News Column

MERCURY GENERAL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 29, 2014

Cautionary Statements Certain statements in this Quarterly Report on Form 10-Q or in other materials the Company has filed or will file with the Securities and Exchange Commission ("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 Quarterly Report on Form 10-Q and from those that may be expressed or implied by the forward-looking statements contained in this Quarterly Report on Form 10-Q 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 business in non-California states; 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 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 insurance 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 16



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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 uncertainties, all of which are difficult to predict and many of which are beyond the Company's control. GAAP prescribes when the Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q 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. Any forward-looking statements should also be considered in light of the information provided in "Item 1A. Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2013 and in Item 1A. Risk Factors in Part II - Other Information of this Quarterly Report on Form 10-Q. 17



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Table of Contents 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 insurance 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 Company's ability to grow and retain business. 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 condensed consolidated financial statements and notes thereto, and all other items contained within this Quarterly Report on Form 10-Q. B. Business The Company is primarily engaged in writing personal automobile insurance through 13 insurance subsidiaries ("Insurance Companies") in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, and umbrella insurance. These policies are mostly sold through independent agents who receive a commission for selling policies. The Company believes that it has thorough underwriting and claims handling processes that, together with its agent relationships, provide the Company with competitive advantages because they allow the Company to charge lower prices while realizing better margins than many competitors. The direct premiums written during the six months ended June 30, 2014 and 2013 by state and line of business were: Six Months Ended June 30, 2014 (Amounts in thousands) Private Commercial Passenger Auto Homeowners Auto Other Lines Total California $ 927,757$ 144,702$ 32,747$ 40,560$ 1,145,766 80.3 % Florida 66,234 5 12,829 4,103 83,171 5.8 % Other states (1) 121,926 35,496 20,379 19,586 197,387 13.9 % Total $ 1,115,917$ 180,203$ 65,955$ 64,249$ 1,426,324 100.0 % 78.2 % 12.6 % 4.7 % 4.5 % 100.0 % Six Months Ended June 30, 2013 (Amounts in thousands) Private Commercial Passenger Auto Homeowners Auto Other Lines Total California $ 868,887$ 131,033$ 25,566$ 35,285$ 1,060,771 78.1 % Florida 70,546 0 9,259 3,491 83,296 6.1 % Other states (1) 143,553 35,104 13,065 22,485 214,207 15.8 % Total $ 1,082,986$ 166,137$ 47,890 $

61,261 $ 1,358,274 100.0 % 79.8 % 12.2 % 3.5 % 4.5 % 100.0 %



(1) No individual state accounts for more than 5% of total direct premiums written.

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C. Regulatory and Litigation Matters The Department of Insurance ("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. The following table presents a summary of current financial and market conduct examinations: State Exam Type Period Under Review Status CA Financial 2011 to 2013 Fieldwork began in April 2014. GA Financial 2011 to 2013 Fieldwork began in April 2014. FL Financial 2010 to 2013 Fieldwork began in April 2014. IL Financial 2010 to 2013 Fieldwork began in April 2014. TX Financial 2010 to 2013 Fieldwork began in April 2014. CA Market Conduct 2013 to 2014 Fieldwork will begin in August 2014. TX Market Conduct 2013 to 2014 Fieldwork will begin in August 2014. During the course of and at the conclusion of these examinations, the examining DOI generally reports findings to the Company. None of the findings reported to date is expected to be material to the Company's financial position. Effective January 2014, the Company implemented a 6.0% rate increase on its California preferred private passenger automobile line of business, which represents approximately 51% of the total Company net premiums earned. In addition, in January 2014, the Company implemented an 8.26% rate increase on its California homeowners line of business, which represents approximately 10% of the total Company net premiums earned. In April 2010, the California DOI issued a Notice of Non-Compliance ("2010 NNC") to Mercury Insurance Company ("MIC"), Mercury Casualty Company ("MCC"), and California Automobile Insurance Company ("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. 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. In February 2012, the ALJ submitted a proposed decision dismissing the California DOI's 2004 NNC. In March 2012, the California Insurance Commissioner rejected the ALJ's proposed decision. The Company challenged the rejection in Los Angeles Superior Court ("Superior Court") in April 2012. Following a hearing, the Superior Court sustained the California Insurance Commissioner's demurrer without leave to amend because it found the Company must first exhaust its administrative remedies. In January 2013, the Superior Court's decision was affirmed on appeal. In January 2013, the ALJ heard various pending motions that had been filed by the Company in June 2011. The ALJ granted certain portions of the California DOI's motion for collateral estoppel to prevent the Company from litigating certain findings of fact reached in a prior litigation action and denied the Company's motion for governmental estoppel and laches, without prejudice, on the ground that a resolution of the motion requires specific factual findings in the context of the evidentiary hearing. The ALJ held an evidentiary hearing on the noncompliance portion of the 2004 NNC in April 2013. A mediation was held in September 2013, but the parties were unable to reach a settlement of the matter. The Company, the California DOI, and a consumer group filed post-hearing briefs following the April 2013 evidentiary hearing and the ALJ closed the evidentiary record on April 30, 2014. The Company is awaiting notice of the ALJ's decision. Following receipt of the ALJ's decision, the California Insurance Commissioner will issue his final order adopting, rejecting or modifying the ALJ's decision. 19



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The Company denies the allegations in the 2004 and 2010 NNC matters, and believes that no monetary penalties are warranted, and the Company intends to defend itself against the allegations vigorously. The Company has been subject to fines and penalties by the California DOI in the past due to alleged violations of the California Insurance Code. The largest and most recent of these was settled in 2008 for $300,000. However, prior settlement amounts are not necessarily indicative of the potential results in the current notice of non-compliance matters. 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 accrued a liability for the estimated cost 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 the Company's Annual Report on Form 10-K for the year ended December 31, 2013. 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 the Company's Annual Report on Form 10-K for the year ended December 31, 2013. D. 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 also engages an independent actuarial consultant 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 consultant for GAAP reporting or periodic report 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. 20



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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.

At June 30, 2014 and December 31, 2013, the Company recorded its point estimate of approximately $1.05 billion and $1.04 billion, respectively, in losses and loss adjustment expenses liabilities, which include approximately $426 million and $409 million, respectively, of incurred but not reported loss reserves ("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 June 30, 2014, 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 the six months ended June 30, 2014, the Company reported favorable development of approximately $8 million on the 2013 and prior accident years' losses and loss adjustment expenses reserves, which at December 31, 2013 totaled approximately $1.04 billion. The favorable development in 2014 came primarily from California lines of business. For the six months ended June 30, 2014, the Company recorded catastrophe losses of approximately $6 million which were primarily related to winter freeze events on the East Coast. For a further discussion of the Company's reserving methods, see the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Investments 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 3 of Condensed 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. 99.5% of the fair value of financial instruments held at June 30, 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. 21



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Income Taxes At June 30, 2014, the Company's deferred income taxes were in a net liability position materially 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 and other 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 expects to hold certain quantities of debt securities, which are currently in loss positions, to recovery or maturity. Management believes unrealized losses related to these debt securities, which represent a significant 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. The Company also has unrealized gains in its investment portfolio that could be realized through asset dispositions, at management's discretion. 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. 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 for the year could be different from the effective tax rate for the six months ended June 30, 2014 and will be dependent on the Company's profitability for the remainder of the year. The Company's effective income tax rate can be affected by several factors. These generally include tax exempt investment income, other non-deductible expenses, and periodically, non-routine tax items such as adjustments to unrecognized tax benefits related to tax uncertainties. The effective tax rate for the six months ended June 30, 2014 was 29.7%, compared to 13.4% for the same period in 2013. The increase in the effective tax rate is mainly due to an increase in taxable income relative to tax exempt investment income. The Company's effective tax rate for the six months ended June 30, 2014 was lower than the statutory tax rate primarily as a result of tax exempt investment income earned. However, the effective tax rate for the entire year could differ from the rate for the six months ended June 30, 2014. 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 condensed 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. 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 on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs, and maintenance costs 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. 22



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Table of Contents RESULTS OF OPERATIONS Three Months Ended June 30, 2014 compared to Three Months Ended June 30, 2013 Revenue Net premiums written and net premiums earned for the three months ended June 30, 2014 increased 5.0% and 3.3%, respectively, from the corresponding period in 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: Three Months Ended June 30, 2014 2013 (Amounts in thousands) Net premiums written $ 698,759$ 665,479 Change in net unearned premium (870 ) 10,308 Net premiums earned $ 697,889$ 675,787



Expenses

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies' loss ratio, expense ratio, and combined ratio determined in accordance with GAAP: Three Months Ended June 30, 2014 2013 Loss ratio 69.2 % 72.1 % Expense ratio 26.8 % 26.7 % Combined ratio (1) 96.0 % 98.7 % (1) Combined ratio for the three months ended June 30, 2013 does not sum due to rounding. Loss ratio is calculated by dividing losses and loss adjustment expenses by net premiums earned. The 2014 loss ratio includes approximately $2 million of catastrophe losses and approximately $4 million of favorable development on prior accident year reserves. The 2013 loss ratio includes approximately $13 million of catastrophe losses and no reserve development on prior accident year reserves. Excluding the impacts of these items, the loss ratio for the two periods would have been 69.5% and 70.2%, for 2014 and 2013, respectively. Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned and did not materially change for the three months ended June 30, 2014 compared to the same period in 2013. 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 (benefit) was $41.5 million and $(15.7) million for the three months ended June 30, 2014 and 2013, respectively. The increase in income tax expense resulted primarily from net realized investment gains in 2014 compared to the corresponding period in 2013. 23



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Investments

The following table presents the investment results of the Company:

Three Months Ended June 30, 2014 2013 (Amounts in thousands)



Average invested assets at cost (1) $ 3,132,330$ 3,046,790 Net investment income (2) Before income taxes

$ 30,850$ 31,674 After income taxes $ 27,562$ 27,787 Average annual yield on investments (2) Before income taxes 3.9 % 4.2 % After income taxes 3.5 % 3.7 %



Net realized investment gains (losses) $ 76,190$ (67,415 )

(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) Net investment income and average annual yield decreased 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.

Included in net income (loss) are net realized investment gains (losses) of $76.2 million and $(67.4) million for the three months ended June 30, 2014 and 2013, respectively. Net realized investment gains (losses) include gains of $41.4 million and losses of $78.7 million for the three months ended June 30, 2014 and 2013, respectively, due to changes in the fair value of total investments pursuant to the application of the fair value accounting option. Net gains for the three months ended June 30, 2014 arose primarily from $33.0 million and $8.5 million market value increases in the Company's fixed maturity and equity securities, respectively. The Company's municipal bond holdings represent the majority of the fixed maturity portfolio and were positively affected by improvements in the overall municipal bond market during the three months ended June 30, 2014. The primary cause of the increase in the value of the Company's equity securities was the overall improvement in the equity markets during the three months ended June 30, 2014. The net losses for the three months ended June 30, 2013 arose primarily from $59.6 million and $19.0 million market value decreases in the Company's fixed maturity and equity securities, respectively. The Company's municipal bond holdings represent the majority of the fixed maturity portfolio and were adversely affected by the increase in market interest rates during the three months ended June 30, 2013. The primary cause of the decreases in the value of the Company's equity securities was the overall decline in the equity markets during the three months ended June 30, 2013. Net Income Net income (loss) was $95.0 million, or $1.73 per share (basic and diluted), and $(9.3) million, or $(0.17) per share (basic and diluted), in the three months ended June 30, 2014 and 2013, respectively. Diluted per share results were based on a weighted average of 55.0 million and 54.9 million shares for the three months ended June 30, 2014 and 2013, respectively. Included in net income (loss) per share were net realized investment gains (losses), net of income taxes, of $0.90 and $(0.80) per share (basic and diluted) in the three months ended June 30, 2014 and 2013, respectively. Six Months Ended June 30, 2014 compared to Six Months Ended June 30, 2013 Revenue Net premiums written and net premiums earned for the six months ended June 30, 2014 increased 5.0% and 3.2%, respectively, from the corresponding period in 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. The following is a reconciliation of total net premiums written to net premiums earned: Six Months Ended June 30, 2014 2013 (Amounts in thousands) Net premiums written $ 1,423,452$ 1,355,983 Change in net unearned premium (41,862 ) (17,601 ) Net premiums earned $ 1,381,590$ 1,338,382 24



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Expenses

Loss and expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. The following table presents the Insurance Companies' loss ratio, expense ratio, and combined ratio determined in accordance with GAAP: Six Months Ended June 30, 2014 2013 Loss ratio 69.5 % 71.3 % Expense ratio 26.8 % 27.1 % Combined ratio(1) 96.3 % 98.3 % (1) Combined ratio for the six months ended June 30, 2013 does not sum due to rounding. The loss ratio was affected by favorable development of approximately $8 million and $3 million on prior accident years' losses and loss adjustment expenses reserves for the six months ended June 30, 2014 and 2013, respectively. The favorable development in 2014 is primarily from California lines of business. The favorable development in 2013 is primarily from non-California states. The Company also recognized approximately $6 million of catastrophic losses for the six months ended June 30, 2014 related to winter freeze events on the East Coast, and approximately $14 million of catastrophic losses for the six months ended June 30, 2013 as a result of tornadoes in Oklahoma and severe storms in the Midwest and the Southeast region. The improvement in the expense ratio for the six months ended June 30, 2014 was mainly a result of the workforce reduction and operational consolidation that occurred in the first quarter of 2013, which increased the 2013 expense ratio by 0.2 points due to office closure costs and severance related expenses. Income tax expense was $70.9 million and $8.8 million for the six months ended June 30, 2014 and 2013, respectively. The increase resulted primarily from the increased income before income taxes compared to the corresponding period in 2013. Investments The following table presents the investment results of the Company: Six Months Ended June 30, 2014 2013 (Amounts in thousands)



Average invested assets at cost (1) $ 3,097,087$ 3,050,372 Net investment income(2) Before income taxes

$ 61,092$ 62,850 After income taxes $ 54,521$ 55,058 Average annual yield on investments(2) Before income taxes 4.0 % 4.1 % After income taxes 3.5 % 3.6 %



Net realized investment gains (losses) $ 122,902$ (23,365 )

(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) Net investment income and average annual yield decreased 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.

Included in net income are net realized investment gains of $122.9 million and losses of $23.4 million for the six months ended June 30, 2014 and 2013, respectively. Net realized investment gains (losses) include gains of $87.1 million and losses of $35.3 million for the six months ended June 30, 2014 and 2013, respectively, due to changes in the fair value of total investments pursuant to the application of the fair value accounting option. Net gains for the six months ended June 30, 2014 arose primarily from $69.6 million and $17.6 million market value increases in the Company's fixed maturity and equity securities, respectively. The Company's municipal bond holdings represent the majority of the fixed maturity portfolio and were positively affected by improvements in the overall municipal bond market during the six months ended June 30, 2014. The primary cause of the increase in the value of the Company's equity securities was the overall improvement in the equity markets during the six months ended 25



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June 30, 2014. The net losses for the six months ended June 30, 2013 arose primarily from a $70.0 million market value decrease in the Company's fixed maturity securities and offset by a $35.0 million market value increase in its equity securities. The Company's municipal bond holdings represent the majority of the fixed maturity portfolio, which were adversely affected by the increase in interest rates during the six months ended June 30, 2013. The primary cause of the increase in the value of the Company's equity securities was the improvement in the equity markets in the first quarter of 2013. Net Income Net income was $167.6 million, or $3.05 per share (basic and diluted), and $57.2 million, or $1.04 per share (basic and diluted), in the six months ended June 30, 2014 and 2013, respectively. Diluted per share results were based on a weighted average of 55.0 million and 54.9 million shares for the six months ended June 30, 2014 and 2013, respectively. Included in net income per share were net realized investment gains (losses), net of income taxes, of $1.45 and $(0.28) per share (basic and diluted) in the six months ended June 30, 2014 and 2013, respectively. LIQUIDITY AND CAPITAL RESOURCES A. Cash Flows The Company has generated positive cash flow from operations for more than twenty consecutive years and therefore, 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 $487.9 million at June 30, 2014 as well as $70 million of credit available on a $200 million revolving credit facility, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company's liquidity needs. 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 or for future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions. Net cash provided by operating activities in the six months ended June 30, 2014 was $128.4 million, an increase of $31.9 million compared to the corresponding period in 2013. The increase was primarily due to the increased premiums collected and reduced paid losses and loss adjustment expenses, partially offset by increased payment of expenses and income taxes. The Company utilized the cash provided by operating activities primarily for the payment of dividends to its shareholders and for investment. The following table presents the estimated fair value of fixed maturity securities at June 30, 2014 by contractual maturity in the next five years: Fixed Maturities (Amounts in thousands) Due in one year or less $ 51,116 Due after one year through two years 91,882 Due after two years through three years 76,753 Due after three years through four years 110,719 Due after four years through five years 58,260 Total due within five years $ 388,730 B. Reinsurance The Company's Catastrophe Reinsurance Treaty ("Treaty") was renewed for one year beginning July 1, 2014. 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. 26



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C. Invested Assets 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 continues to believe that this strategy enables the optimal investment performance necessary to sustain investment income over time. The Company's portfolio management approach utilizes a market risk and consistent 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 presents the composition of the total investment portfolio of the Company at June 30, 2014: Cost (1) Fair Value (Amounts in thousands) Fixed maturity securities: U.S. government bonds and agencies $ 15,884$ 15,993 Municipal securities 2,254,085 2,353,566 Mortgage-backed securities 36,356 38,817 Corporate securities 291,068 296,252 2,597,393 2,704,628 Equity securities: Common stock: Public utilities 90,983 101,347 Banks, trusts and insurance companies 6,574 8,415 Energy and other 243,337 304,649 Non-redeemable preferred stock 29,057 28,165



Partnership interest in a private credit fund 10,000 12,966

379,951 455,542 Short-term investments 229,665 229,412 Total investments $ 3,207,009$ 3,389,582



(1) Fixed maturities and short-term bonds at amortized cost; and equities and

other short-term investments at cost.

At June 30, 2014, 69.2% of the Company's total investment portfolio at fair value and 86.7% of its total fixed maturity investments at fair value were invested in tax-exempt state and municipal bonds. Equity holdings consist of non-redeemable preferred stocks, dividend-bearing common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. At June 30, 2014, 63.1% of short-term investments consisted of highly rated short-duration securities redeemable on a daily or weekly basis. The Company does not have any direct equity investment in sub-prime lenders. During the six months ended June 30, 2014, the Company recognized $122.9 million in net realized investment gains, which included gains of $53.2 million related to equity securities and $66.2 million related to fixed maturity securities. Included in the gains were $69.6 million and $17.6 million in gains due to changes in the fair value of the Company's fixed maturity and equity security portfolios, respectively, as a result of applying the fair value accounting option. During the six months ended June 30, 2013, the Company recognized $23.4 million in net realized investment losses, which included gains of $47.0 million related to equity securities and losses of $70.8 million related to fixed maturity securities. Included in the gains and losses were $35.0 million in gains due to changes in the fair value of the Company's equity security portfolio and $70.0 million in losses due to changes in the fair value of the Company's fixed maturity security portfolio as a result of applying the fair value option. 27



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Fixed maturity securities and short-term investments Fixed maturity securities include debt securities, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of the Company's asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, tax planning considerations, or other economic factors. Short-term investments include money market accounts, options, and short-term bonds that are highly rated short duration securities and redeemable within one year. 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 has resulted in a portfolio with a moderate duration. The nominal average maturities of the overall bond portfolio were 12.7 years and 13.3 years (both were 12.1 years when including short-term instruments) at June 30, 2014 and December 31, 2013, respectively. The portfolio is 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 maturities of the overall bond portfolio were 3.7 years and 5.2 years (3.5 years and 4.7 years when including short-term instruments) at June 30, 2014 and December 31, 2013, respectively, related to holdings which are heavily weighted with high coupon issues that are expected to be called prior to maturity. The modified durations of the overall bond portfolio reflecting anticipated early calls were 3.0 years and 3.9 years (2.8 years and 3.6 years when including short-term instruments) at June 30, 2014 and December 31, 2013, respectively, including collateralized mortgage obligations with a modified duration of 2.4 years and 2.3 years at June 30, 2014 and December 31, 2013, respectively, and short-term bonds 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 rate, 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 A+, at fair value, at June 30, 2014, compared to AA-, at fair value, at December 31, 2013. The small decrease in the weighted-average rating of the Company's fixed maturity portfolio was a result of the maturation of certain AAA rated bonds that were replaced with lower rated investment grade bonds. To calculate the weighted-average credit quality ratings as disclosed throughout this Quarterly Report on Form 10-Q, individual securities were weighted based on fair value and a credit quality numeric score that was assigned to each rating grade. Tax-exempt bond holdings are broadly diversified geographically. Taxable holdings consist principally of investment grade issues. At June 30, 2014, fixed maturity holdings rated below investment grade and non-rated bonds totaled $44.2 million and $5.8 million, respectively, at fair value, and represented 1.6% and 0.2%, respectively, of total fixed maturity securities. At December 31, 2013, fixed maturity holdings rated below investment grade and non-rated bonds totaled $35.0 million and $13.1 million, respectively, at fair value, and represented 1.4% and 0.5%, respectively, of total fixed maturity securities. The following table presents the credit quality ratings of the Company's fixed maturity portfolio by security type at June 30, 2014 at fair value. The Company's estimated credit quality ratings are based on the average of ratings assigned by nationally recognized securities rating organizations. Credit ratings for the Company's fixed maturity portfolio were stable during the six months ended June 30, 2014, with 93.4% of fixed maturity securities at fair value experiencing no change in their overall rating. 5.3% of fixed maturity securities at fair value experienced upgrades during the period, partially offset by 1.3% in credit downgrades. A majority of the downgrades were slight and still within the investment grade portfolio. 28



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Table of Contents June 30, 2014 (Amounts in thousands) Total Fair AAA AA(1) A(1) BBB(1) Non-Rated/Other Value U.S. government bonds and agencies: Treasuries $ 14,709$ 0 $ 0 $ 0 $ 0 $ 14,709 Government agency 1,284 0 0 0 0 1,284 Total 15,993 0 0 0 0 15,993 100.0 % 100.0 % Municipal securities: Insured 6,728 442,317 579,516 18,615 15,448 1,062,624 Uninsured 233,654 367,578 507,103 178,728 3,879 1,290,942 Total 240,382 809,895 1,086,619 197,343 19,327 2,353,566 10.2 % 34.4 % 46.2 % 8.4 % 0.8 % 100.0 % Mortgage-backed securities: Commercial 0 0 11,413 10,428 0 21,841 Agencies 6,203 0 0 0 0 6,203 Non-agencies: Prime 16 422 653 0 3,021 4,112 Alt-A 0 17 1,386 0 5,258 6,661 Total 6,219 439 13,452 10,428 8,279 38,817 16.0 % 1.1 % 34.7 % 26.9 % 21.3 % 100.0 % Corporate securities: Communications 0 0 5,993 0 0 5,993 Consumer-cyclical 0 0 5,121 5,578 0 10,699 Consumer-non-cyclical 0 0 0 17,172 0 17,172 Industrial 0 0 0 9,981 5,936 15,917 Energy 0 0 0 83,105 5,074 88,179 Basic materials 0 0 0 16,749 0 16,749 Financial 0 13,317 35,374 66,285 7,823 122,799 Technology 0 0 0 10,942 3,574 14,516 Utilities 0 0 2,048 2,180 0 4,228 Total 0 13,317 48,536 211,992 22,407 296,252 0.0 % 4.4 % 16.4 % 71.6 % 7.6 % 100.0 % Total $ 262,594$ 823,651$ 1,148,607$ 419,763$ 50,013$ 2,704,628 9.7 % 30.5 % 42.5 % 15.5 % 1.8 % 100.0 %



(1) Intermediate ratings are offered at each level (e.g., AA includes AA+, AA

and AA-).

At June 30, 2014, the Company had $22.2 million, 0.8% of its fixed maturity portfolio, at fair value, in U.S. government bonds and agencies and mortgage-backed securities (Agencies). In August 2011, Standard and Poor's downgraded the U.S. government's long-term sovereign credit rating from AAA to AA+. This downgrade triggered significant volatility in prices for a variety of investments. While Moody's and Fitch affirmed their AAA ratings, they placed a negative outlook in November 2011 and warned of a potential downgrade if no long-term deficit agreement was reached over the next two years. In 2013, while Moody's and S&P affirmed AAA and AA+ ratings, respectively, with a stable outlook, Fitch warned of a potential downgrade from AAA if the debt limit was not raised in time. In March 2014, Fitch affirmed its AAA rating with a stable outlook after the February suspension of the U.S. federal debt limit in a timely manner. These rating agencies' concerns indicate declining confidence that timely fiscal measures will be forthcoming to place U.S. public finances on a sustainable path and secure the AAA ratings. Standard and Poor's affirmed the U.S. Treasury's short-term credit rating of AAA indicating that the short-term capacity of the U.S. to meet its financial commitment on its outstanding obligations is strong. The Company understands that market participants continue to use rates of return on U.S. government debt as a risk-free rate and have continued to invest in U.S. Treasury securities. 29



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Table of Contents (1) Municipal Securities The Company had $2.4 billion at fair value ($2.3 billion at amortized cost) in municipal bonds at June 30, 2014, of which $1.1 billion were insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was A+ at June 30, 2014. At June 30, 2014, the bond insurers providing credit enhancement were Assured Guaranty Corporation, Berkshire Hathaway Assurance Corporation, and National Public Finance Guarantee Corporation, which covered approximately 49.6% of the insured municipal securities. The average rating of the Company's municipal bonds insured by these bond insurers was A+, with an underlying rating of A. Most of the insured bonds' ratings were investment grade and reflected the credit of the underlying issuers. 8.3% of the remaining insured bonds are non-rated or below investment grade, and the Company does not believe that these insurers provide credit enhancement to the municipal bonds that they insure. The Company considers the strength of the underlying credit as a buffer against potential market value declines which may result from future rating downgrades of the bond insurers. In addition, the Company has a long-term time horizon for its municipal bond holdings which generally allows it to recover the full principal amounts upon maturity and avoid forced sales prior to maturity of bonds that have declined in market value due to the bond insurers' rating downgrades. Based on the uncertainty surrounding the financial condition of these insurers, it is possible that there will be additional downgrades to below investment grade ratings by the rating agencies in the future, and such downgrades could impact the estimated fair value of municipal bonds. (2) Mortgage-Backed Securities The mortgage-backed securities portfolio is categorized as loans to "prime" borrowers except for $6.7 million and $7.0 million ($5.9 million and $6.3 million at amortized cost) of Alt-A mortgages at June 30, 2014 and December 31, 2013, respectively. Alt-A mortgage backed securities are at fixed or variable rates and include certain securities that are collateralized by residential mortgage loans issued to borrowers with credit profiles stronger than those of sub-prime borrowers, but do not qualify for prime financing terms due to high loan-to-value ratios or limited supporting documentation. The Company had holdings of $21.8 million and $21.9 million ($21.6 million and $21.8 million at amortized cost) in commercial mortgage-backed securities at June 30, 2014 and December 31, 2013, respectively. The weighted-average rating of the Company's Alt-A mortgage-backed securities was B+ and the weighted-average rating of the entire mortgage-backed securities portfolio was BBB+ at June 30, 2014. (3) Corporate Securities Included in fixed maturity securities are $296.3 million and $264.7 million of corporate securities, which had durations of 2.4 years and 3.4 years, at June 30, 2014 and December 31, 2013, respectively. The weighted-average rating was BBB as of June 30, 2014 and December 31, 2013. Equity securities Equity holdings consist of non-redeemable preferred stocks, common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction, and a partnership interest in a private credit fund. The net gains due to changes in fair value of the Company's equity portfolio during the six months ended June 30, 2014 were $17.6 million. The primary cause of the increase in the value of the Company's equity securities was the overall improvement in the equity markets. The Company's common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At June 30, 2014, 13.4% of the total investment portfolio at fair value was held in equity securities, compared to 8.9% at December 31, 2013. 30



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D. Debt Notes payable consists of the following: Lender Interest Rate Expiration June 30,



2014 December 31, 2013

(Amounts in thousands) Secured credit Bank of LIBOR plus 40 facility America basis points July 31, 2016 $ 120,000 $ 120,000 LIBOR plus 40 Secured loan Union Bank basis points January 2, 2015 20,000 20,000 Unsecured Bank of credit America and facility Union Bank (1) June 30, 2018 130,000 50,000 Total $ 270,000 $ 190,000 (1) On July 2, 2013, the Company entered into an unsecured $200 million five-year revolving credit facility. The interest rate on borrowings under the credit facility is based on the Company's debt to total capital ratio and ranges from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is above 25%. Commitment fees for the undrawn portion of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is above 25%. During the six months ended June 30, 2014, the interest rate was LIBOR plus 112.5 basis points on the $130 million of borrowings and 12.5 basis points on the undrawn portion of the credit facility. The bank loan and credit facilities contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk based capital ratio. The Company was in compliance with all of its loan covenants at June 30, 2014. E. Regulatory Capital Requirement Among other considerations, industry and regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to statutory policyholders' surplus should not exceed 3.0 to 1. Based on the combined surplus of all the Insurance Companies of $1.5 billion at June 30, 2014, and net premiums written for the twelve months ended on that date of $2.8 billion, the ratio of premiums written to surplus was 1.9 to 1.


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