition, for the 2004 tax return, the FTB has
asserted that a portion of management fee expenses paid by Mercury Insurance
Services, LLC should be disallowed. Based on these assertions, the FTB has
issued notices of proposed tax assessments for the 2001, 2002 and 2004 tax years
totaling approximately $5 million. The Company strongly disagrees with the
position taken by the FTB and plans to formally appeal the assessments before
the California State Board of Equalization (“SBE”). An unfavorable ruling
against the Company may have a material impact on the Company’s results of
operations in the period of such ruling. Management believes that the issues
will ultimately be resolved in favor of the Company. However, there can be no
assurance that the Company will prevail on these matters.
 
 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 judicial decisions. The Company has established reserves
for lawsuits in which the Company is able to estimate its potential exposure and
the likelihood that the court will rule against the Company is probable. The
Company vigorously defends these actions, unless a reasonable settlement appears
appropriate. An unfavorable ruling against the Company in the actions currently
pending may, but is not likely to, 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 position. For a further discussion of the Company’s
pending material litigation, see Item 1. Legal Proceedings in Part II – Other
Information of this Quarterly Report on Form 10-Q and the Company’s Annual
Report on Form 10-K for the year ended December 31, 2007.
 
 Critical
Accounting Policies and Estimates
 
 Reserves
 
 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 (“SFAS”) No. 60,
“Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”), and SFAS
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
required.  Changes in the regulatory and legal environment, results of
litigation, medical costs, the cost of repair materials and labor rates, among
other factors, can each 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, such as bodily injury
claims.  Inflation is reflected in the reserving process through
analysis of cost trends and reviews of historical reserving
results.
 
 The Company engages independent
actuarial consultants to review the Company’s reserves and to provide the annual
actuarial opinions required under state regulatory requirements. The Company
does not rely on actuarial consultants for GAAP reporting or periodic report
disclosure purposes. The Company analyzes loss reserves internally on a
quarterly basis using primarily the incurred loss development, average severity
and claim count development methods described below. The Company also uses the
paid loss development method to analyze loss adjustment expense reserves and at
times uses industry claims data as part of its reserve analysis. When deciding
which methodologies to use in estimating its reserves, the Company evaluates the
credibility of each methodology based on the maturity of the data available and
the claims settlement practices for each particular line of business or coverage
within a line of business. When establishing the reserve, the Company will
generally analyze the results from all of the methods used rather than relying
on one method over the others. While these methodologies are designed to
determine the ultimate losses on claims under the Company’s policies, there is
inherent uncertainty in all actuarial models since they generally use historical
data to project outcomes. The Company believes that the techniques it uses
provide a reasonable basis in estimating loss reserves.
 
  16
  
 The incurred loss development method
analyzes historical incurred case loss (case reserves plus paid losses)
development to estimate ultimate losses. The Company applies development factors
against current incurred case losses by accident period to calculate ultimate
expected losses. The Company believes that the incurred loss development method
provides a reasonable basis for evaluating ultimate losses, particularly in the
Company’s larger, more established lines of business which have a long operating
history. The average severity method analyzes historical loss payments and/or
incurred losses divided by closed claims and/or total claims to calculate an
estimated average cost per claim. From this, the expected ultimate average cost
per claim can be estimated. The claim count development method analyzes
historical claim count development to estimate future incurred claim count
development for current claims. The Company applies these development factors
against current claim counts by accident period to calculate ultimate expected
claim counts. The average severity method coupled with the claim count
development method provides meaningful information regarding inflation and
frequency trends that the Company believes is useful in establishing reserves.
The paid loss development method analyzes historical payment patterns to
estimate the amount of losses yet to be paid. The Company primarily uses this
method for loss adjustment expenses because specific case reserves are not
established for loss adjustment expenses.
 
 The Company uses varying methods and
assumptions in states with little operating history where there is insufficient
claims data to prepare a reserve analysis relying solely on the Company’s
historical data. In these cases, the Company may project ultimate losses using
industry average loss data or based on expected loss ratios. As the Company
develops an operating history in these states, the Company will rely
increasingly on the incurred loss development and average severity and claim
count development methods. The Company analyzes catastrophe losses separately
from non-catastrophe losses. For catastrophe losses, the Company determines
claim counts based on claims reported and development expectations from previous
catastrophes and applies an average expected loss per claim based on reserves
established by adjusters and average losses on previous
catastrophes.
 
 At September 30, 2008, the Company
recorded its point estimate of approximately $1,049 million in loss and loss
adjustment expense reserves which includes approximately $328 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 September 30, 2008
and estimated future payments for reopened claims. Management believes that
the liability for losses and loss adjustment expenses is adequate to cover the
ultimate net cost of losses and loss adjustment expenses incurred to date;
however, since the provisions are necessarily based upon estimates, the ultimate
liability may be more or less than such provision.
 
 The Company reevaluates its reserves
quarterly. When management determines that the estimated ultimate claim cost
requires reduction for previously reported accident years, positive development
occurs and a reduction in losses and loss adjustment expenses is reported in the
current period. If the estimated ultimate claim cost requires an increase for
previously reported accident years, negative development occurs and an increase
in losses and loss adjustment expenses is reported in the current period. For
the nine months ended September 30, 2008, the Company reported adverse
development of approximately $46 million on the 2007 and prior accident years’
loss and loss adjustment expense reserves which at December 31, 2007 totaled
approximately $1.1 billion. The loss development included approximately $34
million of negative development from the California operations and approximately
$12 million of negative development from the operations outside of California.
The negative development from California operations resulted primarily from
increases in the personal automobile loss severity estimates for the 2007 and
2006 accident years. The negative development from operations outside of
California primarily arose in the state of New Jersey, a state where the Company
has had a limited operating history. The development in New Jersey largely
resulted from the Personal Injury Protection (“PIP”) coverage and loss
adjustment expenses related to handling those PIP claims.
 
 For a further discussion of the
Company’s reserving methods, see the Company’s Annual Report on Form 10-K for
the year ended December 31, 2007.
 
 Premiums
 
 The Company complies with SFAS No. 60
in recognizing 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, net of investment income. To the extent that any of the Company’s
lines of business become substantially unprofitable, a premium deficiency
reserve may be required. The Company does not expect this to occur on any of its
significant lines of business.
 
  17
  
 Investments
 
 Beginning January 1, 2008, all of the
Company’s fixed maturity and equity investments are classified as “trading” and
carried at fair value as required by SFAS No. 115, “Accounting for Certain
Investments in Debt and Equity Securities” (“SFAS No. 115”), as amended, and
SFAS No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities” (“SFAS No. 159”). Prior to January 1, 2008, the Company’s
fixed maturity and equity investment portfolios were classified either as
“available for sale” or “trading” and carried at fair value under SFAS No. 115,
as amended. The Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS
No. 157”) and SFAS No. 159 as of the beginning of 2008. See Notes 2, 3 and 4 to
the consolidated financial statements in Part I, Item 1 of this Quarterly Report
on Form 10-Q. 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. Changes
in fair value of the investments are reflected in net realized investment gains
or losses in the consolidated statements of operations as required under SFAS
No. 115, as amended, and SFAS No. 159.
 
 For equity securities, the net loss due
to changes in fair value during the first nine months of 2008 was approximately
29.5%. The primary cause of the losses in fair value of equity securities was
the overall decline in the stock markets, which saw a decline of approximately
20.7% in the S&P 500 index during the nine months ended September 30, 2008.
For fixed maturity securities, the net loss due to changes in fair value was
approximately 6.8% for the first nine months of 2008. The Company believes that
the primary causes of the majority of the losses in fair value of fixed maturity
securities were ongoing downgrades of municipal bond insurers, widening credit
spreads, and reduced market liquidity.
 
 Fair
Value of Financial Instruments
 
 Certain financial assets and financial
liabilities are recorded at fair value. The fair value of a financial instrument
is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date. The fair values of the Company’s financial instruments are
generally based on, or derived from, executable bid prices. In the case of
financial instruments transacted on recognized exchanges, the observable prices
represent quotations for completed transactions from the exchange on which the
financial instrument is principally traded.
 
 The Company’s financial instruments
include securities issued by the U.S. government and its agencies, securities
issued by states and municipalities, certain corporate and other debt
securities, corporate equity securities, and exchange traded funds. The fair
value of over 99% of the financial instruments that the Company holds at
September 30, 2008 is based on observable market prices, observable market
parameters, or is derived from such prices or parameters. The availability of
observable market prices and pricing parameters can vary across different
financial instruments. Observable market prices and pricing parameters in a
financial instrument (or a related financial instrument) are used to derive a
price without requiring significant judgment.
 
 Certain financial instruments that the
Company holds or may acquire may lack observable market prices or market
parameters currently or in future periods because they are less actively traded.
The fair value of such instruments is determined using techniques appropriate
for each particular financial instrument. These techniques could involve some
degree of judgment. The price transparency of the particular financial
instrument will determine the degree of judgment involved in determining the
fair value of the Company’s financial instruments. Price transparency is
affected by a wide variety of factors, including, for example, the type of
financial instrument, whether it is a new financial instrument and not yet
established in the marketplace, and the characteristics particular to the
transaction. Financial instruments for which actively quoted prices or pricing
parameters are available or for which fair value is derived from actively quoted
prices or pricing parameters will generally have a higher degree of price
transparency. By contrast, financial instruments that are thinly traded or not
quoted will generally have diminished price transparency. Even in normally
active markets, the price transparency for actively quoted instruments may be
reduced for periods of time during periods of market dislocation. Alternatively,
in thinly quoted markets, the participation of market-makers willing to purchase
and sell a financial instrument provides a source of transparency for products
that otherwise are not actively quoted.
 
 Income
Taxes
 
 At September 30, 2008, the Company’s
deferred income taxes were in a net asset position, compared to a net liability
position at December 31, 2007. The movement to net asset position is due
primarily to a decrease in the market value of investment securities. The
Company assesses the likelihood that deferred tax assets will be realized and to
the extent management believes realization is not likely, a valuation allowance
is established. Management’s recoverability assessment is based on estimates of
anticipated capital gains and tax-planning strategies available to generate
future taxable income to offset potential future capital losses. In addition,
the Company expects to hold certain securities which are currently in loss
positions to recovery or maturity. Although realization is not assured,
management believes it is more likely than not that the deferred tax assets will
be realized.
 
  18
  
 Contingent
Liabilities
 
 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 its
business. The Company continually evaluates these potential liabilities and
accrues for them and/or discloses them in the notes to the consolidated
financial statements 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, an unfavorable result 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 position.
 
 Forward-Looking
Statements
 
 Certain statements in this report on
Form 10-Q that are not historical facts 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, the Company’s
strategy for growth, business development, regulatory approvals, market
position, expenditures, financial results and reserves. Forward-looking
statements are not guarantees of performance and are subject to important
factors and events that could cause the Company’s actual business, prospects and
results of operations to differ materially from the historical information
contained in this Form 10-Q 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, the Company’s success in expanding its
business in states outside of California, the Company’s ability to successfully
complete its initiative to standardize its policies and procedures nationwide in
all of its functional areas, the impact of potential third party “bad-faith”
legislation, changes in laws or regulations, the ultimate outcome of tax
position challenges by the California Franchise Tax Board, and decisions of
courts, regulators and governmental bodies, particularly in California, the
Company’s ability to obtain and the timing of the approval of premium rate
changes for private passenger automobile policies issued in states where the
Company does business, the investment yields the Company is able to obtain with
its investments in comparison to recent yields and the general market risk
associated with the Company’s 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, including the impact of the current liquidity crisis and economic
weakness on the Company's market and investment portfolio, 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, adverse weather
conditions or natural disasters in the markets served by the Company, the
stability of the Company’s information technology systems and the ability of the
Company to execute on its information technology initiatives, the Company’s
ability to realize current deferred tax assets or to hold certain securities
with current loss positions to recovery or maturity, and other uncertainties,
all of which are difficult to predict and many of which are beyond the Company’s
control. GAAP prescribes when a Company may reserve for particular risks
including litigation exposures. Accordingly, results for a given reporting
period could be significantly affected if and when a reserve is established for
a major contingency. Reported results may therefore appear to be volatile
in certain periods. The Company undertakes no obligation to publicly update any
forward-looking statements, whether as a result of new information or future
events or otherwise. Investors are cautioned not to place undue reliance on
any forward-looking statements, which speak only as of the date of this Form
10-Q or, in the case of any document the Company incorporates 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 the Company’s
forward-looking statements prove inaccurate or if risks or uncertainties arise,
actual results could differ materially from those predicted in any
forward-looking statements. The factors identified above are believed to be
some, but not all, of the important factors that could cause actual events and
results to be significantly different from those that may be expressed or
implied in any forward-looking statements.  Any forward-looking
statements should also be considered in light of the information provided in
“Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2007 and in Item 1A. Risk Factors in Part II - Other
Information of this Quarterly Report on Form 10-Q.
 
 Results
of Operations
 
 Three
Months Ended September 30, 2008 compared to Three Months Ended September 30,
2007
 
 Premiums earned in the third quarter of
2008 decreased approximately 7.0% from the corresponding period in 2007. Net
premiums written in the third quarter of 2008 decreased approximately 8.4% from
the corresponding period in 2007. Net premiums written by the Company’s
California operations were $544.3 million in the third quarter of 2008, a 7.4%
decrease over the corresponding period in 2007. Net premiums written by the
Company’s non-California operations were $150.8 million in the third quarter of
2008, an 11.9% decrease over the corresponding period in 2007. The decrease in
net premiums written is primarily due to a small decrease in the number of
policies written and slightly lower average premiums per policy reflecting the
continuing soft market conditions.
 
  19
  
 Net premiums written is a non-GAAP
financial measure which represents the premiums charged on policies issued
during a fiscal period less any applicable reinsurance. Net premiums
written is a statutory measure designed to determine production levels. Net
premiums earned, the most directly comparable GAAP measure, represents the
portion of net premiums written that is recognized as income in the financial
statements for the period presented. The following is a reconciliation of total
Company net premiums written to net premiums earned for the quarters ended
September 30, 2008 and 2007, respectively:
 
 Three
      Months Ended September 30,2008
              
              2007(in
      thousands)Net
      premiums written
              
              $
              695,142
              
              
              $
              758,849Decrease
      (increase) in unearned premiums
              
              
              1,463
              
              
              
              (10,051
              )Net
      premiums earned
              
              $
              696,605
              
              
              $
              748,798
 
 The loss ratio (GAAP basis) in the
third quarter (loss and loss adjustment expenses related to premiums earned) was
73.5% in 2008 and 66.5% in 2007. There was negative development of approximately
$16 million and $2 million on prior periods’ loss reserves for the quarters
ended September 30, 2008 and 2007, respectively. Excluding the effect of prior
periods’ loss development, the loss ratio in the third quarter was 71.2% in 2008
and 66.2% in 2007. The increase in the loss ratio excluding the effect of prior
periods’ loss development is due to several factors including: higher severity
in the California personal and commercial automobile lines of business, which
was partially offset by lower frequency; a large commercial property fire loss
in California; higher severity on the California homeowners line of business
related to several large non-catastrophe fire losses; and a $6 million
catastrophe loss from Hurricane Ike.
 
 The expense ratio (GAAP basis) in the
third quarter (policy acquisition costs and other expenses related to premiums
earned) was 28.5% in 2008 and 27.7% in 2007. The increase in the expense ratio
is largely reflective of costs such as payroll and benefits that have not
declined in proportion to the decline in premium volumes. In addition, an
increase in technology-related expenses and advertising, as well as the
establishment of the product management function, contributed to the higher
expense ratio.
 
 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 102.0% in the third
quarter of 2008 compared with 94.2% in the corresponding period of 2007, which
indicates that the Company’s underwriting performance contributed $14.1 million
of loss and $43.2 million of income to the Company’s results of operations
before income tax benefit and expense for the quarters ended September 30,
2008 and 2007, respectively.
 
 Investment income in the third quarter
of 2008 was $38.1 million, compared with $39.2 million in the third quarter of
2007. The after-tax yield on average investments (fixed maturities and equities
valued at cost) was constant at 3.9% in the third quarter of 2008 and 2007 on
average invested assets of $3.4 billion and $3.5 billion,
respectively.
 
 Included in net (loss) income are net
realized investment losses, net of tax, of $180.0 million in the third quarter
of 2008 compared with net realized investment gains, net of tax, of $1.3 million
in the same period in 2007. Net realized investment losses, net of tax, in the
third quarter 2008 of $180.0 million includes losses, net of tax, of $165.1
million due to changes in the fair value of total investments measured at fair
value pursuant to SFAS No. 159.  These losses, primarily in fixed
maturity securities, arise from the market value declines on the Company’s
holdings during the third quarter of 2008 resulting from ongoing downgrades of
municipal bond insurers, widening credit spreads, and the lack of liquidity in
the market.
 
 Income tax benefit in the third quarter
of 2008 was $112.8 million compared with income tax expense of $20.4 million in
the corresponding period of 2007. Investment losses had a significant impact on
the 2008 effective tax rate. Additionally, the Company recorded a net tax
benefit of $17.5 million for a California franchise tax refund received in the
third quarter of 2008. Excluding these factors, the effective tax rate in the
third quarter of 2008 is 7% compared to 24% in the corresponding period of 2007.
The lower adjusted effective tax rate in 2008 compared to 2007 is primarily
attributable to an increased proportion of tax exempt investment income
including tax sheltered dividend income, in contrast to taxable investment
income and underwriting income.
 
 Operating income for the third quarter
of 2008 was $39.5 million, down 36% from the prior year quarter largely due to a
decrease in premiums earned reflecting the continuing soft market conditions,
higher losses as a result of inflation and higher other operating expenses,
leading to a higher combined ratio. In addition, a decrease in net investment
income resulting from lower invested assets contributed to the decrease in
operating income. Partially offsetting this was a $17.5 million net tax benefit
realized from the tax case victory over the California FTB.
 
  20
  
 Operating income is a non-GAAP measure
which represents net income excluding realized investment gains and losses, net
of tax, and adjustments for other significant non-recurring, infrequent or
unusual items. Net income is the GAAP measure that is most directly comparable
to operating income. Operating income is meant as supplemental information and
is not intended to replace net income. It should be read in conjunction with the
GAAP financial results. The following is a reconciliation of operating income to
the most directly comparable GAAP measure:
 
 Three
      Months Ended September 30,2008
              
              2007(in
      thousands)Operating
      income
              
              $
              39,493
              
              
              $
              61,946Net
      realized investment (losses) gains, net of tax
              
              
              (180,032
              )
              
              
              1,332Net
      (loss) income
              
              $
              (140,539
              )
              
              $
              63,278
 
 Nine
Months Ended September 30, 2008 compared to Nine Months Ended September 30,
2007
 
 Premiums earned in the nine months
ended September 30, 2008 decreased approximately 5.8% from the corresponding
period in 2007. Net premiums written in the nine months ended September 30, 2008
decreased approximately 7.6% from the corresponding period in 2007. Net premiums
written by the Company’s California operations were $1.7 billion in the first
nine months of 2008, a 5.8% decrease over the corresponding period in 2007. Net
premiums written by the Company’s non-California operations were $453.4 million
in the first nine months of 2008, a 13.7% decrease over the corresponding period
in 2007. The decrease in net premiums written is primarily due to a small
decrease in the number of policies written and slightly lower average premiums
per policy reflecting the continuing soft market conditions.
 
 Net premiums written is a non-GAAP
financial measure which represents the premiums charged on policies issued
during a fiscal period less any applicable reinsurance. Net premiums written is
a statutory measure designed to determine production levels. Net premiums
earned, the most directly comparable GAAP measure, represents the portion of net
premiums written that is recognized as 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 for the nine months ended September 30, 2008 and
2007, respectively:
 
 Nine
      Months Ended September 30,2008
              
              2007(in
      thousands)Net
      premiums written
              
              $
              2,108,585
              
              
              $
              2,282,126Decrease
      (increase) in unearned premiums
              
              
              20,140
              
              
              
              (23,500
              )Net
      premiums earned
              
              $
              2,128,725
              
              
              $
              2,258,626
 
 The loss ratio (GAAP basis) in the
first nine months (loss and loss adjustment expenses related to premiums earned)
was 69.7% in 2008 and 66.9% in 2007. There was negative development of
approximately $46 million and $16 million on prior accident years’ loss reserves
for the nine months ended September 30, 2008 and 2007, respectively. Excluding
the effect of prior accident years’ loss development, the loss ratio in the
first nine months was 67.5% in 2008 and 66.2% in 2007. The slight increase in
the loss ratio excluding the effect of prior accident years’ loss development is
primarily due to higher severity, which was partially offset by lower frequency,
in the California automobile lines of business.
 
 The expense ratio (GAAP basis) in the
first nine months of 2008 (policy acquisition costs and other operating expenses
related to premiums earned) was 28.4% compared to 27.3% in the corresponding
period of 2007. The increase in the expense ratio largely reflects costs such as
payroll and benefits that have not declined in proportion to the decline in
premium volumes. In addition, an increase in technology-related expenses and
advertising, as well as the establishment of the product management function,
contributed to the higher expense ratio.
 
 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 98.1% in the first nine
months of 2008 compared with 94.2% in the corresponding period of 2007, which
indicates that the Company’s underwriting performance contributed $40.0 million
and $130.0 million to the Company’s results of operations before income tax
benefit and expense for the nine months ended September 30, 2008 and
2007, respectively.
 
  21
  
 Investment income for the first nine
months of 2008 was $116.4 million, compared with $122.2 million in the first
nine months of 2007. The after-tax yield on average investments (fixed
maturities and equities valued at cost) was 3.9% in the first nine months of
2008 compared to 4.0% in the corresponding period of 2007 on average invested
assets of $3.5 billion for each period. The slight decrease in after-tax yield
is due to a decrease in short-term interest rates.
 
 Included in net (loss) income are net
realized investment losses, net of tax, of $216.2 million in the first nine
months of 2008 compared with net realized investment gains, net of tax, of $7.1
million in the same period in 2007. Net realized investment losses, net of tax,
of $216.2 million in the first nine months of 2008 includes losses, net of tax,
of $211.1 million due to changes in the fair value of total investments measured
at fair value pursuant to SFAS No. 159. These losses, primarily in fixed
maturity securities, arise from the market value declines on the Company’s
holdings during the third quarter of 2008 resulting from ongoing downgrades of
municipal bond insurers, widening credit spreads, economic downturn impacting
municipalities and the lack of liquidity in the market.
 
 Income tax benefit for the first nine
months of 2008 was $102.4 million compared with income tax expense of $67.1
million in the corresponding period of 2007. Investment losses had a significant
impact on the 2008 effective tax rate. Additionally, the Company recorded a net
tax benefit of $17.5 million for a California franchise tax refund received in
the third quarter of 2008. Excluding these factors, the effective tax rate for
the first nine months of 2008 is 20% compared to 25% in the corresponding period
of 2007. The lower adjusted effective tax rate in 2008 compared to 2007 is
primarily attributable to an increased proportion of tax exempt investment
income including tax sheltered dividend income, in contrast to taxable
investment income and underwriting income.
 
 Operating income for the first nine
months of 2008 was $142.4 million, down 23.5% from the corresponding prior year
period largely due to a decrease in premiums earned reflecting the continuing
soft market conditions, higher losses as a result of inflation and higher other
operating expenses, leading to a higher combined ratio. In addition, a decrease
in net investment income resulting from lower investment yields and lower
invested assets contributed to the decrease in operating income. Partially
offsetting this was a $17.5 million net tax benefit realized from the tax case
victory over the California FTB.
 
 Operating income is a non-GAAP measure
which represents net income excluding realized investment gains and losses, net
of tax, and adjustments for other significant non-recurring, infrequent or
unusual items. Net income is the GAAP measure that is most directly comparable
to operating income. Operating income is meant as supplemental information and
is not intended to replace net income. It should be read in conjunction with the
GAAP financial results. The following is a reconciliation of operating income to
the most directly comparable GAAP measure:
 
 Nine
      Months Ended September 30,2008
              
              2007(in
      thousands)Operating
      income
              
              $
              142,425
              
              
              $
              186,093Net
      realized investment (losses) gains, net of tax
              
              
              (216,199
              )
              
              
              7,147Net
      (loss) income
              
              $
              (73,774
              )
              
              $
              193,240
 
 Liquidity
and Capital Resources
 
 Net cash provided by operating
activities in the first nine months of 2008 was $72.6 million, a decrease of
$133.8 million over the same period in 2007. This decrease was primarily due to
lower premiums collected during the first nine months of 2008 coupled with
higher losses and loss adjustment expenses paid compared with the same period in
2007. The Company has utilized the cash provided from operating activities
primarily for its investment in fixed maturity and equity securities, the
purchase and development of information technology, and the payment of dividends
to its shareholders. Funds derived from the sale, redemption or maturity of
fixed maturity investments of $607.9 million year to date were
reinvested, mostly in highly-rated fixed maturity securities.
 
 The Company has entered into an
agreement to purchase AIS, which will require $120 million in the first quarter
of 2009. The Company is currently in negotiation with a bank for a $120 million
credit facility to finance the AIS acquisition. In addition, the Company may be
required to pay up to $34.7 million over the next two years as additional
consideration for the AIS acquisition. The Company plans to fund that portion
from cash on hand and cash flow from operations.
 
 The Company’s cash and short-term
investment portfolio totaled $283.3 million at September 30, 2008. Together with
cash flows from operations, the Company believes that such liquid assets 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.
  22
  
 The following table sets forth the
composition of the total investment portfolio of the Company as of September 30,
2008:
 
 Fair
      Value(in
      thousands)Fixed
      maturity securities:U.S.
      government bonds and agencies
              
              $
              19,672States,
      municipalities and political subdivisions
              
              
              2,274,373Mortgage-backed
      securities
              
              
              212,801Corporate
      securities
              
              
              93,935Redeemable
      preferred stock
              
              
              8882,601,669Equity
      securities:Common
      Stock:Public
      utilities
              
              
              43,942Banks,
      trusts and insurance companies
              
              
              17,275Industrial
      and other
              
              
              293,564Non-redeemable
      preferred stock
              
              
              11,957366,738Short-term
      cash investments
              
              
              249,516Total
      investments
              
              $
              3,217,923
 
 From the second half of 2007 through
the first half of 2008, the investment markets experienced substantial
volatility due to uncertainty in the credit markets. In the third quarter of
2008 and continuing into October 2008, this uncertainty developed into a credit
crisis that led to extreme volatility in the capital markets, a widening of
credit spreads beyond historic norms and a significant decline in asset values
across most asset categories. Consequently, during the first nine months of
2008, the Company recognized approximately $332.6 million in net realized
investment losses. Included in this loss is $328.6 million related to the change
in fair value of the total investment portfolio. As a result of the adoption of
SFAS No. 159 on January 1, 2008, change in unrealized gains and losses on all
investments are recorded as realized gains and losses on the statements of
operations.
 
 At September 30, 2008, the average
rating of the $2,601.7 million bond portfolio at fair value was AA, unchanged
from December 31, 2007. Bond holdings are broadly diversified geographically,
within the tax-exempt sector. Holdings in the taxable sector consist principally
of investment grade issues. At September 30, 2008, bond holdings rated below
investment grade totaled $36.6 million at fair value representing approximately
1.1% of total investments. This compares to approximately $47.7 million at fair
value representing approximately 1.3% of total investments at December 31,
2007.
 
 The entire CMO portfolio consisted of
loans to prime borrowers except for approximately $17 million and $20 million,
at fair value, of Alt-A CMO’s at September 30, 2008 and December 31, 2007,
respectively. Alt-A mortgages are generally home loans made to individuals that
have credit scores as high as prime borrowers, but provide less documentation of
their finances on their credit applications. The average rating of the
Company’s  Alt-A CMO’s is AA+ and the average rating of the entire CMO
portfolio is AAA. The valuation of these securities is based on Level 2 inputs
that can be observed in the market.
 
 The Company had approximately $2,274.4
million at fair value ($2,408.9 million at amortized cost) in municipal bonds at
September 30, 2008, which represented approximately 66% of net losses held in
the portfolio. Approximately half of the municipal bonds do not carry insurance
from bond insurers and have an average rating of AA. The other half of the
municipal bond positions are insured by bond insurers. The following bond
insurers each insured more than one percent of the Company’s municipal bond
portfolio at September 30, 2008: MBIA: 17.3%, FSA: 9.3%, FGIC: 10.2%, AMBAC:
9.1%, and XLCA: 1.7%.
 
 For insured municipal bonds that have
underlying ratings, the average underlying rating was A+. There was also
approximately $158 million of insured municipal bonds that carried no official
underlying rating. The Company considers municipal bonds that carry no
underlying rating as being investment grade since it is an underwriting policy
of the “AAA” mono-line insurers that the issuer qualifies as an investment grade
credit in order to receive the bond insurer’s rating. The Company considers the
strength of the underlying credit as a buffer against potential market value
declines which may result from future rating downgrades of the bond
insurers. In addition, the Company has a long-term time horizon for its
municipal bond holdings, which generally allows it to recover the full principal
amounts upon maturity, avoiding forced sales, prior to maturity, of bonds that
have declined in market value due to the bond insurers’ rating
downgrades.
 
  23
  
 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. Included in the
equity portfolio was $14.3 million of preferred stock from Fannie Mae and Lehman
Brothers that was written down during the third quarter of 2008.  At
September 30, 2008, short-term cash investments consisted of highly rated short
duration securities redeemable on a daily or weekly basis. The Company does not
have any material direct equity investment in subprime lenders.
 
 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 to 1. Based
on the combined surplus of all of the licensed insurance subsidiaries of $1.6
billion at September 30, 2008 and net written premiums for the twelve months
ended on that date of $2.8 billion, the ratio of writings to surplus was
approximately 1.7 to 1.
 
 The
Company’s book value per share at September 30, 2008 was $30.95 per
share.
 
 Item
      3.
              Quantitative
      and Qualitative Disclosures About Market
Risk
 
 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 September 30, 2008
comprised approximately 81% of total investments at fair value. Tax-exempt bonds
represent approximately 87% of the fixed maturity investments with the remaining
amount consisting of sinking fund preferred stocks and taxable bonds. Equity
securities account for approximately 11% of total investments at fair value. The
remaining 8% 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 increases and vice versa. 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.
 
 The Company has 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. Bond
investments made by the Company typically have call options attached, which
further reduce the duration of the asset as interest rates decline. The modified
duration of the bond portfolio is 7.0 years at September 30, 2008 compared
to 4.4 years at December 31, 2007. Given a hypothetical parallel increase
of 100 basis points in interest rates, the fair value of the bond portfolio at
September 30, 2008 would decrease by approximately $182
million.
 
 At September 30, 2008, the
Company’s primary objective for common equity investments is current income with
a secondary objective of capital appreciation. The fair value of the equity
investment consists of $354.8 million in common stocks and $12.0 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 common equity portfolio represents
approximately 11% of total investments at fair value. 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 1.05. Based on a
hypothetical 20% or 40% reduction in the overall value of the stock market, the
fair value of the common stock portfolio would decrease by approximately $75
million or $150 million, respectively.
 
 Item
      4.
              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.
 
  24
  
 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 quarter 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 control 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 control 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.
 
  25
  
 PART
II - OTHER INFORMATION
 
 Item
      1.
              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 judicial decisions. The Company has established reserves
for lawsuits in which the Company is able to estimate its potential exposure and
the likelihood that the court will rule against the Company is
probable.  The Company vigorously defends these actions, 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 position.  Also, see the Company’s
Annual Report on Form 10-K for the year ended December 31, 2007.
 
 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 alleging that they systematically
undervalue medical payment claims to the detriment of insureds. The Plaintiff is
seeking 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 Plaintiff sought class action certification of 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. The Court certified the class on January 11,
2007. The Company appealed the class certification ruling, and the Court of
Appeal stayed the case pending their review. The Company and the Plaintiff have
subsequently agreed to settle the claims for an amount that is immaterial to the
Company’s operations and financial position. The settlement was approved by the
Court on April 24, 2008, subject to class members’ ability to object. Class member objections
were due by August 5, 2008. No objections to the class settlement were
filed. The final approval hearing has been continued to December 8,
2008.  The ultimate outcome of this matter is not expected to be material
to the Company’s operations or financial position.
 
 On March 28, 2006, the 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.
As a result of this ruling, the Company recorded an income tax charge (including
penalties and interest) of approximately $15 million, after federal tax benefit,
in the first quarter of 2006. On April 24, 2007, the Company filed a complaint
in the Superior Court for the City and County of San Francisco challenging the
SBE decision and seeking recovery of the taxes, penalties and interest paid by
the Company as a result of the SBE decision.  On July 1, 2008, the
California Superior Court ruled in favor of Mercury General Corporation in a
case filed against the FTB entitling the Company to a tax refund of $24.5
million, including interest. The time period for appeal of the decision has
passed and the Company received the full amount on August 15, 2008. After
providing for federal taxes, the Company recognized a net tax benefit of $17.5
million in the third quarter 2008.
 
 Item
      1A.
              Risk
      Factors
 
 The Company’s business, operations, and
financial position are subject to various risks. These risks are described
elsewhere in this report and in its other filings with the United States
Securities and Exchange Commission, including the Company’s Annual Report on
Form 10-K for the year ended December 31, 2007. The risk factors identified in
the Company’s Annual Report on Form 10-K for the year ended December 31, 2007
have not changed in any material respect, except as noted
below.
 
 General
economic conditions may affect the Company’s revenue and profitability and harm
its business.
 
 As widely reported, financial markets
in the United States, Europe and Asia have been experiencing extreme disruption
in recent months. Unfavorable changes in economic conditions, including
declining consumer confidence, inflation, recession or other changes, may lead
the Company’s customers to cancel insurance policies, modify coverage or not
renew with the Company, and the Company’s premium revenue could be adversely
affected. Challenging economic conditions also may impair the ability of the
Company’s customers to pay premiums as they fall due, and as a result, the
Company’s reserves and write-offs could increase. The Company is unable to
predict the likely duration and severity of the current disruption in financial
markets and adverse economic conditions in the United States and other
countries.
 
  26
  
 Continued
deterioration in the public debt and equity markets could lead to additional
investment losses and materially and adversely affect the Company’s
business.
 
 The prolonged and severe disruptions in
the public debt and equity markets, including among other things, widening of
credit spreads, bankruptcies and government intervention in a number of large
financial institutions, have resulted in significant losses in the Company’s
investment portfolio. For the quarter and nine month periods ended
September 30, 2008, the Company incurred substantial realized investment
losses, as described in Item 2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations in Part I – Financial Information
of this Quarterly Report on Form 10-Q. Subsequent to September 30, 2008,
through the date of this report, conditions in the public debt and equity
markets have continued to deteriorate and pricing levels have continued to
decline. As a result, depending on market conditions, the Company may incur
substantial additional losses in future periods, which could have a material
adverse impact on its results of operations, equity, business and insurer
financial strength and debt ratings.
 
 Funding
for the Company’s future growth may depend upon obtaining new financing, which
may be difficult to obtain given prevalent economic conditions and the general
credit crisis.
 
 To accommodate the Company’s expected
future growth, the Company may require funding in addition to cash provided from
current operations.  The Company’s ability to obtain financing may be
constrained by current economic conditions affecting global financial
markets.  Specifically, the recent credit crisis and other related
trends affecting the banking industry have caused significant operating losses
and bankruptcies throughout the banking industry. Many lenders and institutional
investors have ceased funding even the most credit-worthy borrowers. If the
Company is unable to obtain necessary financing, it may be unable to take
advantage of opportunities with potential business partners or new products or
to otherwise expand its business as planned.
 
 Item
      2.
              Unregistered
      Sales of Equity Securities and Use of ProceedsNone
 
 Item
      3.
              Defaults
      Upon Senior SecuritiesNone
 
 Item
      4.
              Submission
      of Matters to a Vote of Security HoldersNone
 
 Item
      5.
              Other
      InformationNone
 
 Item
      6.
              Exhibits
 
 2.1
              Stock
      Purchase Agreement, dated as of October 10, 2008, by and among Aon
      Corporation, a Delaware corporation, Aon Services Group, Inc., a Delaware
      corporation, and Mercury Casualty Company, a California
      corporation
 
 15.1
              Letter
      Regarding Unaudited Interim Financial
  Information
 
 15.2
              Awareness
      Letter 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 Quarterly Report
      on Form 10-Q 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 Quarterly Report
      on Form 10-Q 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.
 
  27
  
 SIGNATURES
 
 Pursuant to the requirements 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
CORPORATION
 
 
 
 Date:
      November 7, 2008
              By:
              /s/
      Gabriel TiradorGabriel
      TiradorPresident
      and Chief Executive OfficerDate:
      November 7, 2008
              By:
              /s/
      Theodore StalickTheodore
      StalickVice
      President and Chief Financial Officer
 
  28