SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarter Ended September 30, 2006March 31, 2007

Commission File No. 001-12257

MERCURY GENERAL CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’sRegistrant's telephone number, including area code:

(323) 937-1060

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨Non-accelerated filer  ¨

Indicate by check mark whether the Registrant is a shell company (as defined in the Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At October 31, 2006,April 30, 2007, the Registrant had issued and outstanding an aggregate of 54,685,49154,683,676 shares of its Common Stock.

PART 1 - 1—FINANCIAL INFORMATION

Item 1. Financial Statements

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

Amounts expressed in thousands, except share data

ASSETS

See accompanying Notesnotes to the Consolidated Financial Statements.consolidated financial statements.

2

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

Three Months Ended September 30,March 31,

Amounts expressed in thousands, except share and per share data

See accompanying Notesnotes to the Consolidated Financial Statements.consolidated financial statements.

3

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

Nine Months Ended September 30,

Amounts expressed in thousands, except share and per share data

See accompanying Notes to the Consolidated Financial Statements.

4

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

Three Months Ended September 30,March 31,

Amounts expressed in thousands

See accompanying Notesnotes to the Consolidated Financial Statements.consolidated financial statements.

5

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

Nine Months Ended September 30,

Amounts expressed in thousands

See accompanying Notes to the Consolidated Financial Statements.

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MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

NineThree Months Ended September 30,March 31,

Amounts expressed in thousands

(Continued)

75

MERCURY GENERAL CORPORATION

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Continued)

See accompanying Notesnotes to the Consolidated Financial Statements.consolidated financial statements.

86

MERCURY GENERAL CORPORATION & SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

The preparation of financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant assumptions in the preparation of these consolidated financial statements relate to losses and loss adjustment expenses. Actual results could differ materially from those estimates (See Note 1 “Significant Accounting Policies” of Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005)2006).

The financial data of Mercury General Corporation and its subsidiaries (collectively, the “Company”), included herein hashave been prepared without audit. In the opinion of management, all material adjustments of a normal recurring nature necessary to present fairly the Company’s financial position at September 30, 2006March 31, 2007 and the results of operations, comprehensive income and cash flows for the periods presented have been made. Operating results for the three and nine months ended September 30, 2006 and cash flows for the ninethree months ended September 30, 2006March 31, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.2007.

Certain reclassifications have been made to the prior-period balances to conform to the current-period presentation.

Effective January 1, 2007, the Company adopted the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 provides guidance on financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return related to uncertainties in income taxes. FIN No. 48 prescribes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement is recognized in the financial statements. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company’s adoption of FIN No. 48 did not have a material impact on its consolidated financial statements.

Effective January 1, 2007, the Company adopted the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts other than those already described in Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company’s adoption of SOP 05-1 did not have a material impact on its consolidated financial statements.

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MERCURY GENERAL CORPORATION & SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Effective January 1, 2007, the Company adopted SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140.” The provisions of SFAS No. 155 are effective for all financial instruments acquired or issued after the beginning of the first fiscal year after September 15, 2006. SFAS No. 155 amends the accounting for hybrid financial instruments and eliminates the exclusion of beneficial interests in securitized financial assets from the guidance under SFAS No.133, “Accounting for Derivative Instruments and Hedging Activities.” It also eliminates the prohibition on the type of derivative instruments that qualified special purpose entities may hold under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” Furthermore, SFAS No. 155 clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. The Company’s adoption of SFAS No. 155 did not have a material impact on its consolidated financial statements.

The Company monitors investments that have declined in fair value below net book value and if the decline is judged to be other-than-temporary, the asset is written down to its fair value in accordance with Statement of Financial Accounting Standards No. 115, as amended, “Accounting for Certain Investments in Debt and Equity Securities.” The Company wrote down approximately $0.4 million ($0.3 million after tax) and $0.9 million ($0.6 million after tax) of its investments as other-than-temporary declines during the first three months of 2007 and 2006, respectively.

Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), using the modified prospective transition method and therefore has not restated results for prior periods.method. Under this transition method, stock-basedshare-based compensation expense for the nine months ended September 30, 2006 includes compensation expense for all stock-basedshare-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Stock-based compensation expense for all stock-based compensation awards granted after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of generally five years for stock options. Prior to the adoption of SFAS No. 123R, the Company recognized stock-based compensation expense in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). In March 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB No. 107”), regarding the SEC’s interpretation of SFAS No. 123R and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123R.

The Company monitors investments that have declined in fair value below net book value and if the decline is judged to be other-than-temporary, the asset is written down to fair value in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.Compensation.” The Company wrote down approximately $2.0 million ($1.3 million after tax) and $2.2 million ($1.4 million after tax) of its investments as other-than-temporary declines during the first nine months of 2006 and 2005, respectively.

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MERCURY GENERAL CORPORATION & SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

At September 30, 2006, the Company maintains an equity incentive award plan that was adopted in 2005 which succeeded a plan adopted in 1995. Under each plan, 5,400,000 shares of Common Stock were authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. As of September 30, 2006, only options and restricted stock awards have been granted under these plans. Options granted for which the Company has recognized stock-based compensation expense generally become exercisable 20% per year beginning one year from the date granted, are granted at the market price on the date of grant, and expire after 10 years.

On May 5, 2006, the Company’s Compensation Committee approved the grant of 17,385 shares of restricted stock under the equity incentive award plan adopted in 2005. The restricted stock vests in four equal installments of 25% on the first four anniversaries of the grant date. All of the 17,385 shares of the restricted stock were cancelled as of October 30, 2006 following the resignation of the Company’s officer previously awarded with the shares.

Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement provisions of APB No. 25. The Company provided pro forma disclosure amounts in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS No. 148”), as if the fair value method defined by SFAS No. 123 had been applied to its stock-based compensation. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123R, using the modified prospective transition method and therefore has not restated prior periods’ results. Under this transition method, stock-based compensation expense for the first nine months of fiscal 2006 included compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123. Stock-basedShare-based compensation expense for all share-based payment awards granted or modified on or after January 1, 2006 is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. The Company recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is the option vesting term of generally five years, for only those shares expected to vest.

As a result of adopting SFAS No. 123R, the Company recognized stock-based compensation expense of $323,000 and $894,000 for the quarter and nine months ended September 30, 2006, respectively. The adoption of SFAS No. 123R had an impact of $0.01 and $0.02 on the reported basic and diluted earnings per share for the quarter and nine months ended September 30, 2006, respectively. Had the Company applied the fair value recognition provisions of SFAS No. 123stock option awards is estimated using the Black-Scholes option pricing model with the grant-date assumptions and weighted-average fair values.

The Company and its subsidiaries file income tax returns in the nineU.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2003 through 2006 for federal taxes and 2001 through 2006 for California state taxes.

The total amount of unrecognized tax benefits at implementation of FIN No. 48 as of January 1, 2007, excluding consideration of expected offsetting federal tax benefits and accrued interest expense, was $7,382,000. Of this total, $2,266,000, net of federal tax benefit and including interest expense, represents exposures which, if recognized, would affect the Company's effective tax rate.

The Company does not expect any changes in unrecognized tax benefits within the next 12 months ended September 30, 2005, compensation expense of $218,000 and $633,000 wouldto have been recognized for the quarter and nine months ended September 30, 2005, respectively. Theany significant impact on the reported basicits consolidated financial statements. The Company recognizes interest and diluted earnings per share would have been $0.00 and $0.01 for the quarter and nine months ended September 30, 2005, respectively.

Priorpenalties related to the adoption of SFAS No. 123R, the Company presented allunrecognized tax benefits resulting from the exerciseas part of stock options as cash provided by operating activities in the consolidated statementsincome taxes. As of cash flows. SFAS No. 123R requires the cash flows resulting from excess tax benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as cash provided by financing activities. As such, the $489,000 excess tax benefit classified as a financing activity on the Company’s consolidated statement of cash flows for the nine months ended September 30, 2006 would have been recognized as an operating activity ifJanuary 1, 2007, the Company had not adopted SFAS No. 123R.accrued $260,000 of interest and penalties related to unrecognized tax benefits. During the three months ended March 31, 2007, there have been no material changes in the liability for uncertain tax positions.

108

MERCURY GENERAL CORPORATION & SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Cash received from option exercisesThe Company is under examination by the state of California taxing authority for tax years 2001, 2002 and 2004. The taxing authority has proposed significant adjustments to the nine months ended September 30, 2006 was $1,866,000. The actualCompany’s California tax benefit realized forliabilities. Management does not believe that the tax deduction from option exercisesultimate outcome of the share-based payment awards totaled $489,000 for the nine months ended September 30, 2006.

The fair value of stock option awards was estimated using the Black-Scholes option pricing model with the following grant-date assumptions and weighted-average fair values:

The risk free interest rate is determined based on U.S. treasury yields with equivalent remaining terms in effect at the time of the grant. The expected volatilitythis examination will have a material impact on the grant-date is calculated basedCompany's financial position. However, an unfavorable outcome may have a material impact on historical volatility over the expected termCompany’s results of the options. The expected term computation is based on historical exercise patterns and post-vesting termination behavior.

Option activity as of September 30, 2006 and changes during the nine months ended September 30, 2006 were as follows:

The aggregate intrinsic valueoperations in the table above represents the total pretax intrinsic value (the difference between the Company’s closing stock price on September 30, 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all options been exercised on September 30, 2006. Total intrinsic value of options exercised during the nine months ended September 30, 2006 was $1,615,000.

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MERCURY GENERAL CORPORATION & SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)

As of September 30, 2006, $2,304,000 of total unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of 2.3 years.

Restricted stock activity as of September 30, 2006 and changes during the nine months ended September 30, 2006 were as follows:

The fair value of each restricted stock is the market price of the stock on the date of grant. As of September 30, 2006, there was $875,000 of total unrecognized compensation cost related to nonvested restricted stock.such resolution.

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”– an interpretation of FASB Statement No. 109 (“FIN No. 48”). This Interpretation provides guidance on financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return related to uncertainties in income taxes. The Interpretation prescribes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement is recognized in the financial statements. The Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 becomes effective January 1, 2007 for the Company. The Company has not yet fully assessed the impact of implementing FIN No. 48 on its consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently assessing the impact of adopting SFAS No. 157 on its consolidated financial statements.

In September 2006,February 2007, the SECFASB issued StaffStatement of Financial Accounting BulletinStandards No. 108, “Considering159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits an entity to measure certain financial assets and financial liabilities at fair value. The main objective of SFAS No. 159 is to improve financial reporting by allowing entities to mitigate volatility in reported earnings caused by the Effectsmeasurement of Prior Year Misstatements when Quantifying Misstatementsrelated assets and liabilities using different attributes, without having to apply complex hedge accounting provisions. Entities that elect the fair value option will report unrealized gains and losses in Current Year Financial Statements” (“SABearnings at each subsequent reporting date. SFAS No. 108”). SAB159 establishes presentation and disclosure requirements to help financial statement users understand the effect of the entity’s election on its earnings, but does not eliminate disclosure requirements of other accounting standards. SFAS No. 108 provides guidance related159 is expected to quantifying prior period misstatements and states that both a balance sheet approach and an income statement approach should be used when quantifying and evaluatingexpand the materialityuse of a misstatement. It also provides guidance on correcting errors underfair value measurement, which is consistent with the dual approach and transition guidanceFASB’s long-term measurement objectives for correcting errors existing in prior years. SABaccounting for financial instruments. SFAS No. 108159 is effective for annual financial statements coveringas of the beginning of the first fiscal year endingthat begins after November 15, 2006.2007. The Company is currently assessing the impact of adopting SABSFAS No. 108159 on its consolidated financial statements.

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General

The operating results of property and casualty insurance companies are subject to significant fluctuations from quarter-to-quarter and from 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.

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 net premiums written, a non-GAAP financial measure, which represents the premiums charged on policies issued during a fiscal period less any reinsurance. This 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, earned premiums, below in Results of Operations.

The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer, selling policies through a network of independent producers. The Company also offers homeowners insurance, mechanical breakdown insurance, commercial and dwelling fire insurance, umbrella insurance, commercial automobile insurance and commercial property insurance. Private passenger automobile lines of insurance accounted for approximately 84% of the Company’s $2,304$786 million of net written premiums in the first ninethree months of 2006.2007.

The Company operates primarily in California, the only state in which it operated in prior to 1990. The Company has since expanded its operations into the following states: Georgia (1990),and Illinois (1990), Oklahoma (1996),and Texas (1996), Florida (1998), Virginia (2001),and New York (2001), New Jersey (2003), Arizona, (2004), Pennsylvania, (2004), Michigan (2004) and Nevada (2004). California accounted for approximately 73%76% and 72%73% of the Company’s net written premiums during the ninethree months ended September 30,March 31, 2007 and 2006, and 2005, respectively.

Effective July 2006, Concord Insurance Services, Inc. (“Concord”), a wholly-owned subsidiary of the Company engaged in agency operations in Texas, sold the renewal and servicing rights of the business it serviced for Mercury County Mutual Insurance Company (“MCM”), a mutual insurance company controlled by the Company. Subsequent to the sale transaction, the buyers will continue to write premiums through MCM using the Company’s policy forms, and the premiums will continue to be reported in the Company’s consolidated financial statements. In light of the known contractual sales price, the Company conducted an impairment analysis of the $7.3 million of goodwill related to the Concord assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”). As a result of the analysis, the Company recognized a goodwill impairment loss of approximately $3 million during the quarter ended June 30, 2006. This impairment charge is included in other operating expenses in the consolidated financial statements.

Regulatory and Litigation Matters

The Department of Insurance (“DOI”) in each state in which the Company operates conducts periodic financial and market conduct examinations of the Company’s insurance subsidiaries domiciled within the respective state. The Georgia DOI is conductingconducted a financial examination of the Company’s Georgia insurance subsidiaries for the period January 1, 2001 through December 31, 2003. No material matters were noted in the final report of this examination. The FloridaVirginia DOI is conducting a financial examination of Mercury Select Management Company,

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Inc. for the period January 1, 2003 through December 31, 2005. Reports for these examinations are not yet available.

In addition to the financial examinations, the DOI in each state conducts market conduct examinations of the Company’s compliance with insurance statutes and regulations with respect to rating, underwriting, claims handling, billing and other practices. The Florida DOI is conductingconducted a market conduct examination of Mercury Select ManagementCasualty Company Inc. for the period January 1, 2003 through December 31, 2005. The report for this examination is not yet available.

In February 2004, the California DOI issued a Notice of Non-Compliance (“NNC”) alleging that the Company willfully misrepresented the actual price consumers could expect to pay for insurance by the amount of a one-time fee charged by the consumer’s insurance broker. The Company filed a Notice of Defense in response to the NNC and the hearing is scheduled for March 2007. The Company does not believe that it has done anything to warrant a monetary penalty from the California DOI. The San Francisco Superior Court, inKrumme v. Mercury Insurance Company, denied plaintiff’s requests for restitution or any other form of retrospective monetary relief based on the same facts and legal theory. If a monetary penalty is imposed by the California DOI, the Company is unable to estimate the monetary penalty and therefore, no reserve for the potential monetary penalty has been established in the consolidated financial statements.

In December 2005, the California DOI issued an NNC challenging the Company’s application of the marital status rating factor. The Company has filed a Statement of Compliance asserting that its rating factor is applied according to industry standard and has been approved as such by the California DOI.

On March 28, 2006, the California State Board of Equalization (“SBE”) upheld Notices of Proposed Assessments issued against the Company for tax years 1993 through 1996 in which the Franchise Tax Board (“FTB”) disallowed a portion of the Company’s expenses related to management services provided to its insurance company subsidiaries on grounds that such expenses were allocable to the Company’s tax-deductible dividends from such subsidiaries. The SBE decision resulted in a smaller disallowance of the Company’s interest expense deductions than was proposed by the FTB in those years. As a result of this ruling, the Company recorded an income tax charge (including penalties and interest) of approximately $15 million, after federal tax benefit, induring the first quarter of 2006. The Company believes that the deduction of the expenses related to management services provided to its insurance company subsidiaries is appropriate and intends to challenge the SBE decision in Superior Court.

The California FTB has audited the 1997 through 2004 tax returns and accepted the 1997 through 2000 returns to be correct as filed. The Company has not received examination results2007 for the 2003 tax return. For the 2001, 2002, and 2004 tax returns, the FTB has taken exception to the state apportionment factors used by the Company. Specifically, the FTB has asserted that payroll and property factors from Mercury Insurance Services, LLC, a subsidiary of Mercury Casualty Company that is excluded from the Mercury General California Franchise tax return, should be included in the California apportionment factors. In addition, for the 2004 tax return, the FTB has asserted that a portion of the management fee expenses paid by Mercury Insurance Services, LLC should be disallowed. Based on these assertions, the FTB issued notices of proposed tax assessments in January 2006 for the 2001 and 2002 tax years and in October 2006 for the 2004 tax year totaling approximately $5 million. The Company strongly disagrees with the position taken by the FTB and plans to formally appeal the assessments before the SBE. An unfavorable ruling against the Company may have a material impact on the Company’s quarterly results of operations in the period of such ruling. Management believes thatJanuary 1, 2006 through June 30, 2006. No material matters were noted in the issue will ultimately be resolved in favorpreliminary report of the Company. However, there can be no assurance that the Company will prevail on this matter.examination.

On July 14, 2006, the California Office of Administrative Law approved proposed regulations by the California DOI that effectively reduce the weight that insurers can place on a person’s residence when establishing automobile insurance rates. Insurance companies in California are now required to file rating plans with the

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California DOI that comply with the new regulations. There is a two year phase-in period for insurers to fully implement those plans. As such, the Company made a rate filing in August 2006 that reduced the territorial impact of its rates and requested a small overall rate increase. Additional rate filings will be required during the two year phase-in period. ThereThe DOI has not yet approved the August 2006 filing, nor is nothere any assurance that the DOI will approve the Company’s filings.it will. In general, the Company expects that the regulations will cause rates for urban drivers to decrease and those for non-urban drivers to increase. These rate changes are likely to cause consumers to shop around moreincrease consumer shopping for insurance which could affect the volume and the retention rates of the Company’s business. It is the Company’s intention to maintain its competitive position in the marketplace while complying with the new regulations.

In April 2007, new regulations governing the approval of property and casualty insurance rates became effective in California. These regulations generally tighten the existing Proposition 103 prior approval ratemaking regime primarily by establishing a maximum allowable rate of return of currently just below 11 percent (the average of short, intermediate and long-term T-bill rates, plus 6 percent) and a minimum allowable rate of return of negative

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6 percent of surplus. However, the practical impact of these limitations is unclear because the new regulations allow for the California DOI to grant a number of variances based on loss prevention, business mix, service to underserved communities, and other factors.

In the January 2007 special session of the Florida Legislature, a bill designed to improve the availability and affordability of property insurance in Florida, HB 1A, was passed and subsequently signed by the Governor. Among the significant provisions in the new law is a requirement that all companies that write private passenger automobile policies in Florida also write homeowners policies in the state if they write homeowners policies in any other state. The law also expands the availability of reinsurance through the Florida Hurricane Catastrophe Fund, requires rate filings to reflect savings from the availability of such reinsurance, includes homeowners insurance under Florida’s existing excess profits regulations, and requires insurers to offer discounts for various deductible options and hurricane mitigation measures. The Company has made the rate filings required by the new law, and is prepared to comply with all provisions as they become effective. Several bills are now pending in the regular legislative session which would amend or clarify numerous provisions of HB 1A and expand the state-run Citizens Property Insurance Corporation. The Company is closely monitoring the pending legislation.

The Company is not currently able to estimatedetermine the impact of any of the new regulations on the volumelegal and profitability of its business. The new regulations are being challenged by several insurance industry trade associations.

On January 31, 2006, the Florida Financial Services Commission approved new regulations requiring insurers to submit information to the Florida Office of Insurance Regulation (“OIR”) regarding the use of credit reports and credit scores in establishing rules, rates or underwriting guidelines. Under the new regulations, any insurer that uses credit scores or credit reports in filing a new rule, rate or underwriting guideline will be required to provide information sufficient to demonstrate that its credit scoring methodology does not disproportionately affect persons of any particular race, color, religion, marital status, age, gender, income level or place of residence. The new regulations were challenged by several insurance industry trade associations and were recently struck down by a Florida Court, and hence, there is no near-term compliance deadline. It is uncertain if and when these requirements would be implemented as the OIR intends to continue to pursue this reform. The Company cannot estimate what impact the regulations will have on the volume and profitability of its business. The Company intends to maintain its competitive positionregulatory changes described in the Florida marketplace while complying withthree paragraphs above. However, it is possible that the new regulations if they are implemented.impact could adversely affect the Company and its operating results.

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may, but is not likely to, have a material impact on the Company’s quarterly results of operations; however, it is not expected to be material to the Company’s financial position. For a further discussion of the Company’s pending material litigation, see Item 1. Legal Proceedings in Part II – Other Information of this Quarterly Report on Form 10-Q and the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.2006.

Critical Accounting Policies

Reserves

The preparation of the Company’s consolidated financial statements requires judgment and estimates. The most significant is the estimate of loss reserves as required by Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS No. 60”), and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). Estimating loss reserves is a difficult process as many factors can ultimately affect the final settlement of a claim, and therefore, the reserve that is required. Changes in the regulatory and legal environment, results of litigation, medical costs, the cost of repair materials and labor rates, among other factors, can each impact ultimate claim costs. In addition, time can be a critical part of reserving determinations since the longer the span between the incidence of a loss and the payment or settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims, such as bodily injury claims. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

The Company performs its own loss reserve analysis and also engages the services of independent actuaries to assist in the estimation of loss reserves. The Company and the actuaries do not calculate a range of loss reserve estimates but rather calculate a point estimate. Management reviews the underlying factors and assumptions that serve as the basis for preparing the reserve estimate. These include paid and incurred loss development factors, expected average costs per claim, inflation trends, expected loss ratios, industry data and other relevant information. The Company’s recorded reserve represents its best estimate as derived from the actuarial methodologies used. As with any actuarial estimates, there is uncertainty in the Company’s estimates of ultimate losses. This uncertainty comes from many factors which may include changes in claims reporting and settlement patterns, changes in the

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regulatory or legal environment, uncertainty over inflation rates, unexpected large extra-contractual losses and uncertainty for unknown items. The Company does not make specific provisions for these uncertainties, rather it

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considers them in establishing its reserves by looking atreviewing historical patterns and trends and projecting these out to current reserves.

The Company analyzes loss reserves internally on a quarterly basis using primarily the incurred loss development, average severity and claim count development methods described below. The Company also uses the paid loss development method to analyze loss adjustment expense reserves and at times uses industry claims data as part of its reserve analysis. When deciding which methodologies to use in estimating its reserves, the Company and its actuaries evaluate the credibility of each methodology based on the maturity of the data available and the claims settlement practices for each particular line of business or coverage within a line of business. When establishing the reserve, the Company will generally analyze the results from all of the methods used rather than relying on one method over the others. While these methodologies are designed to determine the ultimate losses on claims under the Company’s policies, there is inherent uncertainty in all actuarial models since they generally use historical data to project outcomes. The Company believes that the techniques it uses provide a reasonable basis in estimating loss reserves.

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 claim count development method analyzes historical claim count development to estimate future incurred claim count development for current claims. The Company applies these development factors against current claim counts by accident period to calculate ultimate expected claim counts. The average severity method coupled with the claim count development method provide meaningful information regarding inflation and frequency trends that the Company believes is useful in establishing reserves. The paid loss development method analyzes historical payment patterns to estimate the amount of losses yet to be paid. The Company primarily uses this method for loss adjustment expenses because specific case reserves are not established for loss adjustment expenses.

The Company uses varying methods and assumptions in states with little operating history where there areis insufficient claims data to prepare a reserve analysis relying solely on Company historical data. In these cases, the Company may project ultimate losses using industry average loss data or based on expected loss ratios. As the Company develops an operating history in these states, the Company will rely increasingly on the incurred loss development and average severity and claim count development methods. The Company analyzes hurricane catastrophe losses separately from non-catastrophe losses. For these losses, the Company determines claim counts based on claims reported and development expectations from previous storms and applies an average expected loss per claim based on reserves established by adjusters and average losses on previous storms.

The Company estimates incurred but not reported (“IBNR”) reserves as the difference between its projection of ultimate losses and the payments the Company has made plus case-basis reserves established for those losses. Assumptions, estimates and other factors that may impact the Company’s ultimate losses are discussed among the Company’s management and its internal or independent actuaries, as the case may be, to determine the Company’s best estimate of ultimate losses. Through this process, the Company’s best estimate of ultimate reserves is recorded. The results of this analysis are shared quarterly with the Company’s Board of Directors and the Company’s independent auditors.

At September 30, 2006,March 31, 2007, the Company recorded its point estimate of approximately $1,065$1,078 million in loss and loss adjustment expense reserves which includes approximately $302$305 million of IBNR loss reserves. IBNR includes estimates, based upon past experience, of ultimate developed costs which may differ from case estimates, unreported claims which occurred on or prior to September 30, 2006March 31, 2007 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. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provision.

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The Company reevaluates its reserves quarterly. When management determines that the estimated ultimate claim cost requires reduction for previously reported accident years, positive development occurs and a reduction in losses and loss adjustment expenses is reported in the current period. If the estimated ultimate claim cost requires an increase for previously reported accident years, negative development occurs and an increase in losses and loss adjustment expenses is reported in the current period. For the ninethree months ended September 30, 2006,March 31, 2007, the Company hadreported negative development of approximately $18$13 million on the 20052006 and prior accident years’ loss and loss adjustment expense reserves which at December 31, 20052006 totaled approximately $1,023$1,089 million. The majority of the negative development was recognized in the second quarter of 2006. The negative development primarilyfor the most part relates to increases in the Company’s 20052006 and prior accident years’ loss estimates for personalCalifornia business. This was primarily due to a greater number of reported California automobile insurance in Floridaclaims than was anticipated at December 31, 2006 and New Jersey totaling approximately $20 million and $17 million, respectively, offset by positive reserveadverse development of approximately $19 millionon prior years’ loss reserves for business written in California.California homeowners business.

In Florida,For a large portionfurther discussion of the $20 million in adverse loss development relates to additional reserves recorded for large losses related primarily to extra-contractual claims. Extra-contractual losses are fairly infrequent but can be very large (as great as millions of dollars per claim), especially if the injured party sustained a serious injury (such as a loss of a limb or paralysis). Consequently, these claims can have a large impact onCompany’s reserving methods, see the Company’s losses. During the second quarter of 2006, the Company had extra-contractual losses that settled for amounts much greater than the policy limits and much greater than expected. As a result of these settlements, the Company reevaluated its exposure to extra-contractual claims in Florida and increased its reserve estimates for prior accident years.

Typically, extra-contractual claims are those that settle for more than the policy limits because the original claim was denied, thus exposing the Company to losses greater than the policy limits. Claims may be denied for various reasons, including material misrepresentations made by the insuredAnnual Report on the policy application or insureds that have violated prohibitions in the insurance contract or when there is fraud involved. The Company vigorously defends these claims; however, some claims may result in a settlement or an adverse verdict in court.

The Company has been underwriting personal automobile insurance in New Jersey since the fall of 2003. The short operating history makes it difficult to determine ultimate lossesForm 10-K for the bodily injury (“BI”) and personal injury protection (“PIP”) coverages because many of these claims take a long time to settle. Consequently, the Company has not generated sufficient loss experience data internally for actuarial analysis and as a result, has relied on industry loss data to assist in establishing reserves for those coverages. With many of the 2004 accident year BI and PIP losses settling over time, the Company was able to utilize more internally-generated loss experience together with the industry data to assist in determining ultimate losses. As a result of this process, the Company increased its reserve estimates for the 2004 and 2005 accident years by approximately $17 million during the nine months ended September 30,December 31, 2006.

There were reserve redundancies in the Company’s California operations that partially offset the deficiencies in the Florida and New Jersey operations. The primary contributor to this positive development was reserve redundancies that occurred in the bodily injury coverage reserves for the California automobile insurance lines of business for the 2004 and 2005 accident years totaling approximately $15 million for the nine months ended September 30, 2006. These redundancies were the result of changed inflation rate assumptions and fewer reported claims than originally expected. The Company had redundancies and deficiencies in its other coverages offered within its California automobile insurance lines of business, as well as in other lines of business in California and in other states which net to an immaterial amount.Premiums

The Company complies with SFAS No. 60 in recognizing revenue on insurance policies written. The Company’s insurance premiums are recognized as income ratably over the term of the policies, that is, in proportion to the amount of insurance protection provided. Unearned premiums are carried as a liability on the balance sheet and are computed on a monthly pro-rata basis. The Company evaluates its unearned premiums periodically for premium deficiencies by comparing the sum of expected claim costs, unamortized acquisition costs and maintenance costs to related unearned premiums.premiums, net of investment income. To the extent that any of the Company’s lines of business become substantially unprofitable, a premium deficiency reserve may be required. The Company does not expect this to occur on any of its significant lines of business. The Company presents earned premiums on the consolidated statements of income gross of related premium taxes collected from policyholders in the amount of approximately $17 million and $16 million for the first quarter of 2007 and 2006, respectively.

Investments

The Company carries its fixed maturity and equity investments at market value as required for securities classified as “Available for Sale” by Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”)., as amended. In most cases, market valuations were drawn from trade data sources. No valuations were made by the Company’s management. Equity holdings, including non-sinking

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fund preferred stocks, are, with minor exceptions, actively traded on national exchanges or trading markets, and were valued at the last transaction price on the balance sheet date. The Company constantly evaluates its investments for other-than-temporary declines and writes them off as realized losses through the consolidated statements of income, as required by SFAS No. 115, as amended, when recovery of the net book value appears doubtful. SFAS No. 155 allows the Company to include changes in fair value in earnings on an instrument-by-instrument basis for certain hybrid financial instruments that contains an embedded derivative that would otherwise be required to be bifurcated and accounted for separately under SFAS No. 133. Temporary unrealized investment gains and losses for investments available for sale, except for those accounted for under SFAS No. 133 and SFAS No. 155, are credited or charged directly to shareholders’ equity as part of accumulated other comprehensive income (loss), net of applicable taxes. It is possible that in the future, information will become available about the Company’s current investments that would require accounting for them as realized losses due to other-than-temporary declines in value. The financial statement effect would be to move the unrealized loss from accumulated other comprehensive income (loss) on the consolidated balance sheets to realized investment losses on the consolidated statements of income. Changes in fair value for those investments accounted for under SFAS No. 133 and SFAS No. 155 are immaterial and reflected in realized gains or losses in the consolidated statements of income.

Contingent Liabilities

The Company may have certain known and unknown potential liabilities that are evaluated using the criteria established by SFAS No. 5. These include claims, assessments or lawsuits relating to its business. The Company continually evaluates these potential liabilities and accrues for them or discloses them in the notes to the consolidated financial statement footnotesstatements if they meet the requirements stated in SFAS No. 5. While it is not possible to know with certainty the ultimate outcome of contingent liabilities, an unfavorable result may have a material impact on the

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Company’s quarterly results of operations; however, it is not expected to be material to the Company’s financial position.

Forward-Looking Statements

Certain statements in this report on Form 10-Q that are not historical fact constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may address, among other things, the Company’s strategy for growth, business development, regulatory approvals, market position, expenditures, financial results and reserves. Forward-looking statements are not guarantees of performance and are subject to important factors and events that could cause the Company’s actual business, prospects and results of operations to differ materially from the historical information contained in this Form 10-Q and from those that may be expressed or implied by the forward-looking statements. Factors that could cause or contribute to such differences include, among others: the competition currently existing in the California automobile insurance markets, the Company’s success in expanding its business in states outside of California, the Company’s ability to successfully complete its initiative to standardize its policies and procedures nationwide in all of its functional areas, the impact of potential third party “bad-faith” legislation, changes in laws or regulations, the ultimate outcome of tax position challenges by the California FTB,Franchise Tax Board, and decisions of courts, regulators and governmental bodies, particularly in California, the Company’s ability to obtain and the timing of the approval of premium rate changes for private passenger automobile policies issued in states where the Company does business, the investment yields the Company is able to obtain with its investments in comparison to recent yields and the market risk associated with the Company’s investment portfolio, the cyclical and general competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve or other estimates, the accuracy and adequacy of the Company’s pricing methodologies, uncertainties related to assumptions and projections generally, inflation and changes in economic conditions, changes in driving patterns and loss trends, acts of war and terrorist activities, court decisions and trends in litigation and health care and auto repair costs, adverse weather conditions or natural disasters in the markets served by the Company, the stability of the Company’s information technology systems and the ability of the Company to execute on its information technology initiatives, and other uncertainties, all of which are difficult to predict and many of which are beyond the Company’s control. GAAP prescribes when a Company may reserve for particular risks including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for a major contingency. Reported results may therefore appear to be volatile in certain periods. The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information or future events or otherwise. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this Form 10-Q or, in the case of any document the Company incorporates by reference, the date of that document. Investors also should understand that it is not possible to predict or identify all factors and should not consider the risks set forth above to be a complete statement of all potential risks and uncertainties. If the expectations or assumptions underlying the Company’s forward-looking statements prove inaccurate or if risks or uncertainties arise, actual results could differ materially from those predicted in any forward-looking statements. The factors identified above are believed to be some, but not all, of the important factors that could cause actual events and results to be significantly different from those that may be expressed or implied in any forward-looking statements. Any forward-looking statements should also be considered

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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, 20052006 and in Item 1A. Risk Factors in Part II – Other Information of this Quarterly Report on Form 10-Q.

Results of Operations

Three Months Ended September 30, 2006March 31, 2007 compared to Three Months Ended September 30, 2005March 31, 2006

Premiums earned in the thirdfirst quarter of 20062007 increased approximately 4%2.6% from the corresponding period in 2005.2006. Net premiums written in the thirdfirst quarter of 20062007 increased approximately 2%1.5% from the corresponding period in 2005.2006. Net premiums written on the California automobile lines of business were $510.7$542.7 million in the thirdfirst quarter of 2006,2007, a 5%5.8% increase over the corresponding period in 2005.2006. Net premiums written by the Company’s non-California operations were $203.0$184.9 million in the thirdfirst quarter of 2006, a 7%2007, an 11.2% decrease over the corresponding period in 2005.2006. The growth in net premiums written is primarily due to an increase in the number of policies written by the Company’s California operations and an increase in the average premium collected per policy, which is

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partially offset by a decrease in the number of policies written by the Company’s non-California operations, mostly in New Jersey and Florida.

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.presented. The following is a reconciliation of total Company net premiums written to net premiums earned (000s) for the quarters ended September 30,March 31, 2007 and 2006, and 2005, respectively:

The loss ratio (GAAP basis) in the thirdfirst quarter (loss and loss adjustment expenses related to premiums earned) was 65.2%67.5% in 20062007 and 64.3%64.5% in 2005.2006. There was negative development of approximately $3$13 million and positive development of approximately $5$10 million on prior accident years’ loss reserves respectively, for the quarters ended September 30,March 31, 2007 and 2006, and 2005.respectively. Excluding the effect of prior accident years’ loss development, the loss ratio in the thirdfirst quarter was 64.8%65.7% in 20062007 and 65.0%65.9% in 2005.2006.

The expense ratio (GAAP basis) in the thirdfirst quarter of 20062007 (policy acquisition costs and other expenses related to premiums earned) was 27.8%27.0% compared to 26.5%27.3% in the corresponding period of 2005. The2006. While expenses increased in the first quarter of 2007, the increase in expenditures related to information technology was the primary contributor toat a slightly lower rate than the increase in the expense ratio.

premium volume. The combined ratiomajority of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 93.0% in the third quarter of 2006 comparedvary directly with 90.8% in the corresponding period of 2005, which indicates that the Company’s underwriting performance contributed $52.7 million to the Company’s income before income taxes of $91.4 million during the 2006 period versus contributing $66.5 million to the Company’s income before income taxes of $104.2 million in the 2005 period.

Investment income for the third quarter of 2006 was $36.9 million, compared with $30.9 million in the third quarter of 2005. The after-tax yield on average investments (fixed maturities and equities valued at cost) was 3.7% in the third quarter of 2006 compared to 3.4% in the corresponding period of 2005 on average invested assets of $3,358 million and $3,154 million, respectively. The increase in after-tax yield is largely due to overall higher yields earned on new purchases in the investment portfolio which is reflective of higher market interest rates in 2006 when compared to earlier periods.

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The income tax provision in the third quarter of 2006 of $23.2 million represented an effective tax rate of 25% compared with an effective rate of 30% in the corresponding period of 2005. The lower rate in 2006 is primarily attributable to an increased proportion of investment income which includes tax exempt interest and tax sheltered dividend income, compared to underwriting income which is taxed at the full corporate rate of 35%.

Net income for the third quarter 2006 of $68.2 million, or $1.25 per share (diluted), compares with $73.0 million, or $1.33 per share (diluted), in the corresponding period of 2005. Basic net income per share was $1.25 in the third quarter of 2006 and $1.34 in the third quarter of 2005.

Nine Months Ended September 30, 2006 compared to Nine Months Ended September 30, 2005

Premiums earned in the nine months ended September 30, 2006 increased approximately 6% from the corresponding period in 2005. Net premiums written in the nine months ended September 30, 2006 increased approximately 4% from the corresponding period in 2005. Net premiums written on the California automobile lines of business were $1,512.4 million in the first nine months of 2006, an increase of 5% over the same period in 2005. Net premiums written by the Company’s non-California operations were $612.8 million in the nine months ended September 30, 2006, a decrease of approximately 2% over the same period in 2005. The growth in net premiums written is primarily due to an increase in the number of policies written by the Company’s California operations partially offset by a decrease in the number of policies written by the Company’s non-California operations, mostly in New Jersey and Florida.

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 (000s) for the nine months ended September 30, 2006 and 2005, respectively:

The loss ratio (GAAP basis) in the first nine months (loss and loss adjustment expenses related to premiums earned) was 66.9% in 2006 and 64.1% in 2005. There was negative development of approximately $18 million and positive development of approximately $45 million on prior accident years’ loss reserves, respectively, for the nine months ended September 30, 2006 and 2005. Excluding the effect of prior accident years’ loss development, the loss ratio in the third quarter was 66.1% in 2006 and 66.2% in 2005.

The expense ratio (GAAP basis) in the first nine months of 2006 (policy acquisition costs and other operating expenses related to premiums earned) was 27.6% compared to 27.1% in the corresponding period of 2005. The increase in expenditures related to information technology was the primary contributor to the increase in the expense ratio.premiums.

The combined ratio of losses and expenses (GAAP basis) is the key measure of underwriting performance traditionally used in the property and casualty insurance industry. A combined ratio under 100% generally reflects profitable underwriting results; a combined ratio over 100% generally reflects unprofitable underwriting results. The combined ratio of losses and expenses (GAAP basis) was 94.5% in the first nine monthsquarter of 20062007 compared with 91.2%91.8% in the corresponding period of 2005,2006, which indicates that the Company’s underwriting performance contributed $123.4$41.6 million to the Company’s income before income taxes of $246.2$81.5 million during the 20062007 period versus contributing $186.1$60.4 million to the Company’s income before income taxes of $291.7$105.2 million in the 20052006 period.

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Investment income forin the first nine monthsquarter of 20062007 was $112.5$42.1 million, compared with $90.3$39.4 million in the first nine monthsquarter of 2005.2006. The after-tax yield on average investments (fixed maturities and equities valued at cost) was 3.8%4.2% in the first nine monthsquarter of 20062007 compared to 3.4%4.1% in the corresponding period of 20052006 on average invested assets of $3,291$3,404 million and $3,023$3,219 million, respectively. The small increase in after-tax yield is largely due to overall higher yields earned on new purchases in the investment portfolio which is reflective of higher market interest rates in 2006 and 2007 when compared to earlier periods.

The income tax provision in the first ninethree months of 2006 of $81.5$46.6 million was impacted significantly by a $15 million income tax charge relating to the Notices of Proposed Assessments for the tax years 1993 through 1996 (the “NPAs”) that were upheld by the California State Board of Equalization.Equalization (“SBE”). The Company is challenging the SBE decision in Superior Court. Excluding the effect of this income tax charge results in an effective tax rate of 27%30% in 2006 compared with an effective rate of 29%26% in the corresponding period of 2005.2007. The lower rate in 2007 compared to 2006 after excluding the income tax charge relating to the NPAs in 2006adjustment is primarily attributable to an increased proportion of tax-exempt investment income which includes tax exempt interest and tax sheltered dividend income, in contrast to underwriting income which is taxed at the full corporate rate of 35%.

Net income for the first nine monthsquarter 2007 of 2006 of $164.7$60.5 million, or $3.01$1.10 per share (diluted), compares with $207.0$58.6 million, or $3.78$1.07 per share (diluted), in the corresponding period of 2005.2006. Basic net income per share was $3.01$1.11 in the first nine monthsquarter of 20062007 and $3.80$1.07 in the first nine monthsquarter of 2005.2006.

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Liquidity and Capital Resources

Net cash provided by operating activities in the first ninethree months of 20062007 was $293.2$49.9 million, a decrease of $125.5$63.2 million over the same period in 2005.2006. This decrease was primarily due to higher losses and loss adjustment expenses paid in relation to premiums collected and higher tax payments during the first ninethree months of 20062007 when compared with the same period in 2005.2006. The Company has utilized the cash provided from operating activities primarily to increasefor its investment in fixed maturity securities, the purchase and development of information technology and the payment of dividends to its shareholders. Funds derived from the sale, redemption or maturity of fixed maturity investments of $1,574.3$554.1 million were reinvested by the Company generally in highly-rated fixed maturity securities.

The Company’s cash and short-term cash investment portfolio totaled $351.1$290.7 million at September 30, 2006.March 31, 2007. Together with cash flows from operations, the Company believes that such liquid assets are adequate to satisfy its liquidity requirements without the forced sale of investments. However, the Company operates in a rapidly evolving and often unpredictable business environment that may change the timing or amount of expected future cash receipts and expenditures. Accordingly, there can be no assurance that the Company’s sources of funds will be sufficient to meet its liquidity needs or that the Company will not be required to raise additional funds to meet those needs, including future business expansion, through the sale of equity or debt securities or from credit facilities with lending institutions.

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The following table sets forth the composition of the total investment portfolio of the Company as of September 30, 2006:March 31, 2007:

The market value of all investments held at market as “Available for Sale” exceeded amortized cost at September 30, 2006March 31, 2007 by $98.1$121.0 million. ThatThe net unrealized gain of $98.1$121.0 million reflected in shareholders’ equity,or $78.7 million, net of applicable tax effects, was $63.7 million at September 30, 2006,March 31, 2007, compared with a net unrealized gain of $102.6$107.4 million or $66.5$69.7 million, net of applicable tax effects, at December 31, 2005.2006. The net unrealized gain on all investments of $121.0 million comprised of gross unrealized gains of $141.6 million and gross unrealized losses of $20.6 million. During the first three months of 2007, the Company recognized approximately $1.0 million in net realized losses which included approximately $0.4 million ($0.3 million after taxes) in write-downs of investments as other-than-temporary declines and approximately $0.5 million ($0.3 million after taxes) in changes in the fair value of hybrid financial instruments.

At September 30, 2006,March 31, 2007, the average rating of the $2,876.7$2,926.5 million bond portfolio at market (amortized cost $2,826.8$2,885.3 million) was AA, unchanged from December 31, 2005.2006. Bond holdings are broadly diversified geographically, within the tax-exempt sector. Holdings in the taxable sector consist principally of investment grade issues. At September 30, 2006,March 31, 2007, bond holdings rated below investment grade totaled $42.1$56.0 million at market (amortized cost $39.3$52.5 million) representing approximately 1.2%1.6% of total investments. This compares to approximately $51.1 $48.6

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million at market (cost $49.8(amortized cost $43.8 million) representing approximately 1.6%1.4% of total investments at December 31, 2005.2006.

The Company monitors its investments closely. If an unrealized loss is determined to be other-than-temporary, it is written off as a realized loss through the consolidated statementstatements of income. The Company’s assessment of other-than-temporary impairments is based on security-specific analysis as of the balance sheet date and considers various factors including the length of time and the extent to which the fair value has been lower than the cost, the financial condition and the near term prospects of the issuer, whether the debtor is current on its contractually obligated interest and principal payments, and the Company’s ability and intent to hold the investment for a period of time sufficient to allow the security to recover its value.

DuringThe following table illustrates the first nine months of 2006, the Company recognized approximately $13.4 million in net realized gains which included realized losses of $2.0 million ($1.3 million after taxes) in write-downs of investments as other-than-temporary declines.

At September 30, 2006, the Company had a net unrealized gain on all investments of $98.1 million before income taxes comprised of gross unrealized gains of $121.3 million and gross unrealized losses on securities available for sale and the fair value of $23.2 million. Unrealizedthose securities, aggregated by investment category as of March 31, 2007. The table also illustrates the length of time that they have been in a continuous unrealized loss position.

The $20.6 million gross unrealized losses representing 0.7%on securities available for sale represents 0.6% of total investments at amortized cost are comprised of approximately $14.5 million related to fixed maturity investments and $8.7 million related to equity securities.

The $23.2 million grosscost. These unrealized losses at September 30, 2006 consist mostly of individual securities with unrealized losses of less than 20% of each security’s amortized cost. Of these, the most significant unrealized losses relateloss relates to one corporate bond and two equity securities with an unrealized lossesloss of approximately $1.0$1.1 million each and with a market value declines between 7% and 18%decline of 9% of amortized cost. Approximately $1.6$0.3 million of the total gross

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unrealized losses relate to 23five individual equity securities with unrealized losses that exceed 20% of each security’s amortized cost. Of these, securities, the most significant unrealized losses relateloss relates to fiveone equity securities totaling $1.0 million, eachsecurity with an unrealized losses betweenloss of approximately $0.1 million and $0.3 million and with a market declines between 22% and 38%value decline of 32% of amortized cost.

The following table illustrates the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities, aggregated by investment category as of September 30, 2006. The table also illustrates the length of time that they have been in a continuous unrealized loss position.

The following table illustrates the gross unrealized losses included in the Company’s investment portfolio and the fair value of those securities, aggregated by investment category as of December 31, 2005. The table also illustrates the length of time that they had been in a continuous unrealized loss position.

Unrealized losses that have been in continuous unrealized loss position over 12 months are mostly accounted for by unrealized losses of fixed maturity securities, and amounted to 0.28% of the total investment market value at September 30, 2006 compared to 0.21% at December 31, 2005. The slight increase is largely due to decrease in market values of the fixed maturity securities as a result of increase in market interest rates.

Based upon the Company’s analysis of the securities, which includes the status of debt servicing for fixed maturities and third party analyst estimates for the equity securities, and the Company’s intent and ability to hold the securities until they mature or recover their costs, the Company has concluded that the gross unrealized losses of $23.2$20.6 million at September 30, 2006on securities available for sale were temporary in nature.nature at March 31, 2007. However, facts and circumstances may change which could result in a decline in market value considered to be other-than-temporary.

The following table illustrates the gross unrealized losses on securities available for sale and the fair value of those securities, aggregated by investment category as of December 31, 2006. The table also illustrates the length of time that they had been in a continuous unrealized loss position.

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Unrealized losses that have been in a continuous unrealized loss position over 12 months are mostly accounted for by unrealized losses of fixed maturity securities, and amounted to 0.38% of the total investment market value at March 31, 2007 compared to 0.34% at December 31, 2006.

Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer’sinsurer's annual net premiums written to statutory policyholders’policyholders' surplus should not exceed 3 to 1. Based on the combined surplus of all of the licensed insurance subsidiaries of $1.5$1.6 billion at September 30, 2006March 31, 2007 and net written premiums for the twelve months ended on that date of $3.0$3.1 billion, the ratio of writings to surplus was approximately 21.9 to 1.

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The Company’s book value per share at September 30, 2006March 31, 2007 was $30.98$32.30 per share.

Item 3.        Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in the Company’s investment strategies, types of financial instruments held or the risks associated with such instruments which would materially alter the market risk disclosures made in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.2006.

Item 4.         Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures designed to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefitcost-benefit relationship of possible controls and procedures.

As required by Securities and Exchange Commission Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There has been no change in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting. The Company’s process for evaluating controls and procedures is continuous and encompasses constant improvement of the design and effectiveness of established controls and procedures and the remediation of any deficiencies which may be identified during this process.

PART II - II—OTHER INFORMATION

Item 1.         Legal Proceedings

The Company is, from time to time, named as a defendant in various lawsuits incidental to its insurance business. In most of these actions, plaintiffs assert claims for punitive damages which are not insurable under judicial decisions. The Company has established reserves for lawsuits in which the Company is able to estimate its potential exposure and the likelihood that the court will rule against the Company is probable. The Company vigorously

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defends these actions, unless a reasonable settlement appears appropriate. An unfavorable ruling against the Company in the actions currently pending may have a material impact on the Company’s quarterly results of operations; however, it is not expected to be material to the Company’s financial position. Also, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 and the Company’s Quarterly Reports on Form 10-Q for the periods ended March 31, 2006 and June 30, 2006.

Sam Donabedian, individually and on behalf of those similarly situated v. Mercury Insurance Company, et al., was originally filed on April 20, 2001 in the Los Angeles Superior Court, asserting, among other things, a claim that

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the Company’s calculation of persistency discounts to determine premiums is an unfair business practice, a violation of the California Consumer Legal Remedies Act (“CLRA”) and a breach of the covenant of good faith and fair dealing. The Company originally prevailed on a Demurrer to the Complaint and the case was dismissed; however, the California Court of Appeal reversed the trial court’s ruling, deciding that the California Insurance Commissioner does not have the exclusive right to review the calculation of insurance rates/premiums. After filing two additional pleadings, on June 28, 2005, the Plaintiff filed a Fourth Amended Complaint asserting claims for violation of California Business & Professions Code Section 17200 and breach of the covenant of good faith and fair dealing (the CLRA claim previously had been dismissed with prejudice). Plaintiff again sought injunctive relief, unspecified restitution and monetary damages as well as punitive damages and attorneys’ fees and costs. Without leave of court, the Plaintiff hasalso attempted to state claims for breach of contract and fraud. The Company filed a Demurrer and Motion to Strike certain portions of the Plaintiff’s Fourth Amended Complaint. Following a hearing on September 19, 2005, the Court took the matter under submission. While the motions were under submission, counsel for the Plaintiff asked that Mercury to engage in settlement discussions. The Court agreed to stay the matter and counsel for the Plaintiff and the Company met on several occasions to seek resolution, but none was reached. The Court ordered the parties to a settlement conference before another judge. On August 1, 2006, following three settlement conferences, the Company and the Plaintiff reached a preliminary settlement which is subject to completion of the class approval process and may be subject to objections, which would be reviewed by the Court. A hearing on the motion for preliminary approval of the settlement and temporary and conditional class certification was held on October 30, 2006. The California DOI raised additional issues for the Court’s consideration and the hearing was continued until December 19, 2006. The Company cannot determine if the settlement will be approved by the Court or how the additional issues will affect the settlement. If the proposed settlement is approved, the Company will issue a $65 Rebate Certificate to each prospective class member who does not opt out of the class. The class member could apply the certificate toward the purchase of a new policy, and not a renewal, from the Company or transfer it to a third party who is not a broker or agent. The $65 rebate would be offset against the future related gross premium if and when the certificate is redeemed. At this time, the potential outcome of future redemptions and related premium reductions cannot be determined.

Additionally, over the Company’s objection, on May 9, 2005, the trial court permitted The Foundation for Taxpayer and Consumer Rights (“FTCR”) to file a Complaint in Intervention to allege that the Company’s calculation of persistency discounts constitutes a violation of insurance Code Section 1861.02(a) and (c). Following a ruling by the Court of Appeal in another case which found that there is no private right of action to allege violations of Section 1861.02, the Company brought a motion for judgment on the pleadings to have FTCR’s Complaint in Intervention dismissed. That motion was heard on April 28, 2006. Subsequent to the hearing, FTCR filed an amended complaint in intervention, and Mercury again filed a motion for judgment on the pleadings, which the Court denied at a hearing on July 31, 2006. In view of the pendingthen on-going settlement discussions with the Plaintiff, the Company hasdid not soughtseek further appellate review of the Court’s order. Theruling, but is now contemplating whether to challenge FTCR's participation in the case since the class settlement was not approved.

During the fall of 2005, counsel for the Plaintiff and the Company hasmet on several occasions in an effort to resolve the case. FTCR was not entered intoinvited to participate in these discussions. When Plaintiff and the Company were not able to reach a resolution, the Court ordered the parties to a settlement withconference before another judge. On August 1, 2006, following three settlement conferences, the Company and the Plaintiff reached a preliminary settlement which was subject to completion of the class approval process and was also subject to objections and review by the Court. Prior to the hearing scheduled for October 30, 2006, the FTCR and it is expected that FTCR will filefiled objections to the proposed settlement. Also, shortly before the hearing, the California DOI filed a letter with the Court contending that the terms of the settlement, withwhich provided for a coupon to class members to be used toward the purchase of “new,” not renewal business, constituted a “discount” of insurance rates and thus would be subject to the California DOI’s approval. Following several delays and further briefing by the parties, at a hearing on February 5, 2007, the Court declined to give preliminary approval to the proposed settlement. Accordingly, upon the Company’s request, the tentative ruling on the Company’s demurrer and motion to strike was unsealed. The Court sustained the Company’s demurrer to all but the Section 17200 claim, as well as a claim for alleged violation of Insurance Code Section 1861.02 which the parties subsequently stipulated to dismiss. The Court also granted the Company’s request to strike the punitive damage claim. On February 27, 2007, the Court determined, at the Company's request, that the Court would initially evaluate the Company's defenses that its conduct was protected by the administrave estoppel and filed rate plan doctrines and thus the Company has no liability in the case and established a schedule for discovery and briefing on these issues. Thereafter, the Company and Plaintiff andcontinued settlement discussions which have now resulted in another agreement by the parties to resolve the litigation based on the Company's issuance of a coupon to class members that can be used towards new or renewal business (to the extent that the renewal business provides for increased or additional coverage or an additional insured and/or vehicle). The DOI already has indicated its tentative approval of the settlement though the formal filing process is still required. The parties are also required to secure approval by the Court. A hearing for preliminary approval has been set for May 11, 2007. It is uncertain at this time

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whether FTCR will object to the settlement which also requires that notice to the class described above. At thisbe given within a period of time permitting class members to opt out of the class before the settlement is finally approved by the Court. While the Company continues to believe that it has strong defenses to the action given the DOI's actions in connection with the Company's application of the persistency discount, the proposed settlement is believed to be a favorable outcome of any such objections cannot be anticipated.the case considering the cost and uncertainty of litigation.

InMarissa Goodman, on her own behalf and on behalf of all others similarly situated v. Mercury Insurance Company (Los Angeles Superior Court), filed June 16, 2002, the Plaintiff is challenging the Company’s use of certain automated database vendors to assist in valuing claims for medical payments. The Plaintiff has filed a motion seeking class action certification to include all of the Company’s insureds from 1998 to the present who presented a medical payments claim, had the claim reduced using the computer program and whose claim did not reach the policy limits for medical payments. On January 11, 2007, the Court certified the requested class and scheduled a case management conference to discuss notifying class members. The hearing on this motion, previously set for June 2, 2006, was continued until August 17, 2006,Company has appealed the class certification ruling, and then continued to September 21, 2006. Thethe Court heard oral argument, requested further briefing and tookof Appeal has stayed the motion under submission.case pending their review. The Plaintiff alleges that these automated databases systematically undervalue medical payment claims to the detriment of insureds. The Plaintiff is seeking unspecified actual and punitive damages. Similar lawsuits have been filed against other insurance carriers in the industry. The case has been coordinated with two other similar cases, and also with ten other cases relating to total loss claims. The Court denied the Company’s Motion for Summary Judgment holding that there is an issue of fact as to whether Ms. Goodman sustained any damages as a result of the Company’s handling of her medical payments claim. The original trial date has been vacated by the Court and not rescheduled. The Company is not able to evaluate the likelihood of an unfavorable outcome or to estimate a range of potential loss in the event of an unfavorable outcome

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at the present time. The Company intends to vigorously defend this lawsuit jointly with the other defendants in the coordinated proceedings.

Robert Dolan, et al. v. Mercury Insurance Company, et al., is a collective action claim filed in April of 2006, in the United States District Court for the Middle District of Florida. The plaintiffs, former automobile policy (auto) field adjusters, claim that they and the members of the class they seek to represent were denied overtime compensation in violation of the federal Fair Labor Standards Act. The plaintiffs are seeking certification ofAct (“FLSA”) and California law. In February 2007, the Company and the Plaintiff reached a nationwide class of field adjusterspreliminary settlement providing for a period of three years precedingmaximum payment, including attorneys' fees and court costs, to all FLSA and California class members, which has been approved by the filingCourt. This amount has been accrued for and is not material to the financial position of the action,Company. It is anticipated that the settlement will be finally approved by the Court in July 2007.

On March 28, 2006, the California State Board of Equalization (“SBE”) upheld Notices of Proposed Assessments issued against the Company for tax years 1993 through 1996 in which the California Franchise Tax Board disallowed a portion of the Company’s expenses related to management services provided to its insurance company subsidiaries. As a result of this ruling, the Company recorded an income tax charge (including penalties and interest) of approximately $15 million, after federal tax benefit, in the first quarter of 2006. On April 24, 2007, the Company filed a complaint in the Superior Court for the City and County of San Francisco challenging the SBE decision and seeking recovery of allegedly unpaid overtime compensation, liquidated damages,the taxes, penalties and attorneys’ fees and costs. The Court has granted conditional certification for notice purposes.interest paid by the Company as a result of the SBE decision. The Company believes that the deduction of the expenses related to management services provided to its autoinsurance company subsidiaries is appropriate and intends to vigorously prosecute the case. The case is in its preliminary stages.

InRobert Krumme, On Behalf Of The General Public v. Mercury Insurance Company, Mercury Casualty Company, and California Automobile Insurance Company (Superior Court for the City and County of San Francisco), the Court issued a modified injunction on July 11, 2005 that, among other things, required the Company to accept applications for insurance from any California licensed broker with limited exceptions, restricted the use of broker manuals and communications with brokers by the Company’s field adjusters have properly been paidpersonnel, and allowed the Company to compensate brokers at the same rate based on volume of sales. The Company has implemented changes to its operations and believes that it is in compliance with the modified injunction. At the time the injunction was issued, the Court stated that it would consider vacating the modified injunction following a one year period of review of the changes in the Company’s operations. On March 2, 2007, the Company filed a motion seeking to vacate the modified injunction. A hearing on the Company’s motion is scheduled for all time worked, including any overtime hours andMay 15, 2007. The Company is vigorously defendingunable to determine whether the lawsuit.modified injunction will be vacated or estimate the impact of the Court’s decision regarding the modified injunction on future trends in earnings or loss ratios.

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Item 1A.         Risk Factors

There have been no material changes to the risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.2006.

None

None

None

None

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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