I. 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, natural disasters, general economic conditions, the general regulatory environment in those states in which an insurer operates, state regulation of premium rates, and other factors such as changes in tax laws. The property and casualty industry has been highly cyclical, with periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. These cycles can have a large impact on the ability of the Company to grow and retain business. Additionally, with the adoption of SFAS No. 159, changes in the fair value of the investment portfolio are reflected in the consolidated statements of operations, which may result in volatility of earnings, particularly in times of high volatility in the capital markets.

The Company utilizes standard industry measures to report operating results that may not be presented in accordance with GAAP. Included within Management's Discussion and Analysis of Financial Condition and Results of Operations are non-GAAP financial measures, net premiums written, which represents the premiums charged on policies issued during a fiscal period less any reinsurance, and operating income, which represents net income excluding realized investment gains and losses, net of tax. These measures are not intended to replace, and should be read in conjunction with, the Company's GAAP financial results and are reconciled to the most directly comparable GAAP measures, net premiums earned and net income, respectively, below in Results of Operations.

B. Operations

The Company generates its revenues through the sale of insurance policies, primarily covering personal automobiles and dwellings through 13 insurance subsidiaries ("Insurance Companies"). These policies are mostly sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling and servicing policies. The Company believes that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent relationships and underwriting process as one of its primary competitive advantages because it allows the Company to charge lower prices yet realize better margins than many competitors. The Company also offers mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. The Company operates primarily in California, the only state in which it operated prior to 1990. The Company has since expanded its operations into the following states: Georgia and Illinois (1990), Oklahoma and Texas (1996), Florida (1998), Virginia and New York (2001), New Jersey
(2003), and Arizona, Pennsylvania, Michigan and Nevada (2004). Direct premiums written during the three-month period ended March 31, 2009 by state and line of business were:

                                                                   Three Months ended March 31, 2009
                                 Private Passenger
                                       Auto               Commercial Auto        Homeowners        Other Lines         Total
                                                                         (Amounts in thousands)
California                      $           446,954      $          22,435      $     46,160      $      13,278      $ 528,827      78.7 %
Florida                                      36,416                  3,485             2,698              1,633         44,232       6.6 %
Texas                                        18,917                  1,921               326              4,072         25,236       3.7 %
New Jersey                                   21,165                     -                 -                  15         21,180       3.2 %
Other states                                 41,037                  1,923             3,400              5,750         52,110       7.8 %

Total                           $           564,489      $          29,764      $     52,584      $      24,748      $ 671,585       100 %

                                               84.1 %                  4.4 %             7.8 %              3.7 %          100 %

The Company also generates income from its investment portfolio. Approximately $37.9 million in pre-tax investment income was generated during the three-month period ended March 31, 2009 on a portfolio of approximately $3.3 billion at cost at March 31, 2009, compared to $39.3 million pre-tax investment income during the corresponding period in 2008 on a portfolio of approximately $3.5 billion at cost at March 31, 2008. The portfolio is managed by Company personnel with a view towards maximizing after-tax yields and limiting interest rate and credit risk.

The Company's operating results have allowed it to consistently generate positive cash flow from operations, which was approximately $50.9 million and $32.2 million for the three-month periods ended March 31, 2009 and 2008, respectively. Cash flow from operations has historically been used to pay shareholder dividends and to help support growth.

Three Months Ended March 31, 2009 compared to Three Months Ended March 31, 2008

A. Revenue and Operating Income

Net premiums earned and net premiums written in the three-month period ended March 31, 2009 decreased approximately 7.6% and 8.0%, respectively, from the corresponding period in 2008. Net premiums written by the Company's California operations were $526.9 million in the three-month period ended March 31, 2009, an 8.5% decrease over the corresponding period in 2008. Net premiums written by the Company's non-California operations were $144.0 million in the three-month period ended March 31, 2009, a 6.3% decrease over the corresponding period in 2008. The decrease in net premiums written is primarily due to a decrease in the number of policies written and slightly lower average premiums per policy reflecting the continuing soft market conditions.

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

                                            Three Months Ended March 31,
                                              2009                 2008
                                                   (in thousands)
         Net premiums written            $      670,892       $      729,266
         Decrease in unearned premiums           (4,829 )             (8,350 )

         Net premiums earned             $      666,063       $      720,916

Operating income for the three-month period ended March 31, 2009 was $46.0 million, down 17.8% from the corresponding period in 2008 largely due to a decrease in premiums earned reflecting the continuing soft market conditions and an increase in other operating expenses.

Operating income is a non-GAAP measure which represents net income excluding realized investment gains and losses, net of tax, and adjustments for other significant non-recurring, infrequent or unusual items. Net income is the GAAP measure that is most directly comparable to operating income. Operating income is meant as supplemental information and is not intended to replace net income. It should be read in conjunction with the GAAP financial results. The following is a reconciliation of operating income to the most directly comparable GAAP measure:

                                                           Three Months Ended March 31,
                                                             2009               2008
                                                                  (in thousands)
Operating income                                        $       45,999    $         55,928
Net realized investment gains (losses), net of tax              50,654             (59,889 )

Net income (loss)                                       $       96,653    $         (3,961 )

B. Profitability

Loss and expense ratios are used to interpret the underwriting experience of
property and casualty insurance companies. The following table reflects the
Insurance Companies' loss ratio, expense ratio and combined ratio determined in
accordance with GAAP:



                                    Three Months ended March 31,
                                      2009                 2008
                 Loss ratio               66.7 %               67.1 %
                 Expense ratio            30.2 %               28.3 %

                 Combined ratio           96.9 %               95.4 %

The loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The loss ratio was affected by positive development of approximately $21 million and $5 million on prior periods' loss reserves for the three-month periods ended March 31, 2009 and 2008, respectively. Excluding the effect of prior accident years' loss development, the loss ratio was 69.9% and 67.8% for the three-month periods ended March 31, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years' loss development is primarily due to lower average premiums earned per policy.

The combined ratio of losses and expenses 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. The Company's underwriting performance contributed $20.8 million and $33.0 million of income to the Company's results of operations before income tax expense and benefit for the three-month periods ended March 31, 2009 and 2008, respectively.

To improve profitability, the Company has implemented several cost reduction programs, including a salary freeze, a suspension of the employee 401(k) matching program, and a workforce reduction of approximately 360 employees (7% of workforce) primarily located in California. As a result of the workforce reduction, an $8 million expense was recorded ($5 million to losses and loss adjustment expenses, $3 million to other operating expenses) in the first quarter of 2009. The annualized cost savings from these cost reduction programs are expected to be over $20 million, which will begin to be realized in the second quarter of 2009.

Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. As AIS is now a wholly-owned subsidiary, commissions paid are no longer deferrable. During the three-month period ended March 31, 2009, the amortization of deferred commissions offset by deferrable direct sales cost impacted the statement of operations by $12 million. The Company expects an additional $3 million impact in the three-month period ended June 30, 2009 and no material impact thereafter.

C. Investments

The following table summarizes the investment results of the Company:



                                                 Three Months ended March 31,
                                                    2009                2008
                                                    (Amounts in thousands)
      Average invested assets at cost
      (includes short-term investments) (1)    $     3,260,106       $ 3,502,001
      Net investment income:
      Before income taxes                      $        37,914       $    39,299
      After income taxes                       $        33,413       $    34,364
      Average annual yield on investments:
      Before income taxes                                  4.7 %             4.5 %
      After income taxes                                   4.1 %             3.9 %
      Net realized investment gains (losses)   $        81,314       $   (92,137 )

(1) Fixed maturities at amortized cost, and equities and short-term investments at cost.

Included in net income (loss) are net realized investment gains of $81.3 million for the three-month period ended March 31, 2009 compared with net realized investment losses of $92.1 million for the three-month period ended March 31, 2008. Net realized investment gains (losses) include gains of $90.7 million for the three-month period ended March 31, 2009 compared with losses of $93.3 million for the three-month period ended March 31, 2008 due to changes in the fair value of total investments measured at fair value pursuant to SFAS No. 159. The gains during the three-month period ended March 31, 2009, primarily in fixed maturity securities, arise from the market value improvements on the Company's fixed maturity securities. During the three-month period ended March 31, 2009, the Company recorded approximately $101.0 million in gains due to changes in the fair value of its fixed maturity portfolio. Partially offsetting this is $10.3 million of loss recognized due to changes in the fair value of its equity security portfolio. The primary cause of the losses in fair value of equity securities was the overall decline in the equity markets, which saw a decline of approximately 11.7% in the S&P 500 Index during the three-month period ended March 31, 2009.

The income tax expense of $43.5 million and income tax benefit of $15.1 million for the three-month periods ended March 31, 2009 and 2008 respectively, resulted primarily from changes in the fair value of the investment portfolio.

A. Cash Flows

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

The Company has generated positive cash flow from operations for over twenty consecutive years. Because of the Company's long track record of positive operating cash flows, it does not attempt to match the duration and timing of asset maturities with those of liabilities. Rather, the Company manages its portfolio with a view towards maximizing total return with an emphasis on after-tax income. With combined cash and short-term investments of $272.9 million at March 31, 2009, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company's sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

Net cash provided from operating activities in the three-month period ended March 31, 2009 was $50.9 million, an increase of $18.7 million over the corresponding period in 2008. This increase was primarily due to additional operating cash flows from AIS and a decrease in losses and loss adjustment expense paid during the three-month period ended March 31, 2009 compared with the corresponding period in 2008. The Company has utilized the cash provided from operating activities primarily for the development of information technology such as the NextGen and Mercury First computer systems and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $76.3 million, were primarily reinvested by the Company in high grade fixed maturity securities.

The following table shows the estimated fair value of fixed maturity securities at March 31, 2009 by contractual maturity in the next five years:

                                                       Fixed maturities
                                                    (Amounts in thousands)
        Due in one year or less                    $                 18,706
        Due after one year through two years                         28,734
        Due after two years through three years                      33,395
        Due after three years through four years                     69,765
        Due after four years through five years                     133,285

                                                   $                283,885

Effective January 1, 2009, the Company acquired AIS for $120 million. The acquisition was financed by a $120 million credit facility that is secured by municipal bonds pledged as collateral. The credit facility calls for the minimum amount of collateral held multiplied by the banks advance rates to be greater than the loan amount. The collateral requirement is calculated as the fair market value of the municipal bonds held as collateral multiplied by the advance rates, which vary based on the credit quality and duration of the assets pledged and range between 75% and 100% of the fair value of each bond. The loan matures on January 1, 2012 with interest payable at a floating rate of LIBOR rate plus 125 basis points. In addition, the Company may be required to pay up to $34.7 million over the next two years as additional consideration for the AIS acquisition. The Company plans to fund that portion of the purchase price, if necessary, from cash on hand and cash flow from operations. On February 6, 2009, the Company entered into an interest rate swap of its floating LIBOR rate on the loan for a fixed rate of 1.93%, resulting in a total fixed rate of 3.18%. The purpose of the swap is to offset the variability of cash flows resulting from the variable interest rate. The swap is not designated as a hedge. Changes in the fair value are adjusted through the consolidated statement of operations in the period of change.

B. Invested Assets

An important component of the Company's financial results is the return on its investment portfolio. The Company's investment strategy emphasizes safety of principal and consistent income generation, within a total return framework. The investment strategy has historically focused on maximizing after-tax yield with a primary emphasis on maintaining a well diversified, investment grade, fixed income portfolio to support the underlying liabilities and achieve return on capital and profitable growth. The Company believes that investment yield is maximized by selecting assets that perform favorably on a long-term basis and by disposing of certain assets to enhance after-tax yield and minimize the potential effect of downgrades and defaults. The Company believes that this strategy

The following table sets forth the composition of the total investment portfolio of the Company at March 31, 2009 and December 31, 2008:

                                                        March 31, 2009      December 31, 2008
                                                                     Fair Value
                                                               (Amounts in thousands)
Fixed maturity securities:
U.S. government bonds and agencies                     $          8,597    $             9,898
States, municipalities and political subdivisions             2,313,858              2,187,668
Mortgage-backed securities                                      177,641                202,326
Corporate securities                                             64,787                 65,727
Redeemable preferred stock                                       20,342                 16,054

                                                              2,585,225              2,481,673

Equity securities:
Common stock:
Public utilities                                                 35,309                 39,148
Banks, trusts and insurance companies                            11,410                 11,328
Industrial and other                                            170,170                186,294
Non-redeemable preferred stock                                    9,018                 10,621

                                                                225,907                247,391


Short-term investments                                           94,085                204,756


Total investments                                      $      2,905,217              2,933,820

During the three-month period ended March 31, 2009, the Company recognized approximately $81.3 million in net realized investment gains, which include approximately $101.4 million related to fixed maturity securities. Included in this gain was $101.0 million gain due to changes in the fair value of the Company's fixed maturity portfolio measured at fair value pursuant to SFAS No. 159 and $0.4 million gain from the sale of fixed maturity securities. Partially offsetting the gains was approximately $23.8 million in losses related to equity securities. Included in this loss was $10.3 million loss due to changes in the fair value of the Company's equity security portfolio measured at fair value pursuant to SFAS No. 159 and $13.5 million loss from the sale of equity securities.

Fixed maturity securities

Fixed maturity securities include debt securities and redeemable preferred stocks. A primary exposure for the fixed maturity securities is interest rate risk. The longer the duration, the more sensitive the asset is to market interest rate fluctuations. As assets with longer maturity dates tend to produce higher current yields, the Company's historical investment philosophy resulted in a portfolio with a moderate duration. The nominal average maturity of the overall bond portfolio, including collateralized mortgage obligations and short-term investments, was 13.3 years at March 31, 2009, which reflects a portfolio heavily weighted in investment grade tax-exempt municipal bonds. Fixed maturity investments purchased by the Company typically have call options attached, which further reduce the duration of the asset as interest rates decline. The call-adjusted average maturity of the overall bond portfolio, including collateralized mortgage obligations and short-term investments, was approximately 9.3 years, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified duration of the overall bond portfolio reflecting anticipated early calls was 6.3 years at March 31, 2009, including collateralized mortgage obligations with modified durations of approximately 1.6 years and short-term investments that carry no duration. Modified duration measures the length of time it takes, on average, to receive the present value of all the cash flows produced by a bond, including reinvestment of interest. As it measures four factors (maturity, coupon rate, yield and call terms), which determine sensitivity to changes in interest rates, modified duration is considered a better indicator of price volatility than simple maturity alone.

Another exposure related to the fixed maturity securities is credit risk, which is managed by maintaining a weighted-average portfolio credit quality rating of AA- (to calculate the weighted-average credit quality ratings as disclosed throughout this Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade). Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At March 31, 2009, bond holdings rated below investment grade and

The following table presents the credit quality rating of the Company's fixed maturity portfolio by types of security at March 31, 2009 at fair value. Credit quality ratings are assigned by nationally recognized securities rating organizations. Credit ratings for the Company's fixed maturity portfolio were stable during the three-month period ended March 31, 2009, with 87% of fixed maturity securities at fair value experiencing no change in their overall rating. Approximately 10% experienced downgrades during the period, offset by approximately 3% in credit upgrades. The majority of the downgrades were slight and still within the investment grade portfolio, allowing the Company to maintain a high overall credit rating on its fixed maturity securities.

                                                                   March 31, 2009
                                         AAA           AA             A            BBB         Non Rated/Other         Total
                                                               (Amounts in thousands)
U.S. government bonds and agencies:
Treasuries                            $   6,318     $      -      $      -      $      -      $              -      $     6,318
Government agency                         2,279            -             -             -                     -            2,279

Total                                     8,597            -             -             -                     -            8,597

                                          100.0 %                                                                         100.0 %
Municipal securities:
. . .