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 is a non-GAAP financial measure, net premiums written, which represents the premiums charged on policies issued during a fiscal period less any reinsurance. The measure is not intended to replace, and should be read in conjunction with, the Company's GAAP financial results and is reconciled to the most directly comparable GAAP measure, net premiums earned, below in Results of Operations.

B. Operations

The Company generates its revenues through the issuance of insurance policies, primarily covering personal automobiles and dwellings through 13 insurance subsidiaries ("Insurance Companies"). The Company also offers mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. These policies are mostly sold through independent agents and brokers who receive a commission averaging 17% of net premiums written for selling 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 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 six-month period ended June 30, 2009 by state and line of business were:

                                                                  Six Months ended June 30, 2009
                                  Private Passenger        Commercial                          Other
                                        Auto                  Auto           Homeowners        Lines           Total
                                                                      (Amounts in thousands)
California                       $           863,279      $     36,481      $    101,201      $ 26,549      $ 1,027,510      78.5 %
Florida                                       70,169             7,535             6,986         3,208           87,898       6.7 %
Texas                                         35,977             3,716               791         8,376           48,860       3.7 %
New Jersey                                    40,467                -                 -             48           40,515       3.1 %
Other states                                  81,000             3,764             8,171        12,161          105,096       8.0 %

Total                            $         1,090,892      $     51,496      $    117,149      $ 50,342      $ 1,309,879       100 %

                                                83.3 %             3.9 %             9.0 %         3.8 %            100 %

The Company also generates income from its investment portfolio. Approximately $74.1 million in pre-tax investment income was generated during the six-month period ended June 30, 2009 on average investments of approximately $3.2 billion, at cost, for the six-month period ended June 30, 2009, compared to $78.3 million pre-tax investment income during the corresponding period in 2008 on average investments of approximately $3.5 billion, at cost, for the six-month period ended June 30, 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 $106.4 million and $12.9 million for the six-month periods ended June 30, 2009 and 2008, respectively. Cash flow from operations has historically been used to pay shareholder dividends and to help support growth.

Three Months Ended June 30, 2009 compared to Three Months Ended June 30, 2008

A. Revenue

Net premiums earned and net premiums written for the three-month period ended June 30, 2009 decreased approximately 7.3% and 6.8%, respectively, from 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 June 30,
                                                 2009               2008
                                                      (in thousands)
        Net premiums written                $       637,405    $       684,177
        Decrease in net unearned premiums            21,806             27,027

        Net premiums earned                 $       659,211    $       711,204

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 June 30,
                                     2009                 2008
                 Loss ratio             67.6 %               68.8 %
                 Expense ratio          28.5 %               28.2 %

                 Combined ratio         96.1 %               97.0 %

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 $31 million and adverse development of approximately $9 million on prior periods' loss reserves for the three-month periods ended June 30, 2009 and 2008, respectively. Excluding the effect of prior accident years' loss development, the loss ratio was 72.3% and 67.6% for the three-month periods ended June 30, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years' loss development is primarily due to increased loss severity and lower average premiums earned per policy, partially offset by lower loss frequency.

The expense ratio is determined by matching expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The expense ratio slightly increased primarily due to the impact of the amortization of AIS deferred commissions, which is described below.

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 approximately $26 million of income (approximately $5 million of loss when excluding prior accident periods reserve development) and approximately $21 million of income (approximately $30 million of income when excluding prior accident periods reserve development) to the Company's results of operations before income tax expense for the three-month periods ended June 30, 2009 and 2008, respectively.

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 June 30, 2009, the amortization of deferred commissions offset by deferrable direct sales cost impacted the statement of operations by $3 million. The Company expects no material impact after June 30, 2009.

C. Investments

The following table summarizes the investment results of the Company:



                                                Three Months ended June 30,
                                                   2009               2008
                                                   (Amounts in thousands)
       Average invested assets at cost (1)    $    3,195,308       $ 3,455,387
       Net investment income:
       Before income taxes                    $       36,212       $    38,995
       After income taxes                     $       32,557       $    34,441
       Average annual yield on investments:
       Before income taxes                               4.5 %             4.5 %
       After income taxes                                4.1 %             4.0 %
       Net realized investment gains          $       99,862       $    36,496

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

Included in net income are net realized investment gains of $99.9 million for the three-month period ended June 30, 2009 compared with net realized investment gains of $36.5 million for the three-month period ended June 30, 2008. Net realized investment gains include gains of $123.6 million for the three-month period ended June 30, 2009 due to changes in the fair value of total investments measured at fair value pursuant to SFAS No. 159 compared with $22.6 million for the three-month period ended June 30, 2008. The gains during the three-month period ended June 30, 2009 arise from the market value improvements on the Company's fixed maturity and equity securities. During the three-month period ended June 30, 2009, the Company recorded approximately $46.4 million and $77.2 million in gains due to changes in the fair value of its fixed maturity portfolio and equity portfolio, respectively. The primary cause of the significant gains in fair value of equity securities was the overall improvement in the equity markets, which saw a growth of approximately 15.2% in the S&P 500 Index during the three-month period ended June 30, 2009.

The income tax expenses for the three-month periods ended June 30, 2009 and 2008 were $46.5 million and $25.5 million, respectively. The increase resulted primarily from changes in the fair value of the investment portfolio.

Six Months Ended June 30, 2009 compared to Six Months Ended June 30, 2008

A. Revenue

Net premiums earned and net premiums written in the six-month period ended June 30, 2009 decreased approximately 7.5% and 7.4%, respectively, from 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:

                                                Six Months Ended June 30,
                                                   2009            2008
                                                     (in thousands)
          Net premiums written                $    1,308,297    $ 1,413,443
          Decrease in net unearned premiums           16,977         18,677

          Net premiums earned                 $    1,325,274    $ 1,432,120

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:



                                     Six Months ended June 30,
                                       2009              2008
                  Loss ratio               67.2 %            67.9 %
                  Expense ratio            29.3 %            28.3 %

                  Combined ratio           96.5 %            96.2 %

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 $38 million and adverse development of approximately $17 million on prior periods' loss reserves for the six-month periods ended June 30, 2009 and 2008, respectively. Excluding the effect of prior accident years' loss development, the loss ratio was 70.0% and 66.8% for the six-month periods ended June 30, 2009 and 2008, respectively. The increase in the loss ratio excluding the effect of prior accident years' loss development is primarily due to increased loss severity and lower average premiums earned per policy, partially offset by lower loss frequency.

The expense ratio is determined by matching expenses to the period over which net premiums were earned, rather than to the period that net premiums were written. The expense ratio increased primarily due to an accrual for a reduction in workforce during the three-month period ended March 31, 2009 and the impact of the amortization of AIS deferred commissions, both of which are described below.

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 approximately $47 million of income (approximately $9 million of income when excluding prior accident periods reserve development) and approximately $54 million of income (approximately $71 million of income when excluding prior accident periods reserve development) to the Company's results of operations before income tax expense for the six-month periods ended June 30, 2009 and 2008, respectively.

To improve profitability, during the three-month period ended March 31, 2009, the Company 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) during the three-month period ended March 31, 2009. The annualized cost savings from these cost reduction programs are expected to be over $20 million, which began to be realized in the three-month period ended June 30, 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 six-month period ended June 30, 2009, the amortization of deferred commissions offset by deferrable direct sales cost impacted the statement of operations by $15 million. The Company expects no material impact after June 30, 2009.

C. Investments

The following table summarizes the investment results of the Company:



                                                  Six Months ended June 30,
                                                    2009              2008
                                                    (Amounts in thousands)
       Average invested assets at cost (1)      $   3,229,138      $ 3,480,177
       Net investment income:
       Before income taxes                      $      74,126      $    78,294
       After income taxes                       $      65,970      $    68,805
       Average annual yield on investments:
       Before income taxes                                4.6 %            4.5 %
       After income taxes                                 4.1 %            4.0 %
       Net realized investment gains (losses)   $     181,176      $   (55,641 )

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

The income tax expenses for the six-month periods ended June 30, 2009 and 2008 were $89.9 million and $10.4 million, respectively. The increase resulted primarily from changes in the fair value of the investment portfolio.

III. Liquidity and Capital Resources

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 $289.3 million at June 30, 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 six-month period ended June 30, 2009 was $106.4 million, an increase of $93.4 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 expenses paid during the six-month period ended June 30, 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 $235.0 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 June 30, 2009 by contractual maturity in the next five years:

                                                       Fixed maturities
                                                    (Amounts in thousands)
        Due in one year or less                    $                 24,177
        Due after one year through two years                         22,692
        Due after two years through three years                      31,258
        Due after three years through four years                     86,783
        Due after four years through five years                     139,509

                                                   $                304,419

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 held as collateral. The credit facility calls for the collateral requirement 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 held 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.

Portfolio Composition

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

The following table sets forth the composition of the total investment portfolio of the Company at June 30, 2009 and December 31, 2008:

                                                June 30, 2009               December 31, 2008
                                           Cost (1)      Fair Value      Cost (1)      Fair Value
                                                           (Amounts in thousands)
Fixed maturity securities:
U.S. government bonds and agencies        $     9,922    $    10,099    $     9,633    $     9,898
States, municipalities and political
subdivisions                                2,409,548      2,346,427      2,370,879      2,187,668
Mortgage-backed securities                    162,166        148,167        216,483        202,326
Corporate securities                           93,251         86,281         77,097         65,727
Redeemable preferred stock                     49,288         33,838         54,379         16,054

                                            2,724,175      2,624,812      2,728,471      2,481,673

Equity securities:
Common stock:
Public utilities                               30,223         35,726         32,293         39,148
Banks, trusts and insurance companies          19,316         13,291         20,451         11,328
Industrial and other                          277,747        197,922        330,030        186,294
Non-redeemable preferred stock                 20,999         11,874         20,999         10,621

                                              348,285        258,813        403,773        247,391

Short-term investments                         94,574         94,557        208,278        204,756

Total investments                         $ 3,167,034    $ 2,978,182      3,340,522      2,933,820

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

. . .