10-K 1 mcy-20141231x10k.htm 10-K DECEMBER 31, 2014 MCY-2014.12.31-10K

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________ 
FORM 10-K
____________________________ 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2014
Commission File No. 001-12257
____________________________ 
MERCURY GENERAL CORPORATION
(Exact name of registrant as specified in its charter)
____________________________ 
California
 
95-2211612
(State or other jurisdiction
of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
4484 Wilshire Boulevard, Los Angeles, California
 
90010
(Address of principal executive offices)
 
(Zip Code)
____________________________ 
Registrant’s telephone number, including area code: (323) 937-1060
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock
 
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
NONE
____________________________ 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, 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
x
 
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 Rule 12b-2 of the Act). Yes  ¨    No  x
The aggregate market value of the Registrant’s common equity held by non-affiliates of the Registrant at June 30, 2014 was $1,265,038,394 (which represents 26,892,823 shares of common equity held by non-affiliates multiplied by $47.04, the closing sales price on the New York Stock Exchange for such date, as reported by the Wall Street Journal).
At February 2, 2015, the Registrant had issued and outstanding an aggregate of 55,126,462 shares of its Common Stock.
____________________________ 
Documents Incorporated by Reference
Certain information from the Registrant’s definitive proxy statement for the 2015 Annual Meeting of Shareholders is incorporated herein by reference into Part III hereof.
 




MERCURY GENERAL CORPORATION
INDEX TO FORM 10-K
 
 
Page
 
 
 
 
Item 1
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 1A
Item 1B
Item 2
Item 3
Item 4
 
 
 
 
 
 
Item 5
Item 6
Item 7
Item 7A
Item 8
Item 9
Item 9A
Item 9B
 
 
 
 
 
 
Item 10
Item 11
Item 12
Item 13
Item 14
 
 
 
 
 
 
Item 15
 
 



PART I

Item 1.
Business

General

Mercury General Corporation (“Mercury General”) and its subsidiaries (referred to herein collectively as the “Company”) are primarily engaged in writing personal automobile insurance through 13 insurance subsidiaries (referred to herein collectively as the “Insurance Companies”) in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, and umbrella insurance. The direct premiums written for the years ended December 31, 2014, 2013, and 2012 by state and line of business were:

Year Ended December 31, 2014
(Amounts in thousands)
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
1,852,291

 
$
302,493

 
$
69,129

 
$
84,374

 
$
2,308,287

 
80.9
%
Florida (1)
131,281

 
7

 
26,234

 
4,676

 
162,198

 
5.7
%
Other states (2)
239,501

 
71,936

 
40,565

 
30,682

 
382,684

 
13.4
%
Total
$
2,223,073

 
$
374,436

 
$
135,928

 
$
119,732

 
$
2,853,169

 
100.0
%
 
77.9
%
 
13.1
%
 
4.8
%
 
4.2
%
 
100.0
%
 
 

Year Ended December 31, 2013
(Amounts in thousands)
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
1,760,352

 
$
267,563

 
$
53,488

 
$
72,617

 
$
2,154,020

 
78.7
%
Florida (1)
133,947

 
0

 
22,331

 
7,433

 
163,711

 
6.0
%
Other states (2)
271,258

 
72,450

 
28,870

 
47,163

 
419,741

 
15.3
%
Total
$
2,165,557

 
$
340,013

 
$
104,689

 
$
127,213

 
$
2,737,472

 
100.0
%
 
79.1
%
 
12.4
%
 
3.8
%
 
4.7
%
 
100.0
%
 
 

Year Ended December 31, 2012
(Amounts in thousands)
 
Private
Passenger Auto
 
Homeowners
 
Commercial
Auto
 
Other Lines
 
Total
 
 
California
$
1,670,025

 
$
255,418

 
$
41,200

 
$
65,474

 
$
2,032,117

 
76.5
%
Florida (1)
161,720

 
(181
)
 
14,783

 
7,118

 
183,440

 
6.9
%
Other states (2)
308,786

 
63,058

 
18,672

 
49,647

 
440,163

 
16.6
%
Total
$
2,140,531

 
$
318,295

 
$
74,655

 
$
122,239

 
$
2,655,720

 
100.0
%
 
80.6
%
 
12.0
%
 
2.8
%
 
4.6
%
 
100.0
%
 
 
_____________
(1)
The Company is writing and expects to continue writing nominal premiums in the Florida homeowners market.
(2)
No individual state accounts for more than 5% of total direct premiums written.

The Company offers the following types of automobile coverage: collision, property damage, bodily injury (BI), comprehensive, personal injury protection (PIP), underinsured and uninsured motorist, and other hazards.
 
The Company offers the following types of homeowner’s coverage: dwelling, liability, personal property, fire, and other hazards.

The following table presents the published maximum limits of liability, net of reinsurance, for the Company.


1


Insurance type
Published maximum limits of liability
Private Passenger Automobile - bodily injury (BI)
$250,000 per person; $500,000 per accident (1)
Private Passenger Automobile - property damage
$250,000 per accident (1)
Commercial Automobile (combined policy limits)
$1,000,000 per accident
Homeowner property
no maximum (2) (3)
Homeowner liability
$1,000,000 (3)
Umbrella liability
$5,000,000 (4)

(1) The majority of the Company’s automobile policies have liability limits that are equal to or less than $100,000 per person and $300,000 per accident for BI and $50,000 per accident for property damage.

(2) The Company obtains facultative reinsurance above a Company retention limit of up to $7 million.

(3) The majority of the Company’s homeowner policies have liability limits of $300,000 or less and a replacement value of $500,000 or less.

(4) The majority of the Company’s umbrella policies have liability limits of $1,000,000.

The principal executive offices of Mercury General are located in Los Angeles, California. The home office of the Insurance Companies and the information technology center are located in Brea, California. The Company also owns office buildings in Rancho Cucamonga and Folsom, California, which are used to support California operations and future expansion, and in Clearwater, Florida and in Oklahoma City, Oklahoma, which house Company employees and several third party tenants. The Company has approximately 4,400 employees. The Company maintains branch offices in a number of locations in California; Clearwater, Florida; Bridgewater, New Jersey; Oklahoma City, Oklahoma; and Austin and San Antonio, Texas. 

The Company consolidated its non-California office based claims and underwriting operations into hubs located in Clearwater, Florida; Bridgewater, New Jersey; and Austin, Texas, which resulted in a net workforce reduction of approximately 135 employees and a $10 million pre-tax expense in the first quarter of 2013.

Website Access to Information

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

Organization
Mercury General, an insurance holding company, is the parent of Mercury Casualty Company, a California automobile insurer founded in 1961 by George Joseph, the Company’s Chairman of the Board of Directors. Mercury General conducts its business through the following subsidiaries: 

2


Insurance Companies
 
Formed or
Acquired
 
A.M. Best
Rating
 
Primary States
Mercury Casualty Company (“MCC”)(1)
 
1961
 
A+
 
CA, AZ, NV, NY, VA
Mercury Insurance Company (“MIC”)(1)
 
1972
 
A+
 
CA
California Automobile Insurance Company (“CAIC”)(1)
 
1975
 
A+
 
CA
California General Underwriters Insurance Company, Inc. (“CGU”)(1)
 
1985
 
Non-rated
 
CA
Mercury Insurance Company of Illinois
 
1989
 
A+
 
IL, PA
Mercury Insurance Company of Georgia
 
1989
 
A+
 
GA
Mercury Indemnity Company of Georgia
 
1991
 
A+
 
GA
Mercury National Insurance Company
 
1991
 
A+
 
IL, MI
American Mercury Insurance Company
 
1996
 
A-
 
OK, GA, TX, VA
American Mercury Lloyds Insurance Company (“AML”)
 
1996
 
A-
 
TX
Mercury County Mutual Insurance Company
 
2000
 
A-
 
TX
Mercury Insurance Company of Florida
 
2001
 
A+
 
FL, PA
Mercury Indemnity Company of America
 
2001
 
A+
 
FL, NJ
Workmen’s Auto Insurance Company (“WAIC”)(2)
 
2015
 
Non-rated
 
CA
Non-Insurance Companies
 
Formed or
Acquired
 
Purpose
Mercury Select Management Company, Inc.
 
1997
 
AML’s attorney-in-fact
Mercury Insurance Services LLC
 
2000
 
Management services to subsidiaries
AIS Management LLC
 
2009
 
Parent company of AIS and PoliSeek
Auto Insurance Specialists LLC (“AIS”)
 
2009
 
Insurance agent
PoliSeek AIS Insurance Solutions, Inc. (“PoliSeek”)
 
2009
 
Insurance agent
Animas Funding LLC (“AFL”)
 
2013
 
Special purpose investment vehicle
Fannette Funding LLC ("FFL")
 
2014
 
Special purpose investment vehicle
_____________
(1)
The term “California Companies” refers to MCC, MIC, CAIC, and CGU.
(2)
WAIC was acquired January 2, 2015. For more detailed information, see Note 19 of Notes to Consolidated Financial Statements.

Production and Servicing of Business
The Company sells its policies through approximately 8,800 independent agents, of which approximately 1,800 are located in California and approximately 1,400 are located in Florida. Approximately half of the Company’s agents in California have represented the Company for more than ten years. The agents are independent contractors selected and contracted by the Company and generally also represent competing insurance companies. No independent agent accounted for more than 2% of the Company’s direct premiums written during 2014, 2013, and 2012.

The Company believes that it compensates its agents above the industry average. Net commissions incurred in 2014 were approximately 17% of net premiums written.

The Company’s advertising budget is allocated among television, radio, newspaper, internet, and direct mailing media with the intent to provide the best coverage available within targeted media markets. While the majority of these advertising costs are borne by the Company, a portion of these costs are reimbursed by the Company’s independent agents based upon the number of account leads generated by the advertising. The Company believes that its advertising program is important to generate leads, create brand awareness, and remain competitive in the current insurance climate. During 2014, net advertising expenditures were $23.1 million. In 2015, the Company launched a national advertising campaign and expects to spend up to $48 million.

Underwriting

3


The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Department of Insurance or similar governmental agency of each state in which it is licensed to operate (“DOI”). Each state has different rate approval requirements. See “Regulation—Department of Insurance Oversight.”

The Company offers standard, non-standard, and preferred private passenger automobile insurance in 13 states. The Company also offers homeowners insurance in 12 states, commercial automobile insurance in 10 states, and mechanical breakdown insurance in most states.

In California, “good drivers,” as defined by the California Insurance Code, accounted for approximately 82% of all California voluntary private passenger automobile policies-in-force at December 31, 2014, while higher risk categories accounted for approximately 18%. The private passenger automobile renewal rate in California (the rate of acceptance of offers to renew) averages approximately 96%.

Claims
The Company conducts the majority of claims processing without the assistance of outside adjusters. The claims staff administers all claims and manages all legal and adjustment aspects of claims processing.

Losses and Loss Adjustment Expense Reserves and Reserve Development
The Company maintains losses and loss adjustment expense reserves for both reported and unreported claims. Losses and loss adjustment expense reserves for reported claims are estimated based upon a case-by-case evaluation of the type of claim involved and the expected development of such claims. Losses and loss adjustment expense reserves for unreported claims are determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and review of historical reserve settlement.

The Company’s ultimate liability may be greater or less than management estimates of reported losses and loss adjustment expense reserves. Reserves are analyzed quarterly by the Company’s actuarial consultants using current information on reported claims and a variety of statistical techniques. The Company does not discount to a present value that portion of losses and loss adjustment expense reserves expected to be paid in future periods. However, the Company is required to discount losses and loss adjustment expense reserves for federal income tax purposes.

The following table presents the development of losses and loss adjustment expense reserves for the period 2004 through 2014. The top section of the table shows the reserves at the balance sheet date, net of reinsurance recoverable, for each of the indicated years. This amount represents the estimated net losses and loss adjustment expenses for claims arising from the current and all prior years that are unpaid at the balance sheet date, including an estimate for losses that had been incurred but not reported loss reserves (“IBNR”) to the Company. The second section shows the cumulative amounts paid as of successive years with respect to that reserve liability. The third section shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. Estimates change as more information develops about the frequency and severity of claims for individual years. The bottom line shows favorable (unfavorable) development that exists when the original reserve estimates are greater (less) than the re-estimated reserves at December 31, 2014.

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

4


 
December 31,
 
2004
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
 
2013
 
2014
 
(Amounts in thousands)
Gross Reserves for Losses and Loss Adjustment Expenses-end of year(1)
$
900,744

 
$
1,022,603

 
$
1,088,822

 
$
1,103,915

 
$
1,133,508

 
$
1,053,334

 
$
1,034,205

 
$
985,279

 
$
1,036,123

 
$
1,038,984

 
$
1,091,797

Reinsurance recoverable
(14,137
)
 
(16,969
)
 
(6,429
)
 
(4,457
)
 
(5,729
)
 
(7,748
)
 
(6,805
)
 
(7,921
)
 
(12,155
)
 
(13,927
)
 
(14,485
)
Net Reserves for Losses and Loss Adjustment Expenses-end of year(1)
$
886,607

 
$
1,005,634

 
$
1,082,393

 
$
1,099,458

 
$
1,127,779

 
$
1,045,586

 
$
1,027,400

 
$
977,358

 
$
1,023,968

 
$
1,025,057

 
$
1,077,312

Paid (cumulative) as of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One year later
$
525,125

 
$
632,905

 
$
674,345

 
$
715,846

 
$
617,622

 
$
603,256

 
$
614,059

 
$
600,090

 
$
607,527

 
$
585,899

 
 
Two years later
748,255

 
891,928

 
975,086

 
1,009,141

 
913,518

 
889,806

 
896,363

 
873,679

 
862,244

 
 
 
 
Three years later
851,590

 
1,027,781

 
1,123,179

 
1,168,246

 
1,059,627

 
1,023,137

 
1,027,006

 
1,004,373

 
 
 
 
 
 
Four years later
893,436

 
1,077,834

 
1,187,990

 
1,229,939

 
1,118,230

 
1,075,174

 
1,080,265

 
 
 
 
 
 
 
 
Five years later
906,466

 
1,101,693

 
1,211,343

 
1,252,687

 
1,138,546

 
1,094,797

 
 
 
 
 
 
 
 
 
 
Six years later
915,086

 
1,111,109

 
1,219,719

 
1,262,286

 
1,146,899

 
 
 
 
 
 
 
 
 
 
 
 
Seven years later
918,008

 
1,114,241

 
1,224,026

 
1,265,882

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Eight years later
918,488

 
1,115,824

 
1,225,644

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine years later
918,690

 
1,116,622

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ten years later
918,664

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net reserves re-estimated as of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One year later
840,090

 
1,026,923

 
1,101,917

 
1,188,100

 
1,069,744

 
1,032,528

 
1,045,894

 
1,019,690

 
1,026,928

 
1,021,864

 
 
Two years later
869,344

 
1,047,067

 
1,173,753

 
1,219,369

 
1,102,934

 
1,076,480

 
1,073,052

 
1,056,453

 
1,057,693

 
 
 
 
Three years later
894,063

 
1,091,131

 
1,202,441

 
1,246,365

 
1,136,278

 
1,085,591

 
1,094,494

 
1,083,686

 
 
 
 
 
 
Four years later
910,171

 
1,104,988

 
1,217,328

 
1,263,294

 
1,141,714

 
1,095,907

 
1,113,672

 
 
 
 
 
 
 
 
Five years later
914,547

 
1,112,779

 
1,225,051

 
1,263,560

 
1,147,149

 
1,109,707

 
 
 
 
 
 
 
 
 
 
Six years later
918,756

 
1,115,637

 
1,225,131

 
1,265,186

 
1,153,005

 
 
 
 
 
 
 
 
 
 
 
 
Seven years later
919,397

 
1,115,916

 
1,225,519

 
1,268,716

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Eight years later
919,027

 
1,116,494

 
1,227,541

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nine years later
919,165

 
1,117,404

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Ten years later
919,012

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net cumulative development favorable (unfavorable)
$
(32,405
)
 
$
(111,770
)
 
$
(145,148
)
 
$
(169,258
)
 
$
(25,226
)
 
$
(64,121
)
 
$
(86,272
)
 
$
(106,328
)
 
$
(33,725
)
 
$
3,193

 
 
Gross re-estimated liability-latest
$
946,894

 
$
1,149,883

 
$
1,247,999

 
$
1,285,758

 
$
1,163,333

 
$
1,124,026

 
$
1,126,721

 
$
1,094,524

 
$
1,070,812

 
$
1,034,806

 
 
Re-estimated reinsurance recoverable-latest
(27,882
)
 
(32,479
)
 
(20,458
)
 
(17,042
)
 
(10,328
)
 
(14,319
)
 
(13,049
)
 
(10,838
)
 
(13,119
)
 
(12,942
)
 
 
Net re-estimated liability-latest
$
919,012

 
$
1,117,404

 
$
1,227,541

 
$
1,268,716

 
$
1,153,005

 
$
1,109,707

 
$
1,113,672

 
$
1,083,686

 
$
1,057,693

 
$
1,021,864

 
 
Gross cumulative development favorable (unfavorable)
$
(46,150
)
 
$
(127,280
)
 
$
(159,177
)
 
$
(181,843
)
 
$
(29,825
)
 
$
(70,692
)
 
$
(92,516
)
 
$
(109,245
)
 
$
(34,689
)
 
$
4,178

 
 
 
(1)
Under statutory accounting principles (“SAP”), reserves are stated net of reinsurance recoverable whereas under U.S. generally accepted accounting principles (“GAAP”), reserves are stated gross of reinsurance recoverable.

The Company experienced favorable development of approximately $3 million on the 2013 and prior accident years’ loss and loss adjustment expense reserves due primarily to lower than expected loss severity on California personal auto lines of business partially offset by adverse development in other states. See “Critical Accounting Policies and Estimates-Reserves” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

For 2012, the Company experienced unfavorable development of approximately $34 million on prior accident years’ loss and loss adjustment expense reserves due primarily to Florida claims that were re-opened from prior years due to a state supreme court ruling that was adverse to the insurance industry. The 2012 amount includes the cumulative effect of development amounts from prior periods as discussed below.

For 2011, the Company experienced unfavorable development of approximately $106 million on prior accident years’ loss and loss adjustment expense reserves due primarily to an increase in the estimated loss severity for California BI losses. In addition, the Company experienced unfavorable development on the run-off of California commercial taxi business and Florida homeowners lines

5


of business, both of which the Company ceased writing in 2011. The 2011 amount includes the cumulative effect of development amounts from prior periods as discussed below. The Company is writing and expects to continue writing nominal premiums in the Florida homeowners market.

For the years 2008 through 2010, the Company experienced unfavorable development of approximately $25 million to $86 million on prior accident years’ losses and loss adjustment expense reserves. The unfavorable development was primarily due to increases in the estimated loss severity for California BI losses, increases in PIP reserves in Florida resulting from court decisions that were adverse to the insurance industry, and development on 2007 and prior accident years in New Jersey BI reserves that settled for more than anticipated. These were partially offset by reductions in estimates for loss adjustment expenses, particularly for the 2010 accident year, related to the transfer of a higher proportion of litigated claims to house counsel and a reduction in the estimate for Florida sinkhole claims for accident year 2010, resulting from many of those claims being denied due to the absence of sinkhole activity or structural damage to the houses. The 2008 through 2010 amounts include the cumulative effect of development amounts from prior periods as discussed below.

For the years 2005 through 2007, the Company experienced unfavorable development of approximately $112 million to $169 million on prior accident years’ losses and loss adjustment expense reserves. The unfavorable development from these years related primarily to increases in loss severity estimates and loss adjustment expense estimates for the California BI coverage as well as increases in the provision for BI and PIP losses in New Jersey and Florida. The 2005 though 2007 amounts include the cumulative effect of development amounts from prior periods as discussed below.

For 2004, the unfavorable development of approximately $32 million related to an increase in the Company’s prior accident years’ loss estimates for personal automobile insurance in Florida and New Jersey. In addition, an increase in estimates for loss severity for the 2004 accident year reserves for California's automobile lines of business contributed to the deficiencies.

Statutory Accounting Principles
The Company’s results are reported in accordance with GAAP, which differ in some respects from amounts reported under SAP prescribed by insurance regulatory authorities. Some of the significant differences under GAAP are described below:
Policy acquisition costs such as commissions, premium taxes, and other costs that vary with and are primarily related to the successful acquisition of new and renewal insurance contracts, are capitalized and amortized on a pro rata basis over the period in which the related premiums are earned, rather than expensed as incurred, as required by SAP.
Certain assets are included in the consolidated balance sheets whereas, under SAP, such assets are designated as “nonadmitted assets,” and charged directly against statutory surplus. These assets consist primarily of premium receivables outstanding more than 90 days, deferred tax assets that do not meet statutory requirements for recognition, furniture, equipment, leasehold improvements, capitalized software, and prepaid expenses.
Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and losses and loss adjustment expenses reserves, respectively, as required by SAP.
Fixed-maturity securities are reported at fair value rather than at amortized cost, or the lower of amortized cost or fair value, depending on the specific type of security as required by SAP.
Equity securities are marked to market through the consolidated statements of operations rather than through unrealized gains and losses in surplus, as required by SAP.
Goodwill is reported as the excess of cost of an acquired entity over the fair value of the underlying assets and assessed periodically for impairment. Intangible assets are amortized over their useful lives. Under SAP, goodwill is reported as the excess of cost of an acquired entity over the statutory book value and amortized over 10 years. Its carrying value is limited to 10% of adjusted surplus. Intangible assets are not recognized.
The differing treatment of income and expense items results in a corresponding difference in federal income tax expense. Changes in deferred income taxes are reflected as an item of income tax benefit or expense, rather than recorded directly to statutory surplus as regards policyholders, as required by SAP. Admittance testing under SAP may result in a charge to unassigned surplus for non-admitted portions of deferred tax assets. Under GAAP, a valuation allowance may be recorded against the deferred tax assets and reflected as an expense.
Certain assessments paid to regulatory agencies that are recoverable from policyholders in future periods are expensed rather than recorded as receivables under SAP.



6



Operating Ratios (SAP basis)

Loss and Expense Ratios
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. Under SAP, losses and loss adjustment expenses are stated as a percentage of premiums earned because losses occur over the life of a policy, while underwriting expenses are stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and expense ratios are less than 100%. The Insurance Companies’ loss ratio, expense ratio, combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in the following table. Though the Insurance Companies’ ratios include lines of insurance other than private passenger automobile, which represent 22.1% of premiums written, the Company believes its ratios can be compared to the industry ratios included in the following table.
 
Year Ended December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
Loss Ratio
71.0
%
 
72.7
%
 
76.1
%
 
71.2
%
 
71.0
%
Expense Ratio
27.7
%
 
27.2
%
 
26.7
%
 
27.4
%
 
29.1
%
Combined Ratio
98.8
%
(2) 
99.9
%
 
102.8
%
 
98.6
%
 
100.1
%
Industry combined ratio (all writers)(1)
N/A

 
103.4
%
 
101.3
%
 
101.6
%
 
100.4
%
Industry combined ratio (excluding direct writers)(1)
N/A

  
100.7
%
 
102.6
%
 
101.1
%
 
101.1
%
(1)
Source: A.M. Best, Aggregates & Averages (2011 through 2014), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends).
(2)
Combined ratio for 2014 does not sum due to rounding.

Premiums to Surplus Ratio
The following table presents, for the periods indicated, the Insurance Companies’ statutory ratios of net premiums written to policyholders’ surplus. Guidelines established by the National Association of Insurance Commissioners (the “NAIC”) indicate that this ratio should be no greater than 3 to 1.
 
Year Ended December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
(Amounts in thousands, except ratios)
Net premiums written
$
2,840,922

 
$
2,728,999

 
$
2,651,731

 
$
2,575,383

 
$
2,555,481

Policyholders’ surplus
$
1,438,281

 
$
1,528,682

 
$
1,440,973

 
$
1,497,609

 
$
1,322,270

Ratio
2.0 to 1

 
1.8 to 1

 
1.8 to 1

 
1.7 to 1

 
1.9 to 1


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

Tax considerations, including the impact of the alternative minimum tax (“AMT”), are important in portfolio management. Changes in loss experience, growth rates, and profitability produce significant changes in the Company’s exposure to AMT liability, requiring appropriate shifts in the investment asset mix between taxable bonds, tax-exempt bonds, and equities

7


in order to maximize after-tax yield. The Company closely monitors the timing and recognition of capital gains and losses and the generation of ordinary income to maximize the realization of any deferred tax assets arising from capital losses or AMT credit carryforwards, respectively. The Company had no capital loss carryforward at December 31, 2014.

Investment Portfolio
The following table presents the composition of the Company’s total investment portfolio:
 
December 31,
 
2014
 
2013
 
2012
 
Cost(1)
 
Fair Value
 
Cost(1)
 
Fair Value
 
Cost(1)
 
Fair Value
 
 
 
 
 
(Amounts in thousands)
 
 
 
 
Taxable bonds
$
350,343

 
$
350,705

 
$
329,521

 
$
331,506

 
$
253,175

 
$
265,671

Tax-exempt state and municipal bonds
2,153,151

 
2,267,695

 
2,193,521

 
2,229,147

 
2,017,728

 
2,142,683

Total fixed maturities
2,503,494

 
2,618,400

 
2,523,042

 
2,560,653

 
2,270,903

 
2,408,354

Equity securities
387,851

 
412,880

 
223,933

 
281,883

 
475,959

 
477,088

Short-term investments
373,180

 
372,542

 
315,886

 
315,776

 
294,607

 
294,653

Total investments
$
3,264,525

 
$
3,403,822

 
$
3,062,861

 
$
3,158,312

 
$
3,041,469

 
$
3,180,095

__________ 
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost.

The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time the eligible item is first recognized. For more detailed discussion, see “Liquidity and Capital Resources—Invested Assets” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 of Notes to Consolidated Financial Statements.

For more detailed information related to the Company’s investment portfolio including credit ratings, see “Liquidity and Capital Resources—Portfolio Composition” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Investment Results
The following table presents the investment results of the Company for the most recent five years:
 
Year Ended December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
 
(Amounts in thousands)
 
 
Average invested assets at cost(1) (3)
$
3,204,592

 
$
3,028,198

 
$
3,011,143

 
$
3,004,588

 
$
3,121,366

Net investment income(2)
 
 
 
 
 
 
 
 
 
Before income taxes
$
125,723

 
$
124,538

 
$
131,896

 
$
140,947

 
$
143,814

After income taxes
$
111,456

 
$
109,506

 
$
115,359

 
$
124,708

 
$
128,888

Average annual yield on investments(2)
 
 
 
 
 
 
 
 
 
Before income taxes
3.9
%
 
4.1
%
 
4.4
%
 
4.7
%
 
4.6
%
After income taxes
3.5
%
 
3.6
%
 
3.8
%
 
4.2
%
 
4.1
%
Net realized investment gains (losses) after income taxes
$
52,770

 
$
(7,424
)
 
$
43,147

 
$
37,958

 
$
37,108

 __________
(1)
Fixed maturities and short-term bonds at amortized cost; and equities and other short-term investments at cost. Average invested assets at cost are based on the monthly amortized cost of the invested assets for each respective period.
(2)
For 2014, net investment income increased due to higher average invested asset balances; and average annual yield decreased slightly primarily due to the maturity and replacement of higher yielding investments purchased when market interest rates were higher, with lower yielding investments purchased during low interest rate environments.
(3)
At December 31, 2014, fixed maturity securities with call features totaled $2.2 billion and $2.1 billion at fair value and amortized cost, respectively.


8



Competitive Conditions
The Company operates in the highly competitive property and casualty insurance industry subject to competition on pricing, claims handling, consumer recognition, coverage offered and product features, customer service, and geographic coverage. Some of the Company’s competitors are larger and well-capitalized national companies which have broad distribution networks of employed or captive agents.

Reputation for customer service and price are the principal means by which the Company competes with other insurers. In addition, the marketing efforts of independent agents can provide a competitive advantage. Based on the most recent regularly published statistical compilations of premiums written in 2014, the Company was the fourth largest writer of private passenger automobile insurance in California and the fifteenth largest in the United States.

The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company has historically seen significant premium growth during hard markets. The Company believes that the market is mixed with carriers both raising and decreasing rates depending on individual state profitability and the carriers’ growth appetite.

Reinsurance
The Company is party to a Catastrophe Reinsurance Treaty (“Treaty”) that is effective through June 30, 2015. The Treaty provides for $100 million coverage on a per occurrence basis after covered catastrophe losses exceed a $100 million Company retention limit, excludes coverage in Florida, and limits certain coverages to 37% of catastrophe losses resulting from earthquakes and fire following earthquakes. The annual premium is $4.8 million.

The Company has reinsurance for PIP claims in Michigan through the Michigan Catastrophic Claims Association, a private non-profit unincorporated association created by the Michigan Legislature. The reinsurance covers losses in excess of $530,000 per person and has no maximum limit. Michigan law provides for unlimited lifetime coverage for medical costs caused by automobile accidents.

For California homeowners policies, the Company has reduced its catastrophe exposure from earthquakes by placing earthquake risks directly with the California Earthquake Authority (“CEA”). However, the Company continues to have catastrophe exposure to fires following an earthquake. For more detailed discussion, see “Regulation—Insurance Assessments.”

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

Regulation
The Insurance Companies are subject to significant regulation and supervision by insurance departments of the jurisdictions in which they are domiciled or licensed to operate business.

Department of Insurance Oversight
The powers of the DOI in each state primarily include the prior approval of insurance rates and rating factors and the establishment of capital and surplus requirements, solvency standards, restrictions on dividend payments and transactions with affiliates. DOI regulations and supervision are designed principally to benefit policyholders rather than shareholders.

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

Insurance rates in California, Georgia, New York, New Jersey, Pennsylvania, and Nevada require prior approval from the state DOI, while insurance rates in Illinois, Texas, Virginia, Arizona, and Michigan must only be filed with the respective DOI

9


before they are implemented. Oklahoma and Florida have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be excessive, inadequate, or unfairly discriminatory.

The DOI in each state in which the Company operates is responsible for conducting periodic financial and market conduct examinations of the Insurance Companies in their states. Market conduct examinations typically review compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing, and other practices. For more detailed information related to the Company’s current financial and market conduct examinations, see “Liquidity and Capital Resources—Regulatory Capital Requirement” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

For a discussion of current regulatory matters in California, see “Regulatory and Legal Matters” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 16 of Notes to Consolidated Financial Statements.

The operations of the Company are dependent on the laws of the states in which it does business and changes in those laws can materially affect the revenue and expenses of the Company. The Company retains its own legislative advocates in California. The Company made direct financial contributions of approximately $167,000 and $18,000 to officeholders and candidates in 2014 and 2013, respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines to be appropriate.

The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations. The risk-based capital (“RBC”) formula is used by insurance regulators to monitor capital and surplus levels. It was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements, and a number of other factors. The Company periodically monitors the RBC level of each of the Insurance Companies. As of December 31, 2014, 2013, and 2012 each of the Insurance Companies exceeded the minimum required RBC levels. For more detailed information, see “Liquidity and Capital Resources—Regulatory Capital Requirements” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Own Risk and Solvency Assessment

Beginning in 2015, insurance companies will be required to file an Own Risk and Solvency Assessment (“ORSA”) with the insurance regulators in their state of domicile. The ORSA is required to cover, among many items, a company’s risk management policies, the material risks to which the company is exposed, how the company measures, monitors, manages and mitigates material risks, and how much economic and regulatory capital is needed to continue to operate in a strong and healthy manner. The ORSA is intended to be used by the state insurance regulator to evaluate the risk exposure and quality of the risk management processes within insurance companies to assist in conducting risk-focused financial examinations and for determining the overall financial condition of insurance companies. The Company will comply with the ORSA requirements and does not expect these requirements to have a material impact on the Company's consolidated financial statements.

Insurance Assessments

The California Insurance Guarantee Association (“CIGA”) was created to pay claims on behalf of insolvent property and casualty insurers. Each year, these claims are estimated by CIGA and the Company is assessed for its pro-rata share based on prior year California premiums written in the particular line. These assessments are currently limited to 1.83% of premiums written in the preceding year and are recouped through a mandated surcharge to policyholders in the year after the assessment. There were no CIGA assessments in 2014.

The CEA is a quasi-governmental organization that was established to provide a market for earthquake coverage to California homeowners. The Company places all new and renewal earthquake coverage offered with its homeowner policy directly with the CEA. The Company receives a small fee for placing business with the CEA, which is recorded as other revenue in the consolidated statements of operations. Upon the occurrence of a major seismic event, the CEA has the ability to assess participating companies for losses. These assessments are made after CEA capital has been expended and are based upon each company’s participation percentage multiplied by the amount of the total assessment. Based upon the most recent information provided by the CEA, the Company’s maximum total exposure to CEA assessments at April 1, 2014, the most recent date at which information was available, was $62.5 million. There was no assessment made in 2014.

The Insurance Companies in other states are also subject to the provisions of similar insurance guaranty associations. There were no material assessment payments during 2014 in other states.

10




Holding Company Act
The California Companies are subject to California DOI regulation pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the “Holding Company Act”). The California DOI may examine the affairs of each of the California Companies at any time. The Holding Company Act requires disclosure of any material transactions among affiliates within a Holding Company System. Some transactions and dividends defined to be of an “extraordinary” type may not be made if the California DOI disapproves the transaction within 30 days after notice. Such transactions include, but are not limited to, extraordinary dividends; management agreements, service contracts, and cost-sharing arrangements; all guarantees that are not quantifiable; derivative transactions or series of derivative transactions; certain reinsurance transactions or modifications thereof in which the reinsurance premium or a change in the insurer’s liabilities equals or exceeds 5% of the policyholders’ surplus as of the preceding December 31; sales, purchases, exchanges, loans, and extensions of credit; and investments, in the net aggregate, involving more than the lesser of 3% of the respective California Companies’ admitted assets or 25% of statutory surplus as regards policyholders as of the preceding December 31. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the preceding 12 months, exceeds the greater of 10% of the insurance company’s statutory policyholders’ surplus as of the preceding December 31 or the insurance company’s statutory net income for the preceding calendar year.

California-domiciled insurance companies are also required to notify the California DOI of any dividend after declaration, but prior to payment. There are similar limitations imposed by other states on the Insurance Companies’ ability to pay dividends. As of December 31, 2014, the Insurance Companies are permitted to pay in 2015, without obtaining DOI approval for extraordinary dividends, $177.5 million in dividends to Mercury General, of which $145.4 million may be paid by the California Companies.

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

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

Assigned Risks
Automobile liability insurers in California are required to sell BI liability, property damage liability, medical expense, and uninsured motorist coverage to a proportionate number (based on the insurer’s share of the California automobile casualty insurance market) of those drivers applying for placement as “assigned risks.” Drivers seek placement as assigned risks because their driving records or other relevant characteristics, as defined by Proposition 103, make them difficult to insure in the voluntary market. In 2014, assigned risks represented less than 0.1% of total automobile direct premiums written and less than 0.1% of total automobile direct premium earned. The Company attributes the low level of assignments to the competitive voluntary market. Many of the other states in which the Company conducts business offer programs similar to that of California. These programs are not a significant contributor to the business written in those states.

Executive Officers of the Company
The following table presents certain information concerning the executive officers of the Company as of February 2, 2015:

11


Name
 
Age
 
Position
George Joseph
 
93

 
Chairman of the Board
Gabriel Tirador
 
50

 
President and Chief Executive Officer
Allan Lubitz
 
56

 
Senior Vice President and Chief Information Officer
Theodore R. Stalick
 
51

 
Senior Vice President and Chief Financial Officer
Christopher Graves
 
49

 
Vice President and Chief Investment Officer
Robert Houlihan
 
58

 
Vice President and Chief Product Officer
Kenneth G. Kitzmiller
 
68

 
Vice President and Chief Underwriting Officer
Brandt N. Minnich
 
48

 
Vice President—Marketing
Heidi C. Sullivan
 
46

 
Vice President—Human Capital
Charles Toney
 
53

 
Vice President and Chief Actuary
Judy A. Walters
 
68

 
Vice President—Corporate Affairs and Secretary

Mr. Joseph, Chairman of the Board of Directors, has served in this capacity since 1961. He held the position of Chief Executive Officer of the Company for 45 years from 1961 through December 2006. Mr. Joseph has more than 50 years’ experience in the property and casualty insurance business.

Mr. Tirador, President and Chief Executive Officer, served as the Company’s assistant controller from 1994 to 1996. In 1997 and 1998, he served as the Vice President and Controller of the Automobile Club of Southern California. He rejoined the Company in 1998 as Vice President and Chief Financial Officer. He was appointed President and Chief Operating Officer in October 2001 and Chief Executive Officer in January 2007. Mr. Tirador has over 20 years experience in the property and casualty insurance industry and is an inactive Certified Public Accountant.

Mr. Lubitz, Senior Vice President and Chief Information Officer, joined the Company in January 2008. Prior to joining the Company, he served as Senior Vice President and Chief Information Officer of H&R Block/Option One Mortgage from 2003 to 2007. He held executive roles including Chief Information Officer of Ditech Mortgage and President of ANR Consulting Group from 2000 to 2003. Prior to 2000, he held several positions at TRW, Experian, and First American Corporation, most recently as a Senior Vice President and Chief Information Officer.

Mr. Stalick, Senior Vice President and Chief Financial Officer, joined the Company as Corporate Controller in 1997. He was appointed Chief Accounting Officer in October 2000 and Vice President and Chief Financial Officer in October 2001. In July 2013, he was named Senior Vice President and Chief Financial Officer. Mr. Stalick is an inactive Certified Public Accountant.

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

Mr. Houlihan, Vice President and Chief Product Officer, joined the Company in his current position in November 2007. Prior to joining the Company, he served as National Product Manager at Bristol West Insurance Group from 2005 to 2007 and Product Manager at Progressive Insurance Company from 1999 to 2005.

Mr. Kitzmiller, Vice President and Chief Underwriting Officer, has been employed by the Company in the underwriting department since 1972. Mr. Kitzmiller was appointed Vice President in 1991, and named Chief Underwriting Officer in January 2010.

Mr. Minnich, Vice President—Marketing, joined the Company as an underwriter in 1989. In 2007, he joined Superior Access Insurance Services as Director of Agency Operations, in 2008 he rejoined the Company as an Assistant Product Manager, and in 2009, he was named Senior Director of Marketing, a role he held until appointed to his current position later in 2009. Mr. Minnich has over 25 years experience in the property and casualty insurance industry and is a Chartered Property and Casualty Underwriter.

Ms. Sullivan, Vice President—Human Capital, joined the Company in September 2012. Prior to joining the Company, she served as Senior Vice President, Human Capital for Arcadian Health Plan from 2008 to 2012. Prior to 2008, she held various leadership positions at Kaiser Permanente, Progressive Insurance, and Score Educational Centers. 


12


Mr. Toney, Vice President and Chief Actuary, joined the Company in 1984 as a programmer/analyst. In 1994, he earned his Fellowship in the Casualty Actuarial Society and was appointed to his current position. In 2011, he became a board member of the Personal Insurance Federation of California. Mr. Toney is Mr. Joseph’s nephew.

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

Item 1A.
Risk Factors
The Company’s business involves various risks and uncertainties in addition to the normal risks of business, some of which are discussed in this section. It should be noted that the Company’s business and that of other insurers may be adversely affected by a downturn in general economic conditions and other forces beyond the Company’s control. In addition, other risks and uncertainties not presently known or that the Company currently believes to be immaterial may also adversely affect the Company’s business. Any such risks or uncertainties, or any of the following risks or uncertainties, that develop into actual events could result in a material and adverse effect on the Company’s business, financial condition, results of operations, or liquidity.

The information discussed below should be considered carefully with the other information contained in this Annual Report on Form 10-K and the other documents and materials filed by the Company with the SEC, as well as news releases and other information publicly disseminated by the Company from time to time. The following risk factors are in no particular order.

Risks Related to the Company’s Business
The Company remains highly dependent upon California to produce revenues and operating profits.
For the year ended December 31, 2014, the Company generated 81.5% of its direct automobile insurance premiums written in California. The Company’s financial results are subject to prevailing regulatory, legal, economic, demographic, competitive, and other conditions in the states in which the Company operates and changes in any of these conditions could negatively impact the Company’s results of operations.

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

The Insurance Companies are subject to minimum capital and surplus requirements, and any failure to meet these requirements could subject the Insurance Companies to regulatory action.
The Insurance Companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the NAIC, require the Insurance Companies to report their results of RBC calculations to state departments of insurance and the NAIC. If any of the Insurance Companies fails to meet these standards and requirements, the DOI regulating such subsidiary may require specified actions by the subsidiary.

The Company’s success depends on its ability to accurately underwrite risks and to charge adequate premiums to policyholders.
The Company’s financial condition, results of operations, and liquidity depend on its ability to underwrite and set premiums accurately for the risks it assumes. Premium rate adequacy is necessary to generate sufficient premium to offset losses, loss adjustment expenses, and underwriting expenses and to earn a profit. In order to price its products accurately, the Company must collect and properly analyze a substantial volume of data; develop, test, and apply appropriate rating formulae; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. The Company’s

13


ability to undertake these efforts successfully, and as a result, price accurately, is subject to a number of risks and uncertainties, including but not limited to:
availability of sufficient reliable data;
incorrect or incomplete analysis of available data;
uncertainties inherent in estimates and assumptions, generally;
selection and application of appropriate rating formulae or other pricing methodologies;
successful innovation of new pricing strategies;
recognition of changes in trends and in the projected severity and frequency of losses;
the Company’s ability to forecast renewals of existing policies accurately;
unanticipated court decisions, legislation or regulatory action;
ongoing changes in the Company’s claim settlement practices;
changes in operating expenses;
changing driving patterns;
extra-contractual liability arising from bad faith claims;
weather catastrophes, including those which may be related to climate change;
unexpected medical inflation; and
unanticipated inflation in auto repair costs, auto parts prices, and used car prices.

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

The Company’s insurance rates are subject to approval by the departments of insurance in most of the states in which the Company operates, and to political influences.
In six of the states in which it operates, including California, the Company must obtain the DOI’s prior approval of insurance rates charged to its customers, including any increases in those rates. If the Company is unable to receive approval of the rate changes it requests, or if such approval is delayed, the Company’s ability to operate its business in a profitable manner may be limited and its financial condition, results of operations, and liquidity may be adversely affected. Additionally, in California, the law allows for consumer groups to intervene in rate filings, which frequently causes delays in the timeliness of rate approvals and implementation of rate changes and can impact the rate that is ultimately approved.

From time to time, the auto insurance industry comes under pressure from state regulators, legislators, and special interest groups to reduce, freeze, or set rates at levels that do not correspond with underlying costs, in the opinion of the Company’s management. The homeowners insurance business faces similar pressure, particularly as regulators in catastrophe-prone states seek an acceptable methodology to price for catastrophe exposure. In addition, various insurance underwriting and pricing criteria regularly come under attack by regulators, legislators, and special interest groups. The result could be legislation, regulations, or new interpretations of existing regulations that adversely affect the Company’s business, financial condition, and results of operations.

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


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Loss of, or significant restriction on, the use of credit scoring in the pricing and underwriting of personal lines products could reduce the Company’s future profitability.
The Company uses credit scoring as a factor in pricing and underwriting decisions where allowed by state law. Some consumer groups and regulators have questioned whether the use of credit scoring unfairly discriminates against some groups of people and are seeking to prohibit or restrict the use of credit scoring in underwriting and pricing. Laws or regulations that significantly curtail or regulate the use of credit scoring, if enacted in a large number of states in which the Company operates, could negatively impact the Company’s future results of operations.

If the Company cannot maintain its A.M. Best ratings, it may not be able to maintain premium volume in its insurance operations sufficient to attain the Company’s financial performance goals.
The Company’s ability to retain its existing business or to attract new business in its Insurance Companies is affected by its rating by A.M. Best Company. A.M. Best Company currently rates all of the Insurance Companies with sufficient operating history to be rated as either A+ (Superior) or A- (Excellent). If the Company is unable to maintain its A.M. Best ratings, the Company may not be able to grow its premium volume sufficiently to attain its financial performance goals, and the result may adversely affect the Company’s business, financial condition, and results of operations. Two of the smaller Insurance Companies, CGU and WAIC, are not rated by A.M. Best Company.

The Company may require additional capital in the future, which may not be available or may only be available on unfavorable terms.
The Company’s future capital requirements, including to fund future growth opportunities, depend on many factors, including its ability to underwrite new business successfully, its ability to establish premium rates and reserves at levels sufficient to cover losses, the success of its expansion plans, the performance of its investment portfolio and the Company’s ability to obtain financing. The Company may seek to obtain financing through equity or debt issuances, or sales of all or a portion of its investment portfolio or other assets. The Company’s ability to obtain financing also depends on economic conditions affecting financial markets and financial strength and claims-paying ability ratings, which are assigned based upon an evaluation of the Company’s ability to meet its financial obligations. The Company’s current financial strength rating with Fitch is A. If the Company were to seek financing through the capital markets in the future, it may need to apply for Standard and Poor’s and Moody’s ratings and there can be no assurance that the Company would obtain favorable ratings from either agency. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company. In the case of equity financing, the Company’s shareholders could experience dilution. In addition, such securities may have rights, preferences, and privileges that are senior to those of the Company’s current shareholders. If the Company cannot obtain adequate capital on favorable terms or at all, its business, financial condition, and results of operations could be adversely affected.

Changes in market interest rates, defaults on securities and tax considerations may have an adverse effect on the Company’s investment portfolio, which may adversely affect the Company’s financial results.
The Company’s financial results are affected, in part, by the performance of its investment portfolio. The Company’s investment portfolio contains interest rate sensitive-investments, such as municipal and corporate bonds. Increases in market interest rates may have an adverse impact on the value of the investment portfolio by decreasing the value of fixed income securities. Declining market interest rates could have an adverse impact on the Company’s investment income as it invests positive cash flows from operations and as it reinvests proceeds from maturing and called investments in new investments that could yield lower rates than the Company’s investments have historically generated. Defaults in the Company’s investment portfolio may produce operating losses and negatively impact the Company’s results of operations.

Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions, and other factors beyond the Company’s control. Market interest rates have been at historic lows for the last several years. Many observers, including the Company, believe that market interest rates will rise as the economy improves. Although the Company takes measures to manage the risks of investing in a changing interest rate environment, it may not be able to mitigate interest rate sensitivity effectively. The Company’s mitigation efforts include maintaining a high quality portfolio and managing the duration of the portfolio to reduce the effect of interest rate changes. Despite its mitigation efforts, a significant change in interest rates could have a material adverse effect on the Company’s financial condition and results of operations. In addition, changes in loss experience, growth rates and profitability of the Company's investment portfolio significantly impact the Company’s exposure to AMT liability. The Company seeks to manage its AMT liability and maximize after-tax yield through the appropriate investment asset mix between taxable bonds, tax-exempt bonds, and equities. Although the Company monitors the timing and recognition of capital gains and losses and the generation of ordinary income in an effort to maximize the realization of deferred tax assets arising from capital losses or AMT credit carryforwards, no guaranty can be provided that such monitoring or the Company's tax strategies will be effective.


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The Company’s valuation of financial instruments may include methodologies, estimates, and assumptions that are subject to differing interpretations and could result in changes to valuations that may materially adversely affect the Company’s financial condition or results of operations.
The Company employs a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date using the exit price. Accordingly, when market observable data are not readily available, the Company’s own assumptions are set to reflect those that market participants would be presumed to use in pricing the asset or liability at the measurement date. Assets and liabilities recorded on the consolidated balance sheets at fair value are categorized based on the level of judgment associated with the input used to measure their fair value and the level of market price observability.

During periods of market disruption, including periods of significantly changing interest rates, rapidly widening credit spreads, inactivity or illiquidity, it may be difficult to value certain of the Company’s securities if trading becomes less frequent and/or market data become less observable. There may be certain asset classes in historically active markets with significant observable data that become illiquid due to changes in the financial environment. In such cases, the valuations associated with such securities may rely more on management judgment and include inputs and assumptions that are less observable or require greater estimation as well as valuation methods, which are more sophisticated or require greater estimation. The valuations generated by such methods may be different from the value at which the investments ultimately may be sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities as reported within the Company’s consolidated financial statements, and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on the Company’s financial condition or results of operations.

Changes in the financial strength ratings of financial guaranty insurers issuing policies on bonds held in the Company’s investment portfolio may have an adverse effect on the Company’s investment results.
In an effort to enhance the bond rating applicable to certain bond issues, some bond issuers purchase municipal bond insurance policies from private insurers. The insurance generally guarantees the payment of principal and interest on a bond issue if the issuer defaults. By purchasing the insurance, the financial strength ratings applicable to the bonds are based on the credit worthiness of the insurer as well as the underlying credit of the bond issuer. These financial guaranty insurers are subject to DOI oversight. As the financial strength ratings of these insurers are reduced, the ratings of the insured bond issues correspondingly decrease. Although the Company has determined that the financial strength rating of the underlying bond issues in its investment portfolio are within the Company’s investment policy without the enhancement provided by the insurance policies, any further downgrades in the financial strength ratings of these insurance companies or any defaults on the insurance policies written by these insurance companies may reduce the fair value of the underlying bond issues and the Company’s investment portfolio or may reduce the investment results generated by the Company’s investment portfolio, which could have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.

Deterioration of the municipal bond market in general or of specific municipal bonds held by the Company may result in a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
At December 31, 2014, 66.6% of the Company’s total investment portfolio at fair value and 86.6% of its total fixed maturity investments at fair value were invested in tax-exempt municipal bonds. With such a large percentage of the Company’s investment portfolio invested in municipal bonds, the performance of the Company’s investment portfolio, including the cash flows generated by the investment portfolio is significantly dependent on the performance of municipal bonds. If the value of municipal bond markets in general or any of the Company’s municipal bond holdings deteriorate, the performance of the Company’s investment portfolio, financial condition, results of operations, and liquidity may be materially and adversely affected.

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

There is uncertainty involved in the availability of reinsurance and the collectability of reinsurance recoverable.
The Company reinsures a portion of its potential losses on the policies it issues to mitigate the volatility of the losses on its financial condition and results of operations. The availability and cost of reinsurance is subject to market conditions, which are

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

The failure of any of the loss limitation methods employed by the Company could have a material adverse effect on its financial condition or results of operations.
Various provisions of the Company’s policies, such as limitations or exclusions from coverage which are intended to limit the Company’s risks, may not be enforceable in the manner the Company intends. In addition, the Company’s policies contain conditions requiring the prompt reporting of claims and the Company’s right to decline coverage in the event of a violation of that condition. While the Company’s insurance product exclusions and limitations reduce the Company’s loss exposure and help eliminate known exposures to certain risks, it is possible that a court or regulatory authority could nullify or void an exclusion or legislation could be enacted modifying or barring the use of such endorsements and limitations in a way that would adversely affect the Company’s loss experience, which could have a material adverse effect on its financial condition or results of operations.

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

The Company depends on independent agents who may discontinue sales of its policies at any time.
The Company sells its insurance policies primarily through approximately 8,800 independent agents. The Company must compete with other insurance carriers for these agents’ business. Some competitors offer a larger variety of products, lower prices for insurance coverage, higher commissions, or more attractive non-cash incentives. To maintain its relationship with these independent agents, the Company must pay competitive commissions, be able to respond to their needs quickly and adequately, and create a consistently high level of customer satisfaction. If these independent agents find it preferable to do business with the Company’s competitors, it would be difficult to renew the Company’s existing business or attract new business. State regulations may also limit the manner in which the Company’s producers are compensated or incentivized. Such developments could negatively impact the Company’s relationship with these parties and ultimately reduce revenues.

The Company’s expansion plans may adversely affect its future profitability.
The Company intends to continue to expand its operations in several of the states in which the Company has operations and into states in which it has not yet begun operations. The intended expansion will necessitate increased expenditures. The Company expects to fund these expenditures out of cash flow from operations. The expansion may not occur, or if it does occur, may not be successful in providing increased revenues or profitability. If the Company’s cash flow from operations is insufficient to cover the increased costs of the expansion, or if the expansion does not provide the benefits anticipated, the Company’s financial condition, results of operations, and ability to grow its business may be harmed.

Any inability of the Company to realize its deferred tax assets, if and when they arise, may have a material adverse effect on the Company’s financial condition and results of operations.
The Company recognizes deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. The Company evaluates its deferred tax assets for recoverability based on available evidence, including assumptions about future profitability and capital gain generation. Although management believes that it is more likely than not that the deferred tax assets will be realized, some or all of the Company’s deferred tax assets could expire unused if the Company is unable to generate taxable

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income of an appropriate character and in a sufficient amount to utilize these tax benefits in the future. Any determination that the Company would not be able to realize all or a portion of its deferred tax assets in the future would result in a charge to earnings in the period in which the determination is made. This charge could have a material adverse effect on the Company’s results of operations and financial condition. In addition, the assumptions used to make this determination are subject to change from period-to-period based on changes in tax laws or variances between the Company’s projected operating performance and actual results. As a result, significant management judgment is required in assessing the possible need for a deferred tax asset valuation allowance. For these reasons and because changes in these assumptions and estimates can materially affect the Company’s results of operations and financial condition, management has included the assessment of a deferred tax asset valuation allowance as a critical accounting estimate.

The carrying value of the Company’s goodwill and other intangible assets could be subject to an impairment write-down.
At December 31, 2014, the Company’s consolidated balance sheets reflected approximately $43 million of goodwill and $36 million of other intangible assets. The Company evaluates whether events or circumstances have occurred that suggest that the fair values of its intangible assets are below their respective carrying values. The determination that the fair value of the Company’s intangible assets is less than its carrying value may result in an impairment write-down. The impairment write-down would be reflected as expense and could have a material adverse effect on the Company’s results of operations during the period in which it recognizes the expense. In the future, the Company may incur impairment charges related to the goodwill and other intangible assets already recorded or arising out of future acquisitions.

The Company relies on its information technology systems to manage many aspects of its business, and any failure of these systems to function properly or any interruption in their operation could result in a material adverse effect on the Company’s business, financial condition, and results of operations.
The Company depends on the accuracy, reliability, and proper functioning of its information technology systems. The Company relies on these information technology systems to effectively manage many aspects of its business, including underwriting, policy acquisition, claims processing and handling, accounting, reserving and actuarial processes and policies, and to maintain its policyholder data. The Company is developing and deploying new information technology systems that are designed to manage many of these functions across all of the states in which it operates and all of the lines of insurance it offers. See “Overview—Technology” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The failure of hardware or software that supports the Company’s information technology systems, the loss of data contained in the systems, or any delay or failure in the full deployment of the Company’s new information technology systems could disrupt its business and could result in decreased premiums, increased overhead costs, and inaccurate reporting, all of which could have a material adverse effect on the Company’s business, financial condition, and results of operations.

In addition, despite system redundancy, the implementation of security measures, and the existence of a disaster recovery plan for the Company’s information technology systems, these systems are vulnerable to damage or interruption from:
earthquake, fire, flood and other natural disasters;
terrorist attacks and attacks by computer viruses or hackers;
power loss;
unauthorized access; and
computer systems, Internet, telecommunications or data network failure.

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

Cyber security risks and the failure to maintain the confidentiality, integrity, and availability of internal or policyholder systems and data could result in damages to the Companys reputation and/or subject it to expenses, fines or lawsuits.

The Company collects and retains large volumes of internal and policyholder data, including personally identifiable information, for business purposes including underwriting, claims and billing purposes, and relies upon the various information technology systems that enter, process, summarize and report such data. The Company also maintains personally identifiable information about its employees. The confidentiality and protection of the Company’s policyholder, employee and Company data

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are critical to the Company’s business. The Company’s policyholders and employees have a high expectation that it will adequately protect their personal information. The regulatory environment, as well as the requirements imposed by the payment card industry and insurance regulators, governing information, security and privacy laws is increasingly demanding and continues to evolve. Maintaining compliance with applicable information security and privacy regulations may increase the Company’s operating costs and adversely impact its ability to market products and services to its policyholders. Furthermore, a penetrated or compromised information technology system or the intentional, unauthorized, inadvertent or negligent release or disclosure of data could result in theft, loss, fraudulent or unlawful use of policyholder, employee or Company data which could harm the Company’s reputation or result in remedial and other expenses, fines or lawsuits.

Changes in accounting standards issued by the Financial Accounting Standards Board (“FASB”) or other standard-setting bodies may adversely affect the Company’s consolidated financial statements.
The Company’s consolidated financial statements are subject to the application of GAAP, which is periodically revised and/or expanded. Accordingly, the Company is required to adopt new or revised accounting standards from time to time issued by recognized authoritative bodies, including the FASB. It is possible that future changes the Company is required to adopt could change the current accounting treatment that the Company applies to its consolidated financial statements and that such changes could have a material effect on the Company’s financial condition and results of operations.

The Company’s disclosure controls and procedures may not prevent or detect acts of fraud.
The Company’s disclosure controls and procedures are designed to reasonably assure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to management and is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company’s management, including its Chief Executive Officer and Chief Financial Officer, believe that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, the Company cannot provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been prevented or detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by an unauthorized override of the controls. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and the Company cannot assure that any design will succeed in achieving its stated goals under all potential future conditions. Accordingly, because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and not be detected.

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

The ability of the Company to attract, develop and retain talented employees, managers and executives, and to maintain appropriate staffing levels, is critical to the Company’s success.
The Company is constantly hiring and training new employees and seeking to retain current employees. An inability to attract, retain and motivate the necessary employees for the operation and expansion of the Company’s business could hinder its ability to conduct its business activities successfully, develop new products and attract customers.

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

Challenging economic conditions may negatively affect the Company’s business and operating results.

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Challenging economic conditions could adversely affect the Company in the form of consumer behavior and pressure on its investment portfolio. Consumer behavior could include policy cancellations, modifications, or non-renewals, which may reduce cash flows from operations and investments, may harm the Company’s financial position, and may reduce the Insurance Companies’ statutory surplus. Challenging economic conditions also may impair the ability of the Company’s customers to pay premiums as they become due, and as a result, the Company’s bad debt reserves and write-offs could increase. It is also possible that claims fraud may increase. The Company’s investment portfolios could be adversely affected as a result of financial and business conditions affecting the issuers of the securities in the Company’s investment portfolio. In addition, declines in the Company’s profitability could result in a charge to earnings for the impairment of goodwill, which would not affect the Company’s cash flow but could decrease its earnings, and its stock price could be adversely affected.

The Company may be adversely affected if economic conditions result in either inflation or deflation. In an inflationary environment, established reserves may become inadequate and increase the Company’s loss ratio, and market interest rates may rise and reduce the value of the Company’s fixed maturity portfolio, while increasing interest expense on its LIBOR based debt. The DOIs may not approve premium rate increases in time for the Company to adequately mitigate inflated loss costs. In a deflationary environment, some fixed maturity issuers may have difficulty meeting their debt service obligations and thereby reduce the value of the Company’s fixed maturity portfolio; equity investments may decrease in value; and policyholders may experience difficulties paying their premiums to the Company, which could adversely affect premium revenue.

Risks Related to the Company’s Industry
The private passenger automobile insurance industry is highly competitive, and the Company may not be able to compete effectively against larger or better-capitalized companies.
The Company competes with many property and casualty insurance companies selling private passenger automobile insurance in the states in which the Company operates. Many of these competitors are better capitalized than the Company, have higher A.M. Best ratings, and have a larger market share in the states in which the Company operates. The superior capitalization of the competitors may enable them to offer lower rates, to withstand larger losses, and to more effectively take advantage of new marketing opportunities. The Company’s competition may also become increasingly better capitalized in the future as the traditional barriers between insurance companies and banks and other financial institutions erode and as the property and casualty industry continues to consolidate. The Company’s ability to compete against these larger, better-capitalized competitors depends on its ability to deliver superior service and its strong relationships with independent agents.

The Company may undertake strategic marketing and operating initiatives to improve its competitive position and drive growth. If the Company is unable to successfully implement new strategic initiatives or if the Company’s marketing campaigns do not attract new customers, the Company’s competitive position may be harmed, which could adversely affect the Company’s business and results of operations. Additionally, in the event of a failure of any competitor, the Company and other insurance companies would likely be required by state law to absorb the losses of the failed insurer and would be faced with an unexpected surge in new business from the failed insurer’s former policyholders.

The Company may be adversely affected by changes in the private passenger automobile insurance industry.
77.9% of the Company’s direct written premiums for the year ended December 31, 2014 were generated from private passenger automobile insurance policies. Adverse developments in the market for personal automobile insurance or the personal automobile insurance industry in general, whether related to changes in competition, pricing or regulations, could cause the Company’s results of operations to suffer. The property-casualty insurance industry is also exposed to the risks of severe weather conditions, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, wild fires, sinkholes, earthquakes and, to a lesser degree, explosions, terrorist attacks, and riots. The automobile insurance business is also affected by cost trends that impact profitability. Factors which negatively affect cost trends include inflation in automobile repair costs, automobile parts costs, new and used car valuations, medical costs, and changes in non-economic costs due to changes in the legal and regulatory environments. In addition, the advent of driverless cars and usage-based insurance could materially alter the way that automobile insurance is marketed, priced, and underwritten.

The Company cannot predict the impact that changing climate conditions, including legal, regulatory and social responses thereto, may have on its business.
Various scientists, environmentalists, international organizations, regulators and other commentators believe that global climate change has added, and will continue to add, to the unpredictability, frequency and severity of natural disasters (including, but not limited to, hurricanes, tornadoes, freezes, droughts, other storms and fires) in certain parts of the world. In response, a number of legal and regulatory measures and social initiatives have been introduced in an effort to reduce greenhouse gas and other carbon emissions that may be chief contributors to global climate change. The Company cannot predict the impact that

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changing climate conditions, if any, will have on its business or its customers. It is also possible that the legal, regulatory and social responses to climate change could have a negative effect on the Company’s results of operations or financial condition.

Changes in federal or state tax laws could adversely affect the Company’s business, financial condition, results of operations, and liquidity.

The Company’s financial condition, results of operations, and liquidity are dependent in part on tax policy implemented at the federal and/or state level. For example, a significant portion of the Company’s investment portfolio consists of municipal securities that receive beneficial tax treatment under applicable federal tax law. The Company’s results are also subject to federal and state tax rules applicable to dividends received from its subsidiaries and its equity holdings. Additionally, changes in tax laws could have an adverse effect on deferred tax assets and liabilities included in the Company’s consolidated balance sheets and results of operations. The Company cannot predict whether any tax legislation will be enacted or whether any such changes to existing federal or state tax law would have a material adverse effect on the Company's financial condition and results of operations.

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

Required Licensing. The Company operates under licenses issued by the DOI in the states in which the Company sells insurance. If a regulatory authority denies or delays granting a new license, the Company’s ability to enter that market quickly or offer new insurance products in that market may be substantially impaired. In addition, if the DOI in any state in which the Company currently operates suspends, non-renews, or revokes an existing license, the Company would not be able to offer affected products in the state.

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

Regulation of Insurance Rates and Approval of Policy Forms. The insurance laws of most states in which the Company conducts business require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. If, as permitted in some states, the Company begins using new rates before they are approved, it may be required to issue refunds or credits to the Company’s policyholders if the new rates are ultimately deemed excessive or unfair and disapproved by the applicable state regulator. In other states, prior approval of rate changes is required and there may be long delays in the approval process or the rates may not be approved. Accordingly, the Company’s ability to respond to market developments or increased costs in that state can be adversely affected.

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

Other Regulations. The Company must also comply with regulations involving, among other matters:
the use of non-public consumer information and related privacy issues;
the use of credit history in underwriting and rating;
limitations on the ability to charge policy fees;
limitations on types and amounts of investments;

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the payment of dividends;
the acquisition or disposition of an insurance company or of any company controlling an insurance company;
involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;
reporting with respect to financial condition;
periodic financial and market conduct examinations performed by state insurance department examiners; and
the other regulations discussed in this Annual Report on Form 10-K.

The failure to comply with these laws and regulations may also result in regulatory actions, fines and penalties, and in extreme cases, revocation of the Company’s ability to do business in that jurisdiction. In addition, the Company may face individual and class action lawsuits by insured and other parties for alleged violations of certain of these laws or regulations.

In addition, from time to time, the Company may support or oppose legislation or other amendments to insurance regulations in California or other states in which it operates. Consequently, the Company may receive negative publicity related to its support or opposition of legislative or regulatory changes that may have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.

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

Assessments and other surcharges for guaranty funds, second-injury funds, catastrophe funds, and other mandatory pooling arrangements may reduce the Company’s profitability.
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insured parties as the result of impaired or insolvent insurance companies. Many states also have laws that established second-injury funds to provide compensation to injured employees for aggravation of a prior condition or injury which are funded by either assessments based on paid losses or premium surcharge mechanisms. In addition, as a condition to the ability to conduct business in various states, the Insurance Companies must participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various types of insurance coverage to individuals or other entities that otherwise are unable to purchase that coverage from private insurers. The effect of these assessments and mandatory shared-market mechanisms or changes in them could reduce the Company’s profitability in any given period or limit its ability to grow its business.

The insurance industry faces litigation risks, which, if resolved unfavorably, could result in substantial penalties and/or monetary damages, including punitive damages. In addition, insurance companies incur material expenses defending litigation and their results of operations or financial condition could be adversely affected if they fail to accurately project litigation expenses.
Insurance companies are subject to a variety of legal actions including breach of contract claims, tort claims, fraud and misrepresentation claims, employee benefit claims, and wage and hour claims. In addition, insurance companies incur and likely will continue to incur potential liability for claims related to the insurance industry in general and to the Company’s business in particular, such as those related to allegations for failure to pay claims, termination or non-renewal of coverage, interpretation of policy language, policy sales practices, reinsurance matters, and other similar matters. Such actions can also include allegations of fraud, misrepresentation, and unfair or improper business practices and can include claims for punitive damages.

Court decisions and legislative activity may increase exposures for any of the types of claims insurance companies face. There is a risk that insurance companies could incur substantial legal fees and expenses in any of the actions companies defend in excess of amounts budgeted for defense.


22


The Company and the Insurance Companies are named as defendants in a number of lawsuits. Those that management believes could have a material effect on the Company's consolidated financial statements are described more fully at “Overview—B. Regulatory and Legal Matters” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 16 of Notes to Consolidated Financial Statements. Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuit is uncertain and may negatively impact the manner in which the Company conducts its business and results of operations, which could materially increase the Company’s legal expenses. In addition, potential litigation involving new claim, coverage, and business practice issues could adversely affect the Company’s business by changing the way policies are priced, extending coverage beyond its underwriting intent, or increasing the size of claims.

Risks Related to the Company’s Stock
The Company is controlled by small number of shareholders who will be able to exert significant influence over matters requiring shareholder approval, including change of control transactions.
George Joseph and Gloria Joseph collectively own more than 50% of the Company’s common stock. Accordingly, George Joseph and Gloria Joseph have the ability to exert significant influence on the actions the Company may take in the future, including change of control transactions. This concentration of ownership may conflict with the interests of the Company’s other shareholders and lenders.

Future sales of common stock may affect the market price of the Company’s common stock and the future exercise of options and warrants will result in dilution to the Company’s shareholders.
The Company may raise capital in the future through the issuance and sale of shares of its common stock. The Company cannot predict what effect, if any, such future sales will have on the market price of its common stock. Sales of substantial amounts of its common stock in the public market could adversely affect the market price of the Company’s outstanding common stock, and may make it more difficult for shareholders to sell common stock at a time and price that the shareholder deems appropriate. In addition, the Company has issued options to purchase shares of its common stock. In the event that any options to purchase common stock are exercised, shareholders will suffer dilution in their investment.

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

Although the Company has consistently paid cash dividends in the past, it may not be able to pay cash dividends in the future.
The Company has consistently paid cash dividends since the public offering of its common stock in November 1985. However, future cash dividends will depend upon a variety of factors, including the Company’s profitability, financial condition, capital needs, future prospects, and other factors deemed relevant by the Board of Directors. The Company’s ability to pay dividends may also be limited by the ability of the Insurance Companies to make distributions to the Company, which may be restricted by financial, regulatory or tax constraints, and by the terms of the Company’s debt instruments. In addition, there can be no assurance that the Company will continue to pay dividends even if the necessary financial and regulatory conditions are met and if sufficient cash is available for distribution.

Item 1B.
Unresolved Staff Comments
None.

Item 2.
Properties
The Company owns the following buildings which are mostly occupied by the Company’s employees. Space not occupied by the Company may be leased to independent third party tenants.

23


Location
 
Purpose
 
Size in
square feet
 
Percent occupied by
the Company at
December 31, 2014
Brea, CA
 
Home office and I.T. facilities (2 buildings)
 
236,000

 
100
%
Folsom, CA
 
Administrative and Data Center
 
88,000

 
100
%
Los Angeles, CA
 
Executive offices
 
41,000

 
95
%
Rancho Cucamonga, CA
 
Administrative
 
127,000

 
100
%
Clearwater, FL
 
Administrative
 
157,000

 
82
%
Oklahoma City, OK
 
Administrative
 
100,000

 
25
%

The Company leases additional office space for operations. Office location is not crucial to the Company’s operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space. For future expansion, the Company owns 6.3-acre and 5.9-acre parcels of land in Brea and Rancho Cucamonga, California, respectively.

The Company’s properties are well maintained, adequately meet its needs, and are being utilized for their intended purposes.

Item 3.
Legal Proceedings
The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see “Critical Accounting Policies and Estimates” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 1 of Notes to Consolidated Financial Statements.

The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. For loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see “Overview—B. Regulatory and Legal Matters” in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 16 of Notes to Consolidated Financial Statements, which is incorporated herein by reference.

There are no environmental proceedings arising under federal, state, or local laws or regulations to be discussed.

Item 4.
Mine Safety Disclosure
Not applicable.

24


PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The following table presents the high and low sales price per share on the New York Stock Exchange (symbol: MCY) since January 2013.
2014
High
 
Low
1st Quarter
$
49.72

 
$
41.70

2nd Quarter
$
49.08

 
$
44.14

3rd Quarter
$
52.58

 
$
46.00

4th Quarter
$
59.68

 
$
48.25

2013
High
 
Low
1st Quarter
$
40.90

 
$
36.03

2nd Quarter
$
46.98

 
$
37.58

3rd Quarter
$
48.50

 
$
43.08

4th Quarter
$
51.00

 
$
46.00

The closing price of the Company’s common stock on February 2, 2015 was $58.54.
Holders
As of February 2, 2015, there were approximately 129 holders of record of the Company’s common stock.
Dividends
Since the public offering of its common stock in November 1985, the Company has paid regular quarterly dividends on its common stock. During 2014 and 2013, the Company paid dividends on its common stock of $2.4625 and $2.4525 per share, respectively. On February 6, 2015, the Board of Directors declared a $0.6175 quarterly dividend payable on March 31, 2015 to shareholders of record on March 17, 2015.

For financial statement purposes, the Company records dividends on the declaration date. The Company expects to continue paying quarterly dividends; however, the continued payment and amount of cash dividends will depend upon the Company’s operating results, overall financial condition, capital requirements, and general business conditions.

Holding Company Act
Pursuant to the Holding Company Act the Insurance Companies are required to notify the California DOI of any dividend after declaration, but prior to payment. There are similar limitations imposed by other states on the Insurance Companies’ ability to pay dividends. As of December 31, 2014, the Insurance Companies are permitted to pay in 2015, without obtaining DOI approval for extraordinary dividends, $177.5 million in dividends to Mercury General, of which $145.4 million may be paid by the California Companies.

For a discussion of certain restrictions on the payment of dividends to Mercury General by some of its insurance subsidiaries, see Note 11 of Notes to Consolidated Financial Statements.
Performance Graph
The following graph compares the cumulative total shareholder returns on the Company’s Common Stock (Symbol: MCY) with the cumulative total returns on the Standard and Poor’s 500 Composite Stock Price Index (“S&P 500 Index”) and the Company’s industry peer group over the last five years. The graph assumes that $100 was invested on December 31, 2009 in each of the Company’s Common Stock, the S&P 500 Index and the industry peer group and the reinvestment of all dividends.
Comparative Five-Year Cumulative Total Returns
Stock Price Plus Reinvested Dividends

25


 
 
2009
 
2010
 
2011
 
2012
 
2013
 
2014
Mercury General
$
100.00

 
$
115.86

 
$
130.45

 
$
120.23

 
$
159.36

 
$
191.09

Industry Peer Group
100.00

 
120.34

 
119.62

 
141.48

 
188.18

 
229.00

S&P 500 Index
100.00

 
115.06

 
117.49

 
136.30

 
180.44

 
205.14


The industry peer group consists of Ace Limited, Alleghany Corporation, Allstate Corporation, American Financial Group, Berkshire Hathaway, Chubb Corporation, Cincinnati Financial Corporation, CNA Financial Corporation, Erie Indemnity Company, Hanover Insurance Group, HCC Insurance Holdings, Markel Corporation, Old Republic International, Progressive Corporation, RLI Corporation, Selective Insurance Group, Travelers Companies, Inc., W.R. Berkley Corporation and XL Capital, Ltd.
Recent Sales of Unregistered Securities
None.

Share Repurchases
The Company has had a stock repurchase program since 1998. The Company’s Board of Directors authorized a $200 million stock repurchase on July 25, 2014, and the authorization will expire in July 2015. The Company may repurchase shares of its common stock under the program in open market transactions at the discretion of management. The Company will use dividends received from the Insurance Companies to fund the share repurchases. No stock has been purchased since 2000.

Item 6.
Selected Financial Data
The following selected financial and operating data are derived from the Company’s audited consolidated financial statements. The selected financial and operating data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto contained elsewhere in this Annual Report on Form 10-K.

26


 
Year Ended December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
 
(Amounts in thousands, except per share data)
 
 
Income Data:
 
 
 
 
 
 
 
 
 
Net premiums earned
$
2,796,195

 
$
2,698,187

 
$
2,574,920

 
$
2,566,057

 
$
2,566,685

Net investment income
125,723

 
124,538

 
131,896

 
140,947

 
143,814

Net realized investment gains (losses)
81,184

 
(11,422
)
 
66,380

 
58,397

 
57,089

Other
8,671

 
9,738

 
10,174

 
11,884

 
8,297

Total revenues
3,011,773

 
2,821,041

 
2,783,370

 
2,777,285

 
2,775,885

Losses and loss adjustment expenses
1,986,122

 
1,962,690

 
1,961,448

 
1,829,205

 
1,825,766

Policy acquisition costs
526,208

 
505,517

 
477,788

 
481,721

 
505,565

Other operating expenses
249,381

 
219,478

 
207,281

 
215,711

 
255,358

Interest
2,637

 
1,260

 
1,543

 
5,549

 
6,806

Total expenses
2,764,348

 
2,688,945

 
2,648,060

 
2,532,186

 
2,593,495

Income before income taxes
247,425

 
132,096

 
135,310

 
245,099

 
182,390

Income tax expense
69,476

 
19,953

 
18,399

 
53,935

 
30,192

Net income
$
177,949

 
$
112,143

 
$
116,911

 
$
191,164

 
$
152,198

Per Share Data:
 
 
 
 
 
 
 
 
 
Basic earnings per share
$
3.23

 
$
2.04

 
$
2.13

 
$
3.49

 
$
2.78

Diluted earnings per share
$
3.23

 
$
2.04

 
$
2.13

 
$
3.49

 
$
2.78

Dividends paid
$
2.4625

 
$
2.4525

 
$
2.4425

 
$
2.41

 
$
2.37

 
 
December 31,
 
2014
 
2013
 
2012
 
2011
 
2010
 
 
 
(Amounts in thousands, except per share data)
 
 
Balance Sheet Data:
 
 
 
 
 
 
 
 
 
Total investments
$
3,403,822

 
$
3,158,312

 
$
3,180,095

 
$
3,062,421

 
$
3,155,257

Total assets
4,600,289

 
4,315,181

 
4,189,686

 
4,070,006

 
4,203,364

Losses and loss adjustment expenses
1,091,797

 
1,038,984

 
1,036,123

 
985,279

 
1,034,205

Unearned premiums
999,798

 
953,527

 
920,429

 
843,427

 
833,379

Notes payable
290,000

 
190,000

 
140,000

 
140,000

 
267,210

Shareholders’ equity
1,875,446

 
1,822,486

 
1,842,497

 
1,857,483

 
1,794,815

Book value per share
34.02

 
33.15

 
33.55

 
33.86

 
32.75


27


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

Cautionary Statements

Certain statements in this Annual Report on Form 10-K or in other materials the Company has filed or will file with the SEC (as well as information included in oral statements or other written statements made or to be made by the Company) contain or may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results, and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause the Company’s actual business, prospects, and results of operations to differ materially from the historical information contained in this Annual Report on Form 10-K and from those that may be expressed or implied by the forward-looking statements contained in this Annual Report on Form 10-K and in other reports or public statements made by the Company.

Factors that could cause or contribute to such differences include, among others: the competition currently existing in the automobile insurance markets in California and the other states in which the Company operates; the cyclical and generally competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserves or other estimates; the accuracy and adequacy of the Company’s pricing methodologies; the Company’s success in managing its non-California business; the impact of potential third party “bad-faith” legislation, changes in laws, regulations or new interpretations of existing laws and regulations, tax position challenges by the California Franchise Tax Board (“FTB”), and decisions of courts, regulators and governmental bodies, particularly in California; the Company’s ability to obtain and the timing of required regulatory approvals of premium rate changes for insurance policies issued in states where the Company operates; the Company’s reliance on independent agents to market and distribute its policies; the investment yields the Company is able to obtain on its investments and the market risks associated with the Company’s investment portfolio; the effect government policies may have on market interest rates; uncertainties related to assumptions and projections generally, inflation and changes in economic conditions; changes in driving patterns and loss trends; acts of war and terrorist activities; court decisions, trends in litigation, and health care and auto repair costs; adverse weather conditions or natural disasters, including those which may be related to climate change, in the markets served by the Company; the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives; the Company’s ability to realize deferred tax assets or to hold certain securities with current loss positions to recovery or maturity; and other risks and uncertainties, including but not limited to those discussed in “Risk Factors” in Item 1A of this Annual Report on Form 10-K or that are otherwise described or updated from time to time in the Company’s SEC filings, 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.

From time to time, forward-looking statements are also included in the Company’s quarterly reports on Form 10-Q and current reports on Form 8-K, in press releases, in presentations, on its web site, and in other materials released to the public. 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 Annual Report on Form 10-K or, in the case of any document the Company incorporates by reference, any other report filed with the SEC or any other public statement made by the Company, the date of the document, report or statement. Investors should also understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company’s forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements.

OVERVIEW
A. General
The operating results of property and casualty insurance companies are subject to significant quarter-to-quarter and year-to-year fluctuations due to the effect of competition on pricing, the frequency and severity of losses, the effect of weather and natural disasters on losses, general economic conditions, the general regulatory environment in states in which an insurer operates, state regulation of insurance including premium rates, changes in fair value of investments, and other factors such as changes in tax laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of

28


underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the Company’s ability to grow and retain business.

The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents, 100% owned insurance agents, and direct channels, in thirteen states: Arizona, California, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas, and Virginia. The Company also offers homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. Private passenger automobile lines of insurance accounted for 77.9% of the $2.9 billion of the Company’s direct premiums written in 2014 and 83.3% of the private passenger automobile premiums were written in California. 

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

2014 Financial Performance Summary
The Company’s net income for the year ended December 31, 2014 increased to $177.9 million, or $3.23 per diluted share, from $112.1 million, or $2.04 per diluted share, for the same period in 2013. Included in net income is $125.7 million of pre-tax investment income that was generated during 2014 on a portfolio of $3.4 billion at fair value at December 31, 2014, compared to $124.5 million pre-tax investment income during 2013 on a portfolio of $3.2 billion at fair value at December 31, 2013. Included in net income are net realized investment gains of $81.2 million and losses of $11.4 million in 2014 and 2013, respectively.

During 2014, the Company continued its marketing efforts to enhance name recognition and lead generation. The Company believes that its marketing efforts, combined with its ability to maintain relatively low prices and a strong reputation, make the Company very competitive in California and in other states.

The Company believes its thorough underwriting process gives it an advantage over competitors. The Company’s agent relationships and underwriting and claims processes are its most important competitive advantages.

The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $247 million and $210 million in 2014 and 2013, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.

Economic and Industry Wide Factors
Regulatory Uncertainty—The insurance industry is subject to strict state regulation and oversight and is governed by the laws of each state in which each insurance company operates. State regulators generally have substantial power and authority over insurance companies including, in some states, approving rate changes and rating factors, and establishing minimum capital and surplus requirements. In many states, insurance commissioners may emphasize different agendas or interpret existing regulations differently than previous commissioners. There is no certainty that current or future regulations and the interpretation of those regulations by insurance commissioners and the courts will not have an adverse impact on the Company.
Cost Uncertainty—Because insurance companies pay claims after premiums are collected, the ultimate cost of an insurance policy is not known until well after the policy revenues are earned. Consequently, significant assumptions are made when establishing insurance rates and loss reserves. While insurance companies use sophisticated models and experienced actuaries to assist in setting rates and establishing loss reserves, there can be no assurance that current rates or current reserve estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company’s actuarial analysis indicate that they are needed.
Economic ConditionsMany businesses are still experiencing the effects of uncertain conditions in the global economy and capital markets, reduced consumer spending and confidence, and continued volatility, which could adversely impact the Company’s financial condition, results of operations, and liquidity. Further, the volatility and disruptions in global capital markets could adversely affect the Company’s investment portfolio. Although the disruption in the global financial markets has moderated, not all global financial markets are functioning normally. The Company is unable to predict the impact of current and future global economic conditions on the United States, and California, where the majority of the Company’s business is produced.
Inflation—The largest cost component for automobile insurers is losses, which include medical costs, replacement automobile parts, and labor costs. There can be significant variation in the overall increases in medical cost inflation,

29


and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the inflation rate to be known with a reasonable degree of certainty. Therefore, it can be difficult to establish reserves and set premium rates, particularly when actual inflation rates may be higher or lower than anticipated.
Loss Frequency—Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. There has been a long-term trend of declining loss frequency in the personal automobile insurance industry. However, in recent years, the trend has shown increasing loss frequency, and the Company may not be able to accurately predict the trend of loss frequency in the future.
Underwriting Cycle and Competition—The property and casualty insurance industry is highly cyclical, with alternating hard and soft market conditions. The Company has historically seen significant premium growth during hard markets. The Company believes that the market is mixed with carriers both raising and decreasing rates depending on individual state profitability and the carriers’ growth appetite.

Technology
Agency systems
In 2014, the Company continued to invest in its web-based agency systems by adding new capabilities and enhanced features such as improved motor vehicle and accident matching and reconciliation. Many agents use comparative raters to evaluate products and prices from several insurance carriers, and the Company has completed integrations with the most popular raters for the private passenger automobile and homeowner lines of business.
The Company implemented the Agent Incentive Management commission system during 2014 that has enhanced the efficiency and flexibility of the commission calculation and payment process.
Consumer systems
Consumer web and mobile capabilities continued to expand in 2014. Consumers can now quote, bind and purchase new private passenger automobile policies in eight states, with four additional states deploying in 2015. The Company also launched a new on-line and mobile self-service portal for customers.
Operations systems
Guidewire, a commercially available software solution, was launched in 2010 to replace legacy platforms.  As of December 31, 2014, Guidewire for both homeowners and commercial automobile has been deployed in ten states including California. For private passenger automobile, Guidewire has been deployed in eight states, with four additional states scheduled for launch in 2015. California private passenger automobile is expected be implemented in phases over the next two years beginning with claims processing in 2015.
B. Regulatory and Legal Matters
The process for implementing rate changes varies by state. For more detailed information related to insurance rates approval, see “Item 1. Business—Regulation.”
During 2014, the Company implemented rate changes in thirteen states, including rate decreases for private passenger auto in several states outside of California. In California, the following rate increases were implemented:
In January, a 6.0% rate increase on its preferred private passenger automobile line of business, which represents approximately 51% of the total Company net premiums earned.
In January, a 8.26% rate increase on its homeowners line of business, which represents approximately 10% of the total Company net premiums earned.
In October, a 6.9% rate increase on its standard private passenger automobile line of business, which represents approximately 15% of the total Company net premiums earned.
In April 2010, the California DOI issued a Notice of Non-Compliance (“2010 NNC”) to MIC, MCC, and CAIC based on a Report of Examination of the Rating and Underwriting Practices of these companies issued by the California DOI in February 2010. The 2010 NNC includes allegations of 35 instances of noncompliance with applicable California insurance law and seeks to require that each of MIC, MCC, and CAIC change its rating and underwriting practices to rectify the alleged noncompliance and may also seek monetary penalties. In April 2010, the Company submitted a Statement of Compliance and Notice of Defense to the 2010 NNC, in which it denied the allegations contained in the 2010 NNC and provided specific defenses to each allegation. The Company also requested a hearing in the event that the Statement of Compliance and Notice of Defense does not establish to the satisfaction of the California DOI that the alleged noncompliance does not exist, and the matters described in the 2010 NNC are not otherwise able to be resolved informally with the California DOI. However, no assurance can be given that efforts to resolve the 2010 NNC informally will be successful.

30



In March 2006, the California DOI issued an Amended Notice of Non-Compliance to a Notice of Non-Compliance originally issued in February 2004 (as amended, “2004 NNC”) alleging that the Company charged rates in violation of the California Insurance Code, willfully permitted its agents to charge broker fees in violation of California law, and willfully misrepresented the actual price insurance consumers could expect to pay for insurance by the amount of a fee charged by the consumer’s insurance broker. The California DOI seeks to impose a fine for each policy in which the Company allegedly permitted an agent to charge a broker fee and a penalty for each policy on which the Company allegedly used a misleading advertisement and to suspend certificates of authority for a period of one year. In January 2012, an Administrative Law Judge (“ALJ”) bifurcated the 2004 NNC between (a) the California DOI’s order to show cause, in which the California DOI asserts the false advertising allegations and accusation, and (b) the California DOI’s notice of noncompliance, in which the California DOI asserts the unlawful rate allegations. Following an evidentiary hearing on the noncompliance portion of the 2004 NNC in April 2013, post-hearing briefs and an unsuccessful mediation, the ALJ closed the evidentiary record on April 30, 2014. On December 8, 2014 the ALJ submitted a proposed decision to the California Insurance Commissioner and recommended that it be adopted as the decision of the California Insurance Commissioner. The decision states that from the period July 1, 1996 through 2006, Mercury’s "brokers" were actually operating as "de facto agents" and that the charging of "broker fees" by those producers constituted the charging of "premium" in excess of the Company’s approved rates and assesses a civil penalty in the amount of $27,593,550 against the Company. The California Insurance Commissioner adopted the ALJ's proposed decision on January 7, 2015, and the Company received notice of the California Department of Insurance decision on January 10, 2015.

The Company denies the allegations and/or findings in the 2004 and 2010 NNC matters, and believes that no monetary penalties are warranted, and the Company intends to vigorously defend itself against the allegations including the $27,593,550 assessed fine, unless a reasonable settlement can be reached. Although the Company intends to continue to defend the allegations in the 2004 NNC, it accrued a liability, and incurred a corresponding expense, for the full proposed penalty amount in the 2004 NNC matter in the three month and twelve month periods ended December 31, 2014. Based upon its understanding of the facts and the California Insurance Code, the Company does not expect that the ultimate resolution of the 2004 and 2010 NNC matters will be material to the Company’s financial position. The Company has also accrued a liability for the estimated cost to continue to defend itself in the notice of non-compliance matters.

The Company is, from time to time, named as a defendant in various lawsuits or regulatory actions incidental to its insurance business. The majority of lawsuits brought against the Company relate to insurance claims that arise in the normal course of business and are reserved for through the reserving process. For a discussion of the Company’s reserving methods, see “Critical Accounting Policies and Estimates” and Note 1 of Notes to Consolidated Financial Statements.

The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. For material loss contingencies believed to be reasonably possible, the Company also discloses the nature of the loss contingency and an estimate of the possible loss, range of loss, or a statement that such an estimate cannot be made. While actual losses may differ from the amounts recorded and the ultimate outcome of the Company’s pending actions is generally not yet determinable, the Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows.

In all cases, the Company vigorously defends itself unless a reasonable settlement appears appropriate. For a discussion of legal matters, see Note 16 of Notes to Consolidated Financial Statements—Commitments and Contingencies—Litigation.
C. Critical Accounting Policies and Estimates
Reserves
Preparation of the Company’s consolidated financial statements requires management’s judgment and estimates. The most significant is the estimate of loss reserves. Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim and, therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of a claim, the more variable the ultimate settlement amount could be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.

The Company calculates a loss reserve point estimate rather than a range. There is inherent uncertainty with estimates and this is particularly true with loss reserves estimates. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the regulatory or legal environment, uncertainty over inflation rates, and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it considers them

31


in establishing its reserve by looking at historical patterns and trends and projecting these out to current reserves. The underlying factors and assumptions that serve as the basis for preparing the reserve estimate include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data, and other relevant information.
The Company also engages independent actuarial consultants to review the Company’s reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company does not rely on the actuarial consultants for GAAP reporting or periodic disclosure purposes. The Company analyzes loss reserves quarterly primarily using the incurred loss, claim count development, and average severity methods described below. The Company also uses the paid loss development method as part of its reserve analysis. When deciding among methods to use, the Company evaluates the credibility of each method based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single method. While these methods are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.
 
The incurred loss development method analyzes historical incurred case loss (case reserves plus paid losses) development to estimate ultimate losses. The Company applies development factors against current case incurred losses by accident period to calculate ultimate expected losses. The Company believes that the incurred loss development method provides a reasonable basis for evaluating ultimate losses, particularly in the Company’s larger, more established lines of business which have a long operating history.
The average severity method analyzes historical loss payments and/or incurred losses divided by closed claims and/or total claims to calculate an estimated average cost per claim. From this, the expected ultimate average cost per claim can be estimated. The average severity method coupled with the claim count development method provides meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. The claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts.
The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company uses this method for losses and loss adjustment expenses.

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 similar catastrophes.

There are many factors that can cause variability between the ultimate expected loss and the actual developed loss. While there are certainly other factors, the Company believes that the following three items tend to create the most variability between expected losses and actual losses.
(1) Inflation
For the Company’s California automobile lines of business, total reserves are comprised of the following:
BI reserves—approximately 60% of total reserves
Material damage (MD) reserves, including collision and comprehensive property damage—approximately 20% of total reserves
Loss adjustment expenses reserves—approximately 20% of total reserves.
Loss development on MD reserves is generally insignificant because MD claims are generally settled in a shorter period than BI claims. The majority of the loss adjustment expense reserves are estimated costs to defend BI claims, which tend to require longer periods of time to settle as compared to MD claims.

BI loss reserves are generally the most difficult to estimate because they take longer to close than other coverages. BI coverage in the Company’s policies includes injuries sustained by any person other than the insured, except in the case of uninsured or underinsured motorist BI coverage, which covers damages to the insured for BI caused by uninsured or underinsured motorists. BI payments are primarily for medical costs and general damages.

The following table presents the typical closure patterns of BI claims in the California automobile insurance coverage:

32


 
% of Total
 
Claims Closed
 
Dollars Paid
BI claims closed in the accident year reported
45%
 
14%
BI claims closed one year after the accident year reported
81%
 
57%
BI claims closed two years after the accident year reported
94%
 
81%
BI claims closed three years after the accident year reported
98%
 
94%

BI claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $3,000 to $3,500, on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $9,000 to $10,500. The Company creates incurred and paid loss triangles to estimate ultimate losses utilizing historical payment and reserving patterns and evaluates the results of this analysis against its frequency and severity analysis to establish BI reserves. The Company adjusts development factors to account for inflation trends it sees in loss severity. As a larger proportion of claims from an accident year are settled, there becomes a higher degree of certainty for the reserves established for that accident year. Consequently, there is a decreasing likelihood of reserve development on any particular accident year, as those periods age. At December 31, 2014, the Company believes that the accident years that are most likely to develop are the 2012 through 2014 accident years; however, it is possible that older accident years could develop as well.

In general, the Company expects that historical claims trends will continue with costs tending to increase, which is generally consistent with historical data, and therefore the Company believes that it is reasonable to expect inflation to continue. The Company is experiencing inflation at a rate that is higher than in recent years. Many potential factors can affect the BI inflation rate, including changes in claims handling process, statutes and regulations, the number of litigated files, increased use of medical procedures such as MRIs and epidural injections, general economic factors, timeliness of claims adjudication, vehicle safety, weather patterns, and gasoline prices, among other factors; however, the magnitude of such impact on the inflation rate is unknown.

The Company believes that it is reasonably possible that the California automobile BI severity could vary from recorded amounts by as much as 10%, 5%, and 3% for 2014, 2013, and 2012, respectively. For example, at December 31, 2014, the loss severity for the amounts recorded at December 31, 2013 changed by (3.1)%, (1.3)%, and 0.4% for the 2013, 2012, and 2011 accident years, respectively. Comparatively, at December 31, 2013, the loss severity for the amounts recorded at December 31, 2012 changed by (2.2)%, 2.1%, and 1.4% for the 2012, 2011, and 2010 accident years, respectively. The following table presents the effects on the 2014, 2013, and 2012 accident year California BI loss reserves based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.

California Bodily Injury Inflation Reserve Sensitivity Analysis
 
Accident
Year
 
Number of Claims Expected
 
Actual
Recorded
Severity at
12/31/14
 
Implied
Inflation Rate
Recorded (1)
 
(A) Pro-forma
severity if actual
severity is lower by
10% for 2014,
5% for 2013, and
3% for 2012
 
(B) Pro-forma
severity if actual
severity is higher  by
10% for 2014,
5% for 2013, and
3% for 2012
 
Favorable loss
development if
actual severity is
less than recorded
(Column A)
 
Unfavorable loss
development if
actual severity is
more than recorded
(Column B)
2014
 
30,262

 
$
10,454

 
3.6
%
 
$
9,409

 
$
11,499

 
$
31,624,000

 
$
(31,624,000
)
2013
 
29,385

 
$
10,090

 
4.6
%
 
$
9,586

 
$
10,595

 
$
14,839,000

 
$
(14,810,000
)
2012
 
28,012

 
$
9,650

 
4.1
%
 
$
9,361

 
$
9,940

 
$
8,123,000

 
$
(8,095,000
)
2011
 
27,111

 
$
9,268

 

 

 

 

 

Total Loss Development— Favorable (Unfavorable)
 
 
$
54,586,000

 
$
(54,529,000
)
(1)
Implied inflation rate is calculated by dividing the difference between current and prior year actual recorded severity by the prior year actual recorded severity.
(2) Claim Count Development
The Company generally estimates ultimate claim counts for an accident period based on development of claim counts in prior accident periods. For California automobile BI claims, the Company has experienced that approximately 3% to 5% additional claims will be reported in the year subsequent to an accident year. However, such late reported claims could be more or less than the Company’s expectations. Typically, almost every claim is reported within one year following the end of an accident year and at that point the Company has a high degree of certainty as to what the ultimate claim count will be. 


33


There are many other potential factors that can affect the number of claims reported after a period end. These factors include changes in weather patterns, a change in the number of litigated files, the number of automobiles insured, and whether the last day of the period falls on a weekday or a weekend. However, the Company is unable to determine which, if any, of the factors actually impact the number of claims reported and, if so, by what magnitude.

At December 31, 2014, there were 28,940 BI claims reported for the 2014 accident year and the Company estimates that these are expected to ultimately grow by approximately 5%. The Company believes that while actual development in recent years has ranged between approximately 3% to 5%, it is reasonable to expect that the range could be as great as between 0% and 10%. Actual development may be more or less than the expected range. The following table presents the effect on loss development based on different claim count within the broader possible range at December 31, 2014:
California Bodily Injury Claim Count Reserve Sensitivity Analysis
2014 Accident Year
Claims Reported
 
Amount Recorded
at 12/31/14 at 5%
Claim Count
Development
 
Total Expected
Amount If Claim
Count Development is
0%
 
Total Expected
Amount If Claim
Count Development is
10%
Claim count
28,940

 
30,262

 
28,940

 
31,834

Approximate average cost per claim
Not meaningful

 
$
10,454

 
$
10,454

 
$
10,454

Total dollars
Not meaningful

 
$
316,359,000

 
$
302,539,000

 
$
332,793,000

Total Loss Development—Favorable (Unfavorable)
 
 
$
13,820,000

 
$
(16,434,000
)
(3) Unexpected Losses From Older Accident Periods
Unexpected losses are generally not provided for in the current reserve because they are not known or expected and tend to be unquantifiable. Once known, the Company establishes a provision for the losses, but it is not possible to provide any meaningful sensitivity analysis as to the potential size of any unexpected losses. These losses can be caused by many factors, including unexpected legal interpretations of coverage, ineffective claims handling, regulation extending claims reporting periods, assumption of unexpected or unknown risks, adverse court decisions as well as many unknown factors.

Unexpected losses are fairly infrequent but can have a large impact on the Company’s losses. To mitigate this risk, the Company has established claims handling and review procedures. However, it is still possible that these procedures will not prove entirely effective, and the Company may have material unexpected losses in future periods. It is also possible that the Company has not identified and established a sufficient reserve for all unexpected large losses occurring in the older accident years, even though a comprehensive claims file review was undertaken. The Company may experience additional development on these reserves.
Discussion of losses and loss reserves and prior period loss development at December 31, 2014
At December 31, 2014 and 2013, the Company recorded its point estimate of approximately $1.1 billion and $1.0 billion, respectively, in losses and loss adjustment expense liabilities, which include approximately $440.8 million and $409.2 million, respectively, of IBNR. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2014 and 2013 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 provisions.

The Company evaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires a decrease for previously reported accident years, favorable development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, unfavorable development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For 2014, the Company reported favorable development of approximately $3 million on the 2013 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2013 totaled approximately $1.0 billion. The favorable development in 2014 is primarily from California personal auto lines of business partially offset by adverse development in other states.

During 2014, the Company recorded catastrophe losses of approximately $11 million which were primarily related to winter freeze events on the East Coast in the first quarter and homeowners losses in California from severe rainstorms in December.

Investments

34


The Company’s fixed maturity and equity investments are classified as “trading” and carried at fair value as required when applying the fair value option, with changes in fair value reflected in net realized investment gains or losses in the consolidated statements of operations. The majority of equity holdings, including non-redeemable fund preferred stocks, is actively traded on national exchanges or trading markets, and is valued at the last transaction price on the balance sheet dates.

Fair Value of Financial Instruments
Financial instruments recorded in the consolidated balance sheets include investments, receivables, total return swaps, accounts payable, equity contracts, and secured and unsecured notes payable. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Due to their short-term maturity, the carrying values of receivables and accounts payable approximate their fair market values. All investments are carried on the consolidated balance sheets at fair value, as described in Note 1 of Notes to Consolidated Financial Statements.

The Company’s financial instruments include securities issued by the U.S. government and its agencies, securities issued by states and municipal governments and agencies, certain corporate and other debt securities, equity securities, and exchange traded funds. 99.7% of the fair value of financial instruments held at December 31, 2014 is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary by financial instrument. Observable market prices and pricing parameters of a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.

The Company may hold or acquire financial instruments that lack observable market prices or market parameters because they are less actively traded currently or in future periods. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may involve some degree of judgment. The price transparency of the particular financial instrument will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, 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 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. For a further discussion, see Note 3 of Notes to Consolidated Financial Statements.

Income Taxes
At December 31, 2014, the Company’s deferred income taxes were in a net liability position mainly due to deferred tax liabilities generated by deferred acquisition costs and unrealized gains on securities held. These deferred tax liabilities were substantially offset by deferred tax assets resulting from unearned premiums, expense accruals, loss reserve discounting, and alternative minimum tax credit carryforwards. The Company assesses the likelihood that its deferred tax assets will be realized and, to the extent management does not believe these assets are more likely than not to be realized, a valuation allowance is established. Management’s recoverability assessment of the Company’s deferred tax assets, which are ordinary in character, takes into consideration the Company’s strong history of generating ordinary taxable income and a reasonable expectation that it will continue to generate ordinary taxable income in the future. Further, the Company has the capacity to recoup its ordinary deferred tax assets through tax loss carryback claims for taxes paid in prior years. Finally, the Company has various deferred tax liabilities that represent sources of future ordinary taxable income.
Management’s recoverability assessment with regard to its capital deferred tax assets is based on estimates of anticipated capital gains and tax-planning strategies available to generate future taxable capital gains, each of which would contribute to the realization of deferred tax benefits. The Company has significant unrealized gains in its investment portfolio that could be realized through asset dispositions, at management’s discretion. In addition, the Company expects to hold certain debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a portion of the unrealized loss positions at period-end, are fully realizable at maturity. Management believes its long-term time horizon for holding these securities allows it to avoid any forced sales prior to maturity. Further, the Company has the capability to generate additional realized capital gains by entering into sale-leaseback transactions using one or more of its appreciated real estate holdings.
The Company has the capability to implement tax planning strategies as it has a steady history of generating positive cash flow from operations and believes that its cash flow needs can be met in future periods without the forced sale of its investments.

35


This capability assists management in controlling the timing and amount of realized losses generated during future periods. By prudent utilization of some or all of these strategies, management has the intent and believes that it has the ability to generate capital gains and minimize tax losses in a manner sufficient to avoid losing the benefits of its deferred tax assets. Management will continue to assess the need for a valuation allowance on a quarterly basis. Although realization is not assured, management believes it is more likely than not that the Company’s deferred tax assets will be realized.

The Company’s effective income tax rate can be affected by several factors. These generally include tax exempt investment income, nondeductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate was 28.1% for 2014, compared to 15.1% for 2013. The increase in the effective tax rate is mainly due to an increase in taxable income relative to tax exempt investment income and an increase in nondeductible expenses. The Company’s effective tax rate for the year ended December 31, 2014 was lower than the statutory tax rate primarily as a result of tax exempt investment income earned.

Contingent Liabilities
The Company has known, and may have unknown, potential liabilities which include claims, assessments, lawsuits, or regulatory fines and penalties relating to the Company’s business. The Company continually evaluates these potential liabilities and accrues for them and/or discloses them in the notes to the consolidated financial statements where required. The Company does not believe that the ultimate resolution of currently pending legal or regulatory proceedings, either individually or in the aggregate, will have a material adverse effect on its financial condition, results of operations, or cash flows. See also “Regulatory and Legal Matters” and Note 16 of Notes to Consolidated Financial Statements.

For a discussion of recently issued accounting standards, see Note 1 of Notes to Consolidated Financial Statements.

Premiums
The Company’s insurance premiums are recognized as income ratably over the term of the policies and in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the consolidated balance sheets and are computed monthly on a pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs partially offset by investment income to related unearned premiums. To the extent that any of the Company’s lines of business become unprofitable, a premium deficiency reserve may be required.

RESULTS OF OPERATIONS
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
Revenues
Net premiums written and net premiums earned in 2014 increased 4.1% and 3.6%, respectively, from 2013. The increase in net premiums written was primarily due to higher average premiums per policy arising from rate increases in the California private passenger automobile and homeowners lines of business.

Net premiums written is a non-GAAP financial measure which represents the premiums charged on policies issued during a fiscal period less any applicable reinsurance. Net premiums written is a statutory measure designed to determine production levels. Net premiums earned, the most directly comparable GAAP measure, represents the portion of net premiums written that is recognized as revenue in the financial statements for the period presented and earned on a pro-rata basis over the term of the policies. The following is a reconciliation of total net premiums written to net premiums earned:
 
 
2014
 
2013
 
(Amounts in thousands)
Net premiums written
$
2,840,922

 
$
2,728,999

Change in net unearned premium
(44,727
)
 
(30,812
)
Net premiums earned
$
2,796,195

 
$
2,698,187


Expenses
Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Company’s consolidated loss, expense, and combined ratios determined in accordance with GAAP:

36


 
2014
 
2013
Loss ratio
71.0
%
 
72.7
%
Expense ratio
27.7
%
 
26.9
%
Combined ratio (1)
98.8
%
 
99.6
%
__________
(1) Combined ratio for 2014 does not sum due to rounding.

Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The Company’s loss ratio was affected by favorable development of approximately $3 million and unfavorable development of approximately $3 million on prior accident years’ losses and loss adjustment expense reserves for the years ended December 31, 2014 and 2013, respectively. The favorable development in 2014 was primarily from California personal auto lines of business partially offset by adverse development in other states. The unfavorable development in 2013 was primarily from the Florida private passenger automobile line of business. The 2014 loss ratio was also negatively impacted by a total of $11 million of catastrophe losses mostly due to winter freeze events on the East Coast and homeowners losses in California from severe rainstorms during 2014. The 2013 loss ratio was also negatively impacted by a total of $17 million of catastrophe losses mostly due to tornadoes in Oklahoma and severe storms in the Midwest and Southeast regions during 2013. Excluding the effect of estimated prior periods’ loss development and catastrophe losses, the loss ratio was 70.7% and 72.0% for the years ended December 31, 2014 and 2013, respectively. The Company attributes the improved accident year loss ratio to the impact of rate increases which exceeded underlying loss cost trends in 2014.

Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. The increase in the 2014 expense ratio was affected by the $27.6 million penalty assessed by the California DOI as a result of the California Insurance Commissioner's adoption of a decision by the ALJ in the 2004 NNC. Excluding the effect of the California DOI penalty assessment, the expense ratio was 26.8% for the year ended December 31, 2014.

Combined ratio is equal to loss ratio plus expense ratio and is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; and a combined ratio over 100% generally reflects unprofitable underwriting results.

Income tax expense was $69.5 million and $20.0 million for the years ended December 31, 2014 and 2013, respectively. The increase in income tax expense was mainly due to the increase in underwriting and investment gains.
Investments
The following table presents the investment results of the Company:
 
2014
 
2013
 
(Amounts in thousands)