MERCURY GENERAL CORP — Annual Report 1997

Mar 28, 1997

SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1996 Commission File No. 0-3681 MERCURY GENERAL CORPORATION (Exact name of registrant as specified in its charter) California 95-221-1612 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 4484 Wilshire Boulevard, Los Angeles, California 90010 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (213)937-1060 Securities registered pursuant to Section 12(b) of the Act NONE Securities registered pursuant to Section 12(g) of the Act Common Stock (Title of Class) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the Registrant's voting stock held by non- affiliates of the Registrant at March 18, 1997, was approximately $837,029,058 (based upon the closing sales price of such date, as reported by the Wall Street Journal). At March 18, 1997, the Registrant had issued and outstanding an aggregate of 27,531,425 shares of its Common Stock. Documents Incorporated by Reference Proxy statement for the Annual Meeting of Stockholders of Registrant to be held on May 14, 1997 (only portions of which are incorporated by reference). Item 1. Business -------- General The Company is engaged primarily in writing all risk classifications of automobile insurance in California, which in 1996 accounted for approximately 97% of the Company's direct premiums written. In 1990, the Company commenced writing small amounts of automobile insurance in Georgia and Illinois. In December 1996 the Company acquired American Fidelity Insurance Group (AFI), which is headquartered in Oklahoma City, Oklahoma. AFI is licensed in 36 states but writes predominantly in Texas, Oklahoma and Kansas. AFI's primary lines of insurance are private passenger and commercial automobile and automobile mechanical breakdown. One month of AFI's operations are included in the Company's 1996 consolidated financial statements. During 1996, private passenger automobile insurance and commercial automobile insurance accounted for 93.8% and 4.0%, respectively, of the Company's direct premiums written. The Company also writes homeowners insurance, commercial and dwelling fire insurance and commercial property insurance. The non-automobile lines of insurance accounted for 2.3% of direct premiums written in 1996, of which approximately 51% was in commercial lines. The Company offers automobile policyholders the following types of coverage: bodily injury liability, underinsured and uninsured motorist, property damage liability, comprehensive, collision and other hazards specified in the policy. The Company's published maximum limits of liability for bodily injury are $250,000 per person, $500,000 per accident and, for property damage, $250,000 per accident. Subject to special underwriting approval, the combined policy limits may be as high as $1,000,000 for vehicles written under the Company's commercial automobile plan. Under the majority of the Company's automobile policies, however, the limits of liability are less than $100,000 per person, $300,000 per accident and $50,000 for property damage. In 1996, A.M. Best & Co. rated Mercury Casualty Company and Mercury Insurance Company, the Company's chief operating subsidiaries, A+ (Superior). This is the second highest of the fifteen rating categories in the A.M. Best rating system, which range from A++ (Superior) to F (In Liquidation). AFI was rated A- (Excellent) in 1996 by A.M. Best. The principal executive offices of Mercury General Corporation are located in Los Angeles, California. The home office of its California insurance subsidiaries and the Company's computer and operations center is located in Brea, California. The Company maintains branch offices in a number of locations in California. The non-California subsidiaries maintain offices in Vernon Hills, Illinois, Atlanta, Georgia, Oklahoma City, Oklahoma and Cimarron, Kansas. The Company has approximately 1800 employees. Organization Mercury General Corporation ("Mercury General"), an insurance holding company, is the parent of Mercury Casualty Company, a California automobile insurer founded in 1961 by George Joseph, its Chief Executive Officer. Its insurance operations in California are conducted through three California insurance company subsidiaries, Mercury Casualty Company ("Mercury Casualty"), Mercury Insurance Company ("Mercury Insurance"), and California Automobile Insurance Company. Two subsidiaries, Mercury Insurance Company of Georgia and Mercury Insurance Company of Illinois, received authority in late 1989 to write automobile insurance in those two states. In 1992, Mercury Indemnity Company of Georgia and Mercury Indemnity Company of Illinois were formed to write preferred risk automobile insurance in those two states. Through the Company's first acquisition in December 1996, three additional subsidiaries were added to the group: American Fidelity Insurance Company, domiciled in Oklahoma; Cimarron Insurance Company, domiciled in Kansas; and, AFI Management Company, Inc., a Texas corporation which serves as the attorney-in-fact for American Fidelity Lloyds Insurance Company (AFL), a Texas insurer. Accordingly, their operations are included in the consolidated financial statements of the Company effective December 1, 1996. Mercury General furnishes management services to its California, Georgia and Illinois subsidiaries. Mercury General, its subsidiaries, and AFL, are referred to as the "Company" unless the context indicates otherwise, Mercury General Corporation individually is referred to as "Mercury General." The term California Companies refers to Mercury Casualty Company, Mercury Insurance Company and California Automobile Insurance Company. Underwriting The Company sets its own automobile insurance premium rates, subject to rating regulations issued by the Insurance Commissioners of the applicable states. Automobile insurance rates on voluntary business in California have been subject to approval by the DOI since November 1989. The Company uses its own extensive data base to establish rates and classifications. On February 25, 1994, the California Department of Insurance (DOI) approved a revised rating plan and rates for the California Companies which became effective on May 1, 1994. These rates were designed to improve the California Companies' competitive position for new insureds and included a modest overall rate reduction. Further rate modifications were approved and made effective on October 15, 1995 and April 15, 1996. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Overview." In September 1996 the DOI issued new rating factor regulations, replacing expired emergency regulations issued in 1989. See "Regulation - Automobile Insurance Rating Factor Regulations." Approximately 80% of the Company's new applications for automobile insurance in California during 1996 were placed in the lowest risk classifications, known as "good drivers" (as defined by the California Insurance Code), while approximately 20% of new applications were accepted in higher risk classifications at increased rate levels. Policies are reclassified at the time of renewal and may be changed to a higher or lower risk classification. At December 31, 1996, "good drivers" accounted for approximately three quarters of all voluntary private passenger automobile policies in force in 2 California, while the higher risk categories accounted for approximately one quarter. The renewal rate in California (the rate of acceptance of offers to renew) averages approximately 95%. AFI's private passenger automobile business in force is predominantly standard and preferred type risks, although they plan to offer more non-standard programs in the future. Production and Servicing of Business The Company sells its policies through more than 1500 independent agents, of which approximately 800 are located in California and approximately 600 others represent AFI in Oklahoma, Kansas and Texas. Approximately half of the agents in California have represented the Company for more than ten years. The agents, most of whom also represent one or more competing insurance companies, are independent contractors selected and appointed by the Company. One agency produced direct premiums written of approximately 17%, 15% and 13% during 1996, 1995 and 1994, respectively, of the Company's total direct premiums. No other agent accounted for more than 2% of direct premiums written. The Company believes that its agents' compensation is higher than the industry average. During 1996 total commissions and bonuses incurred averaged 16.0% of direct premiums written. The Company is not responsible for any of its agents' expenses. Traditionally, any advertising done has been handled by the individual agents. During the fourth quarter of 1995, the Company began its first advertising program in major newspapers in Southern California. While the Company plans, coordinates and executes the program, the agents are responsible for the cost of the advertisements. The program has been satisfactory and was expanded to Northern California in early 1996. The program was temporarily suspended during the first quarter of 1997 due to a large influx of new business. See "Regulation- Financial Responsibility Law." Claims Claims operations are supervised by the Company. The claims staff in California, Georgia, Illinois and Oklahoma administers all claims and directs all legal and adjustment aspects of the claims process. The Company adjusts most claims without the assistance of outside adjusters. Loss and Loss Adjustment Expense Reserves The Company maintains reserves for the payment of losses and loss adjustment expenses for both reported and unreported claims. Loss reserves are estimated based upon a case-by-case evaluation of the type of claim involved and the expected development of such claim. The amount of loss reserves and loss adjustment expense reserves for unreported claims are determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results. 3 Ultimate liability may be greater or lower than stated loss reserves. Reserves are closely monitored and are analyzed quarterly by the Company's actuarial consultants using new information on reported claims and a variety of statistical techniques. The Company does not discount to a present value that portion of its loss reserves expected to be paid in future periods. The Tax Reform Act of 1986 does, however, require the Company to discount loss reserves for Federal income tax purposes. The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expenses, net of reinsurance deductions, as shown on the Company's consolidated financial statements for the periods indicated.

The purchase agreement includes an indemnification by the seller on the loss and loss adjustment expense reserves of AFI at the acquisition date, excluding the mechanical breakdown line, to avoid any impact on the Company's financial statements from any future adverse development on the acquisition date loss reserves. The difference between the reserves reported in the Company's consolidated financial statements prepared in accordance with generally accepted accounting principles (GAAP) and those reported in the statements filed with the DOI in accordance with statutory accounting principles (SAP) is shown in the table on the following page. 4

The following table represents the development of loss reserves for the period 1987 through 1996. The top line of the table shows the reserves at the balance sheet date net of reinsurance recoverable for each of the indicated years. This represents the estimated amount of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the cumulative amounts paid as of successive years with respect to that reserve liability. The lower portion of the table shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year, including cumulative payments made since the end of the respective year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. A redundancy (deficiency) exists when the original reserve estimate is greater (less) than the re-estimated reserves at December 31, 1996. In evaluating the information in the table, it should be noted that each amount includes the effects of all changes in amounts for prior periods. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.

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For the calendar years 1987 through 1995, the Company's previously estimated loss reserves produced redundancies. The Company attributes this favorable loss development to several factors. First, the Company had completed its development of a full complement of claims personnel early in this period. Second, during 1988, the California Supreme Court reversed what was known as the "Royal Globe" doctrine, which, since 1978, had permitted third party plaintiffs to sue insurers for alleged "bad faith" in resolving claims, even when the plaintiff had voluntarily agreed to a settlement. This doctrine had placed undue pressures on claims representatives to settle legitimate disputes at unfairly high settlement amounts. After the reversal of Royal Globe, the Company believes that it has been able to achieve fairer settlements, because both parties are in a more equal bargaining position. Third, during the years 1988 through 1990, the volume of business written in the Assigned Risk Program expanded substantially as rates were suppressed at grossly inadequate levels. Following the Insurance Commissioner's approval of an 85% temporary rate increase in September 1990, the volume of assigned risk business has declined by nearly 80%. Many of the claims associated with the high volume of assigned risk business in the 1988-1990 period were later found to be fraudulent or grossly exaggerated and were settled in subsequent periods for substantially less than had been initially reserved. Fourth, a number of factors have combined to produce favorable frequency and severity trends in recent years, and actuarial assumptions based on historical trends have proved to be conservative. Operating Ratios Loss and Expense Ratios ----------------------- Loss and underwriting expense ratios are used to interpret the underwriting experience of property and casualty insurance companies. Losses and loss adjustment expenses, on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses on a statutory basis are stated as a percentage of premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratios are less than 100%. The Company's loss ratio, expense ratio and combined ratio, and the private passenger automobile industry combined ratio, on a statutory basis, are shown in the following table. The 1992 ratios exclude the effect of a rate refund made pursuant to a settlement with the 6 California DOI related to the 1988 initiative, Proposition 103. The Company's ratios include lines of insurance other than private passenger automobile written by Mercury Casualty Company and AFI. Since these other lines represent only a small percentage of premiums written, the Company believes its ratios can be compared to the industry ratios included in the table.

(1) Source: A.M. Best, Aggregates & Averages (1996), for all property and casualty insurance companies (private passenger automobile line only, after policyholder dividends). (2) Source: A.M. Best, "Best's Review, January 1997," "Review and Preview." (N.A.) Not available. Premiums to Surplus Ratio ------------------------- The following table shows, for the periods indicated, the insurance companies' statutory ratios of net premiums written to policyholders' surplus. While there is no statutory requirement applicable to the Company which establishes a permissible net premium writings to surplus ratio, widely recognized guidelines established by the National Association of Insurance Commissioners (NAIC) indicate that this ratio should be no greater than 3 to 1.

(1) The 1992 amounts exclude the effect of the Proposition 103 settlement. Risk-Based Capital Requirements ------------------------------- In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment 7 policies, reinsurance arrangements and a number of other factors. Based on the formula adopted by the NAIC, the Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1996. Each of the companies exceeded the highest level of recommended capital requirements. Investments and Investment Results The investments of the Company are made by the Company's Chief Financial Officer under the supervision of the Company's Board of Directors. The Company follows an investment policy which is regularly reviewed and revised. The Company's policy emphasizes investment grade, fixed income securities and maximization of after-tax yields. The Company does not invest with a view to achieving realized gains, and does not maintain a trading account. However, sales of securities are undertaken, with resulting gains or losses, in order to enhance after-tax yield and keep its portfolio in line with current market conditions. Tax considerations are important in portfolio management, and have been made more so since 1986 when the alternative minimum tax was imposed on casualty companies. Changes in loss experience, growth rates and profitability produce significant changes in the Company's exposure to alternative minimum tax liability, requiring appropriate shifts in the investment asset mix between taxable bonds, tax-exempt bonds and equities in order to maximize after-tax yield. The optimum asset mix is subject to continuous review. At year-end, approximately 68% of the Company's portfolio, at market values, was invested in medium to long term, investment grade tax-exempt revenue and municipal bonds. The average Standard & Poor's rating of the Company's bond holdings was A at December 31, 1996. The nominal average maturity of the bond portfolio excluding AFI, was 16.8 years at December 31, 1996, but the call-adjusted average maturity of the portfolio is shorter, approximately 8.7 years, because holdings are heavily weighted with high coupon issues which are expected to be called prior to maturity. The modified duration of the bond portfolio reflecting anticipated early calls was 5.9 years at December 31, 1996 excluding AFI. Duration is a measure of how long it takes, on average, to receive all the cash flows produced by a bond, including reinvestment of interest. Because of its sensitivity to interest rates, it is a proxy for a bond's price volatility. The longer the duration, the greater the price volatility in relation to changes in interest rates. Holdings of lower than investment grade bonds constitute approximately 1.3% of total investments. All but $1.5 million of such holdings were downgraded to their current ratings subsequent to purchase. Equity holdings consist primarily of perpetual preferred stocks and relatively high yielding electric utility common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend exclusion. 8 The following table summarizes the investment results of the Company for the five years ended December 31, 1996.

(1) Includes AFI for the month of December 1996. (2) Fixed maturities at cost, equities at market. The following table sets forth the composition of the investment portfolio of the Company at the dates indicated, including AFI at December 31, 1996.

At December 31, 1996, the Company had a net unrealized gain on all investments of $29,163,000 before income taxes. 9 Competitive Conditions The property and casualty insurance industry is highly competitive. The insurance industry consists of a large number of companies, many of which operate in more than one state, offering automobile, homeowners and commercial property insurance, as well as insurance coverage in other lines. Many of the Company's competitors have larger volumes of business and greater financial resources than the Company. Based on regularly published statistical compilations concerning insurance company operations, the Company in 1995 was the seventh largest writer of private passenger automobile insurance in California. All of the insurance companies having greater shares of the California market sell insurance either directly or through exclusive agents, rather than through independent agents. The property and casualty insurance industry is highly cyclical, character- ized by periods of high premium rates and shortages of underwriting capacity followed by periods of severe price competition and excess capacity. In the Company's view, competitive pressures have become more pronounced in the last several years. The current level of profits makes the market attractive for new companies, although some of the small companies who entered the California private passenger automobile market in recent years have already experienced unsatisfactory results. Price and reputation for service are the principal means by which the Company competes with other automobile insurers. The Company believes that it has a good reputation for service, and it has, historically, been among the lowest-priced insurers doing business in California according to surveys conducted by the California Department of Insurance. In the most recent survey conducted in 1996, the Company's rates for most classes of insureds were among the lowest available in most territories throughout the state. In addition to good service and competitive pricing, for those insurers dealing through independent agents, as the Company does, the marketing efforts of agents is a means of competition. The current and future competitive climate for private passenger automobile insurance in California remains uncertain. All rates charged by private passenger automobile insurers are subject to the prior approval of the California Insurance Commissioner. New rating factor regulations have recently been issued but the filings required under those regulations have not yet been approved. See "Regulation - Automobile Insurance Rating Factor Regulations." AFI encounters similar competition in each state in which it principally operates. Reinsurance The Company no longer maintains reinsurance for its liability coverages in California. Effective January 1, 1994, the Company terminated its liability reinsurance coverage with Employers Reinsurance Corporation (ERC) because of rising premiums and underutilization of such coverage. The Company regularly evaluates the need for liability reinsurance. The Company maintains property reinsurance under a treaty which was effective April 1, 1995 with National Reinsurance Corporation, which is rated A+ by A.M. Best & Co. The treaty provides $900,000 coverage in excess of $100,000 for each risk subject to a maximum of $2,700,000 for any one occurrence. A 10 second layer of coverage provides an additional $1,000,000 in excess of the first $1,000,000 per risk subject to a maximum of $2,000,000 for any one occurrence. Prior to February 1, 1995, ERC provided catastrophe reinsurance for property and auto physical damage business. Under the treaty, ERC agreed to pay 95% of $9,000,000 in excess of $1,000,000 for any single occurrence and 95% of $18,000,000 for all occurrences in one calendar year. Effective February 1, 1995, the treaty with ERC was amended to provide coverage for 95% of $7,500,000 in excess of $5,000,000 each occurrence subject to an aggregate limit of 95% of $15,000,000 for all occurrences. Effective April 1, 1995 this treaty was replaced with a new catastrophe treaty covering all physical damage and property lines with several reinsurers arranged through E.W. Blanch Company, a reinsurance intermediary. The main reinsurers are rated A or better by A.M. Best. Under the new treaty, the first layer of protection is 95% of $7,500,000 in excess of $10,000,000, for a single occurrence, with a second layer providing 95% of $12,500,000 in excess of $17,500,000. Effective September 1, 1996 the treaty was replaced to provide coverage under two new layers through the same principal reinsurers. Under the new treaty coverage is provided for 95% of $10,000,000 in excess of $15,000,000 per occurrence in the first layer and 95% of $15,000,000 in excess of $25,000,000 in the second layer. Employers Reinsurance Corporation reinsures AFI through working layer treaties for property and casualty losses in excess of $150,000. For the years 1990 through 1996 the mechanical breakdown line of business was reinsured with Constitution Reinsurance Corporation through a quota-share treaty covering 50%- 85% of the business written depending on the year the policy incepted. For policies effective on or after January 1, 1997, AFI is retaining the full exposure. AFI has other reinsurance treaties and facultative arrangements in place for various smaller lines of business. If the reinsurers were unable to perform their obligations under the reinsurance treaty, the Company would be required, as primary insurer, to discharge all obligations to its insureds in their entirety. Regulation The Company's business in California is subject to regulation and supervision by the DOI, which has broad regulatory, supervisory and administrative powers. The powers of the DOI primarily include the prior approval of insurance rates and rating factors and the establishment of standards of solvency which must be met and maintained. The regulation and supervision by the DOI are designed principally for the benefit of policyholders and not for insurance company shareholders. The DOI conducts periodic examinations of the Company's insurance subsidiaries. The DOI recently conducted an examination of the California insurance subsidiaries as of December 31, 1994. The reports on the results of that examination recommended no adjustments to the statutory financial statements as filed by the Company. 11 The insurance subsidiaries outside California, including AFI, are subject to the regulatory powers of the insurance departments of those states. Those powers are similar to the regulatory powers in California enumerated above. Generally, the regulations relate primarily to standards of solvency and are designed for the benefit of policyholders and not for insurance company shareholders. In California, insurance rates have required prior approval since November 1989. Georgia and Kansas are also prior approval states, while Illinois only requires that rates be filed with the Department of Insurance prior to their use. Texas and Oklahoma have a modified version of prior approval laws. In all states, the insurance code provides that rates must not be "excessive, inadequate or unfairly discriminatory." The Georgia DOI recently conducted an examination of Mercury Insurance Company of Georgia and Mercury Indemnity Company of Georgia as of December 31, 1994. The reports on that audit have recommended no changes to the statutory financial statements as filed. The DOI of Illinois conducted an examination of Mercury Insurance Company of Illinois and Mercury Indemnity Company of Illinois as of December 31, 1995. The reports on that audit have not been issued but the auditors have indicated there will be no changes recommended to the statutory financial statements as filed. The states of Oklahoma, Kansas and Texas will also conduct periodic examinations of AFI. The operations of the Company are dependent on the laws of the state in which it does business and changes in those laws can materially affect the revenue and expenses of the Company. The Company retains its own legislative advocates in California. The Company also makes financial contributions to officeholders and candidates. In 1996 and 1995, those contributions amounted to $548,000 and $209,000, respectively. The Company believes in supporting the political process and intends to continue to make such contributions in amounts which it determines are appropriate and lawful. Insurance Guarantee Association ------------------------------- In 1969, the California Insurance Guarantee Association (the "Association") was created pursuant to California law to provide for payment of claims for which insolvent insurers of most casualty lines are liable but which cannot be paid out of such insurers' assets. The Company is subject to assessment by the Association for its pro-rata share of such claims based on premiums written in the particular line in the year preceding the assessment by insurers writing that line of insurance in California. Such assessments are based upon estimates of losses to be incurred in liquidating an insolvent insurer. In a particular year, the Company cannot be assessed an amount greater than 1% of its premiums written in the preceding year. The only assessment imposed during the past five years was an immaterial amount in 1994. Assessments are recouped through a mandated surcharge to policyholders the year after the assessment. Insurance subsidiaries in the other states are subject to the provisions of similar insurance guaranty associations. No material assessments were imposed in the last 5 years in those states either. 12 Holding Company Act ------------------- The Company's California subsidiaries are subject to regulation by the DOI pursuant to the provisions of the California Insurance Holding Company System Regulatory Act (the "Holding Company Act"). Pursuant to the Holding Company Act, the DOI may examine the affairs of each company at any time. The Holding Company Act requires disclosure of any material transactions by or among the companies. Certain transactions defined to be of an "extraordinary" type may not be effected without the prior approval of the DOI. Such transactions include, but are not limited to, sales, purchases, exchanges, loans and extensions of credit, and investments made within the immediately preceding 12 months involving, in the net aggregate, more than the lesser of 5% of the company's admitted assets or 25% of surplus as to policyholders, as of the preceding December 31. Effective January 1, 1997 the threshold for a material or extraordinary transaction was amended to a single measure of one half of one percent of admitted assets as of the preceding December 31st. There will no longer be any aggregation of transactions in the determination of the threshold except in the case of dividends. An extraordinary dividend is a dividend which, together with other dividends or distributions made within the preceding 12 months, exceeds the greater of 10% of the insurance company's policyholders' surplus as of the preceding December 31 or the insurance company's net income for the preceding calendar year. An insurance company is also required to notify the DOI of any dividend after declaration, but prior to payment. The Holding Company Act also provides that the acquisition or change of "control" of a California domiciled insurance company or of any person who controls such an insurance company cannot be consummated without the prior approval of the Insurance Commissioner. In general, a presumption of "control" arises from the ownership of voting securities and securities that are convertible into voting securities, which in the aggregate constitute 10% or more of the voting securities of a California insurance company or of a person that controls a California insurance company, such as Mercury General. A person seeking to acquire "control," directly or indirectly, of the Company must generally file with the Commissioner an application for change of control containing certain information required by statute and published regulations and provide a copy of the application to the Company. The Holding Company Act also effectively restricts the Company from consummating certain reorganizations or mergers without prior regulatory approval. The insurance subsidiaries in Georgia, Illinois, Oklahoma, Kansas and Texas are subject to holding company acts in those states, the provisions of which are substantially similar to those of California. Regulatory approval was obtained from California, Oklahoma and Texas before the acquisition of AFI was completed. Assigned Risks -------------- Automobile liability insurers in California are required to sell bodily injury liability, property damage liability, medical expense and uninsured motorist coverage to a proportionate number (based on the insurer's share of the California automobile casualty insurance market) of those drivers applying for placement as "assigned risks." Drivers seek placement as assigned risks because 13 their driving records or other relevant characteristics make them difficult to insure in the voluntary market. During the last five years, approximately 0.9% of the direct automobile insurance premium written was for assigned risk business. In 1996, assigned risks represented 0.6% of total automobile direct premiums written and 0.8% of total automobile direct premium earned. Premium rates for assigned risk business are set by the DOI. In October, 1990 more stringent rules for gaining entry into the plan were approved, resulting in a substantial reduction in the number of assigned risks insured by the Company since 1991. Effective January 1, 1994, the California Insurance Code requires that rates established for the Plan be adequate to support the Plan's losses and expenses. The last rate increase approved by the Commissioner approximated 4.8% and became effective June 1, 1995. Automobile Insurance Rating Factor Regulations ------------------------------------------------ Commencing November 8, 1989, Proposition 103 required that property and casualty insurance rates must be approved by the Commissioner prior to their use, and that no rate shall be approved which is excessive, inadequate, unfairly discriminatory or otherwise in violation of the provisions of the initiative. The proposition specified three statutory factors required to be applied in "decreasing order of importance" in determining rates for private passenger automobile insurance: (1) the insured's driving safety record, (2) the number of miles the insured drives annually, and (3) the number of years of driving experience of the insured. The new law also gave the Commissioner discretion to adopt other factors by regulation that have a substantial relationship to risk of loss. The new statute further provided that insurers are required to give at least a 20% discount to "good drivers," as defined, from rates that would otherwise be charged to such drivers and that no insurer may refuse to insure a "good driver." The Company, and most other insurers, historically charged different rates for residents of different geographical areas within California. The rates for urban areas, particularly in Los Angeles, have been generally substantially higher than for suburban and rural areas. The Company's geographical rate differentials have been derived by actuarial analysis of the claims costs in a given area. In September 1996, the California Insurance Commissioner issued new permanent rating factor regulations which replaced the emergency regulations which have been in use since their issuance in 1989. The new regulations require all automobile insurers in California to submit new rating plans complying with the regulations by February 18, 1997. The Company does not expect the newly filed rating plan, if approved by the Commissioner, to have a material effect on its competitive position or its profitability. However, the Company has not been able to review the filings of its competitors. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Overview." California Financial Responsibility Law --------------------------------------- Effective January 1, 1997 California has a new law which requires proof of insurance for the registration (new or renewal) of a motor vehicle. It also provides for substantial penalties for failure to supply proof of insurance if 14 one is stopped for a traffic violation. Media attention to the new law has resulted in a surge of new business applications in January. Although the initial demand has tapered off, it has produced a backlog of applications, which are being processed. The persistence of this new business is uncertain, but the new law could produce additional growth considering the large proportion of uninsured motorists in California. The Company has suspended its advertising program while it works to eliminate the backlog of new business. In November 1996 an initiative sponsored by the California Insurance Commissioner was overwhelmingly approved by the California voters. It provides that uninsured drivers who are injured in an automobile accident are able to recover only actual, out-of-pocket medical expenses and lost wages and are not entitled to receive awards for general damages, i.e., "pain and suffering." This restriction also applies to drunk drivers and fleeing felons. The law will help in controlling loss costs, but its constitutionality is being challenged by an association of attorneys. Item 2. Properties ---------- The home office of the California insurance subsidiaries and the Company's computer facilities are located in Brea, California in an 80,000 sq.ft. office building owned by the Company. Since December 1986, Mercury General's executive offices are located in a 36,000 sq. ft. office building, in Los Angeles, owned by Mercury Casualty Company. The Company occupies approximately 95% of the building and leases the remaining office space to others. In October 1992 the Company purchased a 158,000 square foot office building in Brea, California. The Company occupies approximately 43% of the facility and leases the remaining office space to others. The Company leases all of its other offices under short-term leases. Office location is not material to the Company's operations, and the Company anticipates no difficulty in extending these leases or obtaining comparable office space. Item 3. 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 California judicial decisions. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. The Company believes that adverse results, if any, in the actions currently pending should not have a material effect on the Company's operations or financial position. 15 Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- No matters were submitted to a vote of security holders by the Company during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE COMPANY The following table sets certain information concerning the executive officers of the Company as of March 21, 1997:

Mr. Joseph, Chief Executive Officer of the Company and Chairman of its Board of Directors, has served in those capacities since 1961. Mr. Joseph has more than 45 years experience in the property and casualty insurance business. Mr. Curtius, President and Chief Operating Officer, has been employed by the Company since 1977. In October 1987, Mr. Curtius was named Vice President and Chief Claims Officer, and in August 1991 he was appointed Executive Vice President. He was elected President and Chief Operating Officer of Mercury General and its four California insurance company subsidiaries in May 1995 and elected to the Board of Directors of Mercury General and the California Companies in 1996. In December of 1996 he was appointed Vice Chairman of American Fidelity Insurance Company. Mr. Curtius has over 20 years of experience in the insurance industry. Mr. Blanton, Executive Vice President, joined the Company in 1966 and supervised its underwriting activities from 1967 until September 1995. He was appointed Executive Vice President of Mercury Casualty and Mercury Insurance in 1983 and was named Executive Vice President of Mercury General in 1985. In May of 1995 he was named President of the Georgia and Illinois insurance company subsidiaries and in February of 1996 he was elected to the Board of Directors of those companies. Mr. Blanton has over 40 years of experience in underwriting and other aspects of the property and casualty insurance business. Mr. Parker, Vice President and Chief Financial Officer, has been employed by the Company or its subsidiaries since 1970 and has held his present position since October 1985. Mr. Parker has over 40 years of investment management experience and has been primarily responsible for management of the Company's investment portfolio since 1972. 16 Mr. Norman, Vice President in charge of Marketing, has been employed by the Company since 1971. Mr. Norman was named to this position in October 1985, and has been a Vice President of Mercury Casualty since 1983. Mr. Norman has supervised the selection and training of agents and managed relations between agents and the Company since 1977. In February of 1996 he was elected to the Board of Directors of the California Companies. Ms. Joanna Moore, Vice President & Chief Claims Officer, joined the Company in the claims department in March 1981. She was named Vice President of Claims of Mercury General in August 1991 and has held her present position since July 1995. Mr. Kitzmiller, Vice President in charge of Underwriting, has been employed by the Company in the underwriting department since 1972. In August 1991 he was appointed Vice President of Underwriting of Mercury General and has supervised the underwriting activities of the Company since early 1996. Ms. Donna Moore, Vice President and Controller, joined the Company in June 1983 as its Controller. She was appointed Vice President in October 1985. Ms. Moore has over 15 years of experience in the insurance industry and is a Certified Public Accountant in the state of California. Ms. Walters has been employed by the Company since 1967, and has served as its Secretary since 1982. 17 PART II Item 5. Market for the Registrant's Common Equity and Related Security -------------------------------------------------------------- Holder Matters -------------- Price Range of Common StocK The following table shows the price range per share in each quarter as reported on the Nasdaq National Market until October 9, 1996 and on the New York Stock Exchange since that date. These quotations do not include adjustments for retail mark-ups, mark-downs or commissions.

Dividends Following the public offering of its Common Stock in November 1985, the Company has paid regular quarterly dividends on its common stock. On February 7, 1997, the Directors declared a $0.29 quarterly dividend ($1.16 annually) payable on March 31, 1997 to stockholders of record on March 17, 1997. The dividend rate has been increased thirteen times since dividends were initiated in January, 1986, at an annual rate of $0.10, adjusted for the two-for-one stock split in September 1992. For financial statement purposes, the Company records dividends on the declaration date. The Company expects to continue the payment of quarterly dividends. The continued payment and amount of cash dividends will depend upon, among other factors, the Company's operating results, overall financial condition, capital requirements and general business conditions. As a holding company, Mercury General is largely dependent upon dividends from its subsidiaries to pay dividends to its shareholders. These subsidiaries are subject to state laws that restrict their ability to distribute dividends. The state laws permit a casualty insurance company to pay dividends and advances within any 12-month period, without any prior regulatory approval, in an amount up to the greater of ten percent of statutory earned surplus at the preceding December 31, or net income for the calendar year preceding the date the dividend is paid. Under this test, the direct insurance subsidiaries of the Company are 18 entitled to pay dividends to Mercury General during 1997 of up to approximately $61.5 million. See Note 9 of Notes to Consolidated Financial Statements and "Business -- Regulation -- Holding Company Act." Shareholders of Record The approximate number of holders of record of the Company's Common Stock as of March 1, 1997 was 230. The approximate number of beneficial holders as of March 17, 1997 was 5,231 according to the Bank of New York, the Company's transfer agent. 19 Item 6. Selected Consolidated Financial Data ------------------------------------

______ 20 Item 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations --------------------- Overview - -------- The operating results of property and casualty insurance companies are subject to significant fluctuations from quarter-to-quarter and from year-to- year due to the effect of competition on pricing, the frequency and severity of losses, including the effect of natural disasters on losses, 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. The Company did business only in the state of California until 1990, when it began operations in Georgia and Illinois. In December 1996, the American Fidelity Insurance Group (AFI) was acquired for cash. The results of operations of AFI for the month of December only are included in the Company's consolidated statements of income. AFI writes automobile (approximately 54% of AFI's direct premiums) and other casualty lines of insurance principally in Oklahoma, Texas and Kansas, and is headquartered in Oklahoma City, Oklahoma. Total direct premiums written by AFI in 1996 were $90.4 million; of that amount $5.5 million of premiums were written in December. The Group is licensed in 36 states. During 1996, approximately 98% of the Company's direct premiums written, excluding AFI, were derived from California. In California, as in various other states, all property and casualty rates must be approved by the Insurance Commissioner before they can be used. In February 1994, the Commissioner approved new rates which were designed to improve the Company's competitive position for new insureds. These rate changes, which became effective on May 1, 1994, provided for decreases in premium rates for new insureds. Further rate modifications were approved and made effective on October 15, 1995 and April 15, 1996. The rate changes made over the last three years have been substantially revenue-neutral overall, with physical damage rates being increased and bodily injury liability rates decreased. The rate changes have resulted in a substantial increase in new business being submitted to the Company. Since March 31, 1994, Private Passenger Automobile (PPA) policies in force in California have increased by approximately 190,000 to 494,000 at December 31, 1996, an annual rate of increase of over 20%, compared with an annualized growth rate of 4.1% over the prior fifteen month period. In September 1996, the California Insurance Commissioner issued new permanent rating factor regulations designed to implement the requirements that automobile insurance rates be determined by (1) driving safety record, (2) years of driving experience, (3) miles driven per year and (4) whatever optional factors are determined by the Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further requires that each of the four factors be applied in decreasing order of importance. 21 The new permanent regulations replace emergency regulations which have been in use since their issuance in 1989. They require all automobile insurers in California to submit new rating plans complying with the regulations in early 1997. In January 1997, in response to a court ruling on the issue of surcharges imposed on drivers not complying with California's financial responsibility law, the Commissioner amended the regulations to exclude such non-compliance as a rating factor. The statistical methodology prescribed by the regulations for determining rating factor weightings are technical and complex. The January amendment required the Company to rework its rate filing. The Company submitted its new proposed rating plan on March 11, 1997. The filings must be reviewed and approved by the Department, and the companies will have ninety days following approval to place their new rates in effect. The Company does not expect the newly filed rating plan, if approved by the Commissioner, to have a material effect on its competitive position or its profitability. However, the Company has not yet been able to review the filings of its competitors. Results of Operations Year Ended December 31, 1996 Compared to Year Ended December 31, 1995 --------------------------------------------------------------------- Premiums earned in 1996 of $754.7 million (including $5.2 million contributed by AFI in December 1996) increased 22.5%, primarily reflecting unit growth. Average premium per policy for the year was substantially unchanged. Net premiums written in 1996 of $795.9 million (including $4.5 million contributed by AFI) increased 25.0% over a year earlier, continuing a growth trend which began in the second quarter of 1993. The loss ratio in 1996 (loss and loss adjustment expenses related to premiums earned) was 66.5%, compared with 67.6% in 1995. The 1996 and 1995 loss ratios reflect small contributions from favorable loss reserve development from prior periods. The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 24.4% in 1996 and 1995. The consolidation of one month of operating results of AFI in 1996 had no material effect on either the loss or expense ratios. Total losses and expenses in 1996, excluding interest expense of $2.0 million, were $686.4 million, resulting in an underwriting gain for the period of $68.4 million, compared with an underwriting gain of $49.0 million in 1995. Investment income in 1996, including a contribution from AFI of $400,000 for the final month of the year, was $70.2 million, compared with $63.0 million in 1995. The after-tax yield on average investments of $975.1 million, including AFI, (fixed maturities at cost, equities at market) was 6.50%, compared with 6.89% on average investments of $827.9 million in 1995. The effective tax rate on investment income was 9.7% in 1996, compared with 9.4% in 1995. The effective tax rate was increased and the effective after-tax yield was reduced slightly by 22 the inclusion of AFI for the month of December 1996. The effective tax rate on investment income in 1996, excluding AFI, was 9.6%, and the after-tax yield was 6.56%. The slightly higher tax rate on investment income in 1996 reflects an increase in the proportion of investment income derived from dividends on equities, principally perpetual preferred stocks. The redemption of bonds acquired during higher interest periods has been a negative influence on realized yields in each of the last several years and will continue in 1997. Bonds matured and called in 1996 totaled $72.9 million, compared with $71.0 million in 1995, and approximately $48.6 million of calls and maturities are expected in 1997. Average yields being obtained during the first quarter of 1997 on new investments are some 50 basis points lower than the average yield realized in 1996. Realized investment losses in 1996 were $3.2 million, compared with realized gains of $1.0 million in 1995. The 1996 losses reflect principally yield-enhancing swaps of both fixed maturities and equity securities, including perpetual preferred stocks, designed to utilize expiring capital gains tax benefits. The 1995 gains arose in part from the early redemption of fixed- maturity investments. The income tax provision of $30.8 million in 1996 represented an effective tax rate of 22.6%, compared with an effective rate of 21.0%, in 1995. The increase in the rate is attributable principally to the greater contribution from underwriting gains, which are fully taxable and increased by $19.4 million during 1996, whereas the predominantly tax-free investment income increased $7.2 million. Net income in 1996 was $105.8 million, or $3.86 per share, compared with $90.3 million, or $3.31 per share, in 1995. Per share results are based on 27.4 million average shares in 1996 and $27.3 million average shares in 1995. Year Ended December 31, 1995 Compared to Year Ended December 31, 1994 --------------------------------------------------------------------- Premiums earned in 1995 increased 16.4%, primarily reflecting unit growth. Average premium per policy for the year was substantially unchanged. Net premiums written in 1995 increased 15.6% over a year earlier, continuing a growth trend which began in the second quarter of 1993. The loss ratio in 1995 (loss and loss adjustment expenses related to premiums earned) was 67.6%, compared with 68.1% in 1994. In contrast to the previous several years, the 1995 and 1994 loss ratios reflect smaller contributions from favorable loss reserve development from prior periods. The expense ratio (policy acquisition costs and other operating expenses related to premiums earned) was 24.4%, compared with 25.2% in 1994. The improvement reflects both economies related to greater premium volume and smaller provisions for agent and employee incentive bonuses in 1995. Total losses and expenses, excluding interest expense of $2.0 million, were $567.4 million, resulting in an underwriting gain for the period of $49.0 million, compared with an underwriting gain of $35.6 million in 1994. 23 Investment income in 1995 was $63.0 million, compared with $54.6 million in 1994. The after-tax yield on average investments of $827.9 million (fixed maturities at cost, equities at market) was 6.89%, compared with 6.84% on average investments of $727.9 million in 1994. The effective tax rate on investment income was 9.4% in 1995, compared with 8.8% in 1994. The slightly higher tax rate reflects an increase in the proportion of investment income derived from dividend income on equities, principally perpetual preferred stocks, compared to tax-exempt income. The maintenance of above-average yields during a period of declining interest rates is, in part, the result of the bond restructuring program undertaken in 1994 when bonds acquired in lower interest rate environments were sold with proceeds reinvested at significantly higher rates. The redemption of bonds acquired during higher interest periods has been a negative influence on realized yields which will continue in 1996 and 1997. Bonds matured and called in 1995 totaled $71.0 million, compared with $53.4 million in 1994, and approximately $83.1 million of calls and maturities are expected in 1996. Average yields being obtained during the first quarter of 1996 on new investments are some 50-75 basis points lower than the average 1995 portfolio yield. Realized investment gains in 1995 were $1.0 million, compared with realized losses of $9.9 million in 1994. The 1994 losses reflect principally yield- enhancing swaps of both fixed maturities and equity securities, including perpetual preferred stocks, undertaken to recapture capital gains taxes paid in prior years. The 1995 gains arose in part from the early redemption of fixed- maturity investments. The income tax provision of $24.0 million in 1995 represented an effective tax rate of 21.0%, compared with an effective rate of 19.6%, in 1994. The increase in the rate is attributable principally to the realization of capital gains in 1995, in contrast to the realization of losses in 1994. Net income in 1995 was $90.3 million, or $3.31 per share, compared with $66.3 million, or $2.43 per share, in 1994. Per share results are based on 27.3 million average shares in both years. Year Ended December 31, 1994 Compared to Year Ended December 31, 1993 --------------------------------------------------------------------- Premiums earned in 1994 increased 11.7%, reflecting unit growth. Average premium per policy was substantially unchanged by the May 1, 1994 rate revisions. Direct premiums written in the first half of 1994 increased 10.7% over a year earlier, continuing the growth trend which began in the second quarter of 1993. During the last half of 1994, this increase accelerated to 14.1% over the prior year as a result of the May 1, 1994 rate revisions. The loss ratio in 1994 was 68.1%, compared with 61.0% in 1993. The higher loss ratio in 1994 reflects a much smaller contribution from favorable loss reserve development from prior periods and a reduction in the estimate of salvage and subrogation recoverable for prior accident years. The major earthquake which struck Southern California on January 17, 1994 resulted in net loss claims, after reinsurance recoveries, of approximately $1.2 million, which added less than 0.25% to the 1994 loss ratio. Earthquake losses were immaterial as the Company writes only a small amount of homeowners' insurance. Approximately one half of 24 the net earthquake losses incurred were related to the Company's principal line, automobile insurance, while the other half was related to the homeowners' line. The expense ratio (policy acquisition costs and other expenses related to premiums earned) was 25.2%, compared with 25.0% in 1993. Total losses and expenses, excluding interest expense of $1,025,000, were $493.8 million, resulting in an underwriting gain for the period of $35.6 million, compared with an underwriting gain of $66.6 million in 1993. Investment income in 1994 was $54.6 million, compared with $54.1 million in 1993. The after-tax yield on average investments of $727.9 million (fixed maturities at cost, equities at market) was 6.84%, compared with 7.05% on average investments of $683.9 million in 1993. The effective tax rate on investment income was 8.8% in 1994, compared with 10.9% in 1993, reflecting an increase in the proportion of tax-exempt interest income. The decline in realized investment yields reflects principally the redemption and maturity of bonds and preferred stocks acquired in higher interest rate environments. Realized investment losses in 1994 were $9.9 million, compared with realized gains of $3.0 million in 1993. The losses reflect principally yield- enhancing swaps of both fixed maturities and equity securities, including perpetual preferred stocks. The 1993 gains arose in significant part from the redemption of fixed-maturity investments. The realized capital losses were undertaken to recapture capital gains taxes paid in prior years. The income tax provision of $16.1 million in 1994 represented an effective tax rate of 19.6%, compared with an effective rate of 23.3%, in 1993. The decrease in the rate is attributable principally to the decrease in fully taxable underwriting income, and the resulting higher proportion of tax exempt investment income. Net income in 1994 was $66.3 million, or $2.43 per share, compared with $96.2 million, or $3.52 per share, in 1993. Per share results are based on 27.3 million average shares in 1994 and 27.4 million average shares in 1993. Liquidity and Capital Resources Net cash provided from operating activities in 1996, including $9.7 million from AFI, was $196.6 million, while funds derived from the sale, redemption or maturity of investments was $531.5 million, of which approximately 75% was represented by the sale of equity securities. The amortized cost of fixed- maturity investments increased by $182.4 million during the year. Equity investments, including perpetual preferred stocks, increased by $34.8 million at cost, and short-term cash investments increased by $37.6 million. The amortized cost of fixed-maturities available for sale that were sold, called or matured during the year was $133.2 million. The market value of all investments held at market as "Available for Sale" exceeded the amortized cost of $1,139.1 million at December 31, 1996 by $29.2 million. That unrealized gain, reflected in shareholders' equity net of applicable tax effects, was $19.0 million at December 31, 1996 compared with an 25 unrealized gain of $25.2 million at December 31, 1995. The decrease in market values since December 31, 1995 reflects principally the increase in intermediate and long term interest rates during 1996. The Company's cash and short term investments totaled $69.7 million at December 31, 1996. Together with funds generated internally, such liquid assets are more than adequate to pay claims without the sale of long term investments. Traditionally, it has been the Company's policy not to invest in high yield or "junk" bonds. In 1995, the Company adopted a policy to place a small proportion of its investments in the taxable sector in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1996 bond holdings rated below investment grade totaled $15.2 million at market (cost $14.9 million), or 1.3% of total investments. All but $1.5 million of such holdings were downgraded to their current ratings subsequent to purchase. The average rating of the $789.6 million bond portfolio, excluding AFI, (at amortized cost) was A, while the average effective maturity, giving effect to anticipated early call, approximates 8.7 years. The modified duration of the bond portfolio at year-end, excluding AFI, was 5.9 years, reflecting the heavy weighting of high coupon issues, including housing issues subject to sinking funds, and other issues which are pre-refunded or are expected to be called prior to their maturity. Duration measures the length of time it takes to receive all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is a much better indicator of price volatility than simple maturity alone. Bond holdings are broadly diversified geographically, and, within the tax-exempt sector, consist largely of high coupon revenue issues, many of which have been pre-refunded and escrowed with U.S. Treasuries. General obligation bonds of the large eastern cities have generally been avoided. Holdings in the taxable sector consist largely of senior public utility issues. Fixed-maturity investments of $924.8 million, including $68.5 million held by AFI, (at amortized cost) include $66.7 million of sinking fund preferreds, principally utility issues. The market value of all fixed maturities exceeded cost by $29.3 at December 31, 1996. The only securities held which may be considered derivatives are a small amount of adjustable rate preferred stocks. Except for Company-occupied buildings, the Company has no direct investments in real estate and no holdings of mortgages secured by commercial real estate. Equity holdings of $148.1 million at market (cost $148.3 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 23.1% of total shareholders' equity. The only significant debt of the Company at December 31, 1996 was a three year, $75,000,000 revolving credit bank loan. The loan agreement requires the Company to meet numerous affirmative and negative covenants. The proceeds of the loan were used to repay a prior loan and to acquire American Fidelity Insurance Company, with the balance contributed to the Company's new insurance subsidiaries. The loan agreement may be extended annually for additional periods 26 of one year each to maintain the three year maturity date. The interest rate is variable and is optionally related to the Federal Funds Rate, Bank of New York Rate (prime rate) or the Eurodollar London Interbank Rate (LIBOR). Based on the rates effective through June 25, 1997, LIBOR plus .50, the net interest cost on the loan approximates 6.08%. In March 1994, the Company's Employee Stock Ownership Plan (the Plan) purchased 161,000 shares of Mercury's common stock in the open market at a price of $29.75 per share. The purchases were funded by a $5.0 million bank loan to the Plan which is guaranteed by the Company. The shares are being allocated to employees over a five year period, with the initial allocation made in December 1994, and the debt is being retired by Company contributions to the Plan over the same time period. Since dividends on unallocated shares held by the Plan are tax deductible if they are used for debt service, as are Company contributions to the Plan, the net, after-tax interest cost to the Company for the borrowed funds used for the Plan stock purchase is less than the nominal 6.98% fixed rate of interest on the loan. In December 1993, the NAIC adopted a risk-based capital formula for casualty insurance companies which establishes recommended minimum capital requirements for casualty companies. The formula has been designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance having differing risk characteristics, as well as writers of similar lines where differences in risk may be related to corporate structure, investment policies, reinsurance arrangements and a number of other factors. The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1996. Each of the companies' policyholders' surplus exceeded the highest level of recommended capital requirements. As of December 31, 1996, the Company had no material commitments for capital expenditures. Industry and regulatory guidelines suggest that the ratio of a property and casualty insurer's annual net premiums written to statutory policyholders' surplus should not exceed 3.0 to 1. Based on the combined surplus of all of the licensed insurance subsidiaries of $594.8 million at December 31, 1996, and net written premiums for the twelve months ended on that date of $795.9 million, the ratio of writings to surplus was approximately 1.3 to 1. Forward-Looking statements The foregoing discussion contains forward-looking statements regarding the Company, its business, prospects and results of operations that are subject to certain risks and uncertainties posed by factors and events that could cause the Company's actual business, prospects and results of operations to differ materially from the historical information contained herein and from those that may be expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, among others, the success of the Company in integrating and profitably operating the business of AFI, the impact of the permanent rating factor regulations recently adopted by the California Insurance Commissioner for private passenger automobile policies issued in California and the level of investment yields obtainable in the 27 Company's investment portfolio in comparison to recent yields, as well as the cyclical and competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve estimates and legislative and regulatory changes. Such risks and uncertainties and other factors are discussed above and in periodic filings with the Securities and Exchange Commission. Supplementary Data Summarized quarterly financial data for 1996 and 1995 is as follows (in thousands except per share data):

28 Item 8. Financial Statements - ------------------------------ INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

29 INDEPENDENT AUDITORS' REPORT The Board of Directors Mercury General Corporation: We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996, in conformity with generally accepted accounting principles. KPMG PEAT MARWICK LLP Los Angeles, California February 21, 1997 30 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1996 AND 1995 AMOUNTS EXPRESSED IN THOUSANDS, EXCEPT SHARE AMOUNTS A S S E T S

See accompanying notes to consolidated financial statements. 31 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME THREE YEARS ENDED DECEMBER 31, 1996 AMOUNTS EXPRESSED IN THOUSANDS, EXCEPT PER SHARE DATA

See accompanying notes to consolidated financial statements. 32 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1996 AMOUNTS EXPRESSED IN THOUSANDS

See accompanying notes to consolidated financial statements. 33 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1996 Amounts expressed in thousands

(Continued) 34 MERCURY GENERAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

See accompanying notes to consolidated financial statements. 35 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1996 and 1995 (1) Significant Accounting Policies Principles of Consolidation and Presentation The Company is primarily engaged in the underwriting of private passenger automobile insurance in the state of California. The consolidated financial statements include the accounts of Mercury General Corporation (the Company) and its wholly-owned subsidiaries, Mercury Casualty Company, Mercury Insurance Company, California Automobile Insurance Company, California General Underwriters Insurance Company, Inc., Mercury Insurance Company of Georgia, Mercury Insurance Company of Illinois, Mercury Indemnity Company of Georgia and Mercury Indemnity Company of Illinois. Effective December 1, 1996 the financial statements also include newly acquired companies American Fidelity Insurance Company, Cimarron Insurance Company, Inc., AFI Management Company, Inc. (AFIMC), and American Fidelity Lloyds Insurance Company (AFL). AFL is not owned by MGC, but is controlled by MGC through its attorney-in-fact, AFIMC. The acquisition is discussed further in Note 8. Collectively, the newly-acquired companies, including AFL, are referred to as AFI. All of the subsidiaries as a group, including AFL, but excluding AFIMC, are referred to as the Insurance Companies. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) which differ in some respects from those filed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Investments Fixed maturities available for sale include those securities that management intends to hold for indefinite periods, but which may be sold in response to changes in interest rates, tax planning considerations or other aspects of asset/liability management. Fixed maturities available for sale, which include bonds and sinking fund preferred stocks, are carried at market. Short-term investments are carried at cost, which approximates market. Investments in equity securities, which include common stocks and non-redeemable preferred stocks, are carried at market. 36 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (1) Significant Accounting Policies (Continued) In most cases, the market valuations were drawn from standard trade data sources. In no case were any valuations made by the Company's management. Equity holdings, including non sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price. Temporary unrealized investment gains and losses on securities available for sale are credited or charged directly to shareholders' equity, net of applicable tax effects. When a decline in value of fixed maturities or equity securities is considered other than temporary, a loss is recognized in the consolidated statement of income. Realized gains and losses are included in the consolidated statements of income based upon the specific identification method. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments", and Statement of Financial Accounting Standards No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments", require disclosure of estimated fair value information about financial instruments, for which it is practicable to estimate that value. Under SFAS No. 115, the Company categorizes all of its investments in debt and equity securities as available for sale. Accordingly, all investments, including cash and short-term cash investments, are carried on the balance sheet at their fair value. The carrying amounts and fair values for investment securities are disclosed in Note 2 and were drawn from standard trade data sources such as market and broker quotes. The estimated fair value is equivalent to the carrying value of receivables, accounts payable and other liabilities. The estimated fair value of notes payable equals their carrying value, which was based on borrowing rates currently available to the Company for bank loans with similar terms and maturities. The terms of the notes are discussed in Note 5. Premium Income Recognition Insurance premiums are recognized as income ratably over the term of the policies. Unearned premiums are computed on the monthly pro rata basis. The liability is stated gross of reinsurance deductions, with the reinsurance deduction recorded in other assets. Net premiums written during 1996, 1995 and 1994 were $795,873,000, $636,590,000 and $550,838,000, respectively. 37 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (1) Significant Accounting Policies (Continued) One agent produced direct premiums written of approximately 17%, 15% and 13% of the Company's total direct premiums written during 1996, 1995 and 1994, respectively. Premium Notes Premium notes receivable represent the balance due to the Company from policyholders who elect to finance their premiums over the policy term. The Company requires both a downpayment and monthly payments as part of its financing program. Premium finance fees are charged to policyholders who elect to finance premiums. The fees are charged at rates that vary with the amount of premium financed. Premium finance fees are recognized over the term of the premium note based upon the effective yield. Deferred Policy Acquisition Costs Acquisition costs related to unearned premiums, which consist of commissions, premium taxes and certain other underwriting costs, which vary directly with and are directly related to, the production of business, are deferred and amortized to income ratably over the terms of the policies. Deferred acquisition costs are limited to the amount which will remain after deducting from unearned premiums and anticipated investment income, the estimated losses and loss adjustment expenses and the servicing costs that will be incurred as the premiums are earned. Losses and Loss Adjustment Expenses The liability for losses and loss adjustment expenses is based upon the accumulation of individual case estimates for losses reported prior to the close of the accounting period, plus estimates, based upon past experience, of ultimate developed costs which may differ from case estimates and of unreported claims. The liability is stated net of anticipated salvage and subrogation recoveries. The amount of reinsurance recoverable is included in other receivables. Estimating loss reserves is a difficult process as there are many factors that can ultimately affect the final settlement of a claim and, therefore, the reserve that is needed. Changes in the law, results of litigation, medical costs, the cost of repair materials and labor rates can all 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. Management believes that 38 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (1) Significant Accounting Policies (Continued) 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 provisions. Depreciation Buildings and furniture and equipment are depreciated over 30-year and 5- year to 10-year periods, respectively, on a combination of straight-line and accelerated methods. Automobiles are depreciated over 5 years, using an accelerated method. Earnings per Share Earnings per share are computed by dividing earnings by the weighted average number of common shares outstanding of 27,397,173 for 1996, 27,311,707 for 1995, and 27,273,192 for 1994. Income Taxes Deferred income taxes result from temporary differences in the recognition of income and expense for tax and financial reporting purposes. Reinsurance In accordance with SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," the liabilities for unearned premiums and unpaid losses are stated in the accompanying consolidated financial statements before deductions for ceded reinsurance. The ceded amounts are immaterial and are carried in other assets and other receivables. Earned premiums are stated net of deductions for ceded reinsurance. The Insurance Companies, as primary insurers, would be required to pay losses in their entirety in the event that the reinsurers were unable to discharge their obligations under the reinsurance agreements. Statements of Cash Flows Interest paid during 1996, 1995, and 1994 was $1,882,000, $1,970,000, and $1,001,000, respectively. Income taxes paid were $30,550,000 in 1996, $18,954,000 in 1995, and $19,315,000 in 1994. 39 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (1) Significant Accounting Policies (Continued) The balance sheet of AFI at acquisition date included the following assets: investments of $75,310,000, cash of $1,362,000, receivables of $44,418,000 and other assets of $31,124,000. Liabilities assumed in the acquisition included unearned premiums of $50,199,000, loss and loss adjustment expense reserves of $47,039,000 and other liabilities of $19,985,000. Stock-Based Compensation During October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"), which is effective for fiscal years beginning after December 15, 1995. The Company accounts for stock-based compensation under the accounting methods prescribed by Accounting Principles Board (APB) Opinion No. 25, as allowed by SFAS No. 123. Disclosure of stock-based compensation determined in accordance with SFAS No. 123 is presented in Footnote 13. Accordingly, adoption of this pronouncement did not have a material effect on the financial statements of the Company. Reclassifications Certain reclassifications have been made to the prior year balances to conform to the current year presentation. (2) Investments and Investment Income A summary of net investment income is shown in the following table:

40 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (2) Investments and Investment Income (Continued) A summary of net realized investment gains (losses) is as follows:

Gross gains and losses realized on the sales of investments (excluding calls) are shown below:

A summary of the net increase (decrease) in unrealized investment gains (losses) less applicable income tax expense (benefit), is as follows:

41 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (2) Investments and Investment Income (Continued) Accumulated unrealized gains and losses on securities available for sale follows:

The amortized cost and estimated market values of investments in fixed maturities available for sale as of December 31, 1996 are as follows:

42 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (2) Investments and Investment Income (Continued) The amortized cost and estimated market values of investments in fixed maturities available for sale as of December 31, 1995 are as follows:

Traditionally, it has been the Company's policy not to invest in high yield or non-investment grade bonds. In 1995, the Company adopted a policy allowing a small percentage of its investments to be placed in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1996 bond holdings rated below investment grade totaled approximately 1.3% of total investments. All but $1.5 million of such holdings were downgraded subsequent to purchase. The average Standard and Poor's rating of the bond portfolio is A. The amortized cost and estimated market value of fixed maturities available for sale at December 31, 1996, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

43 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (2) Investments and Investment Income (Continued) The Company utilizes repurchase agreements for investing funds overnight. All repurchase agreements utilized require U.S. Treasury securities or obligations of U.S. government corporations or agencies as collateral. (3) Fixed Assets A summary of fixed assets follows:

(4) Deferred Policy Acquisition Costs Policy acquisition costs incurred and amortized to income are as follows:

(5) Notes Payable Notes payable at December 31, 1996 consists of three unsecured notes payable under a credit agreement dated November 21, 1996. The combined principal amount on the notes of $75,000,000 is payable on November 21, 1999. The loan agreement may be extended annually for additional periods of one year each to maintain the three year maturity date. The interest rate is variable and is optionally related to the Federal Funds rate, Bank of New York prime rate or the Eurodollar London Interbank rate (LIBOR). Based on the rates effective through June 25, 1997, the net interest cost on the loan at December 31, 1996 is approximately 6.08%. 44 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (5) Notes Payable (Continued) The terms of the loan agreement include certain affirmative and negative covenants, all of which are met by the Company at December 31, 1996. (6) Income Taxes The Company and its subsidiaries file a consolidated Federal income tax return. The provision for income tax expense (benefit) consists of the following components:

The income tax provision reflected in the consolidated statements of income is less than the expected federal income tax on income before income taxes as shown in the table below:

45 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (6) Income Taxes (Continued) The "temporary differences" that give rise to a significant portion of the deferred tax asset (liability) relate to the following:

46 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (7) Reserves for Losses and Loss Adjustment Expenses Activity in the reserves for losses and loss adjustment expenses is summarized as follows:

Decreases in incurred losses relating to prior years reflects the favorable loss experience during these years attributable to a number of combined factors which have produced favorable frequency and severity trends in recent years. In addition, actuarial assumptions based on historical trends have proved to be conservative. 47 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (8) Acquisition of American Fidelity Insurance Company Effective November 30, 1996 the Company acquired all of the issued and outstanding common stock of American Fidelity Insurance Company, including its subsidiaries as described in Note 1, for $35.0 million. The acquisition was paid for in cash with funds raised by increasing the Company's notes payable under the bank credit agreement discussed in Note 5. On December 30, 1996 the Company contributed an additional $15.0 million to AFI. The acquisition was accounted for using the purchase method and resulted in a minimal amount of negative goodwill. The purchase agreement includes an indemnification by the seller on the loss and loss adjustment expense reserves of AFI at the acquisition date, excluding the mechanical breakdown line, to avoid any impact on the Company's financial statements from any future adverse development on the acquisition date loss reserves. AFI writes property and casualty insurance, primarily in Oklahoma, Kansas and Texas, where the companies are domiciled. Its primary lines are automobile and mechanical breakdown insurance. The results of operations for the month of December are included in the consolidated financial statements of the Company. The following unaudited proforma consolidated results of operations for 1996 and 1995 give effect to the acquisition as though it had occurred at the beginning of each year presented:

(9) Dividend Restrictions The Insurance Companies are subject to the financial capacity guidelines established by the Office of the Commissioner of Insurance of their domicile states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For the year 1997, the direct insurance subsidiaries of the Company are permitted to pay approximately $61,471,000 in dividends to the Company without the prior approval of the Commissioner of Insurance of the state of domicile. 48 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (9) Dividend Restrictions (Continued) The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay dividends. (10) Statutory Balances and Accounting Practices The Insurance Companies prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the various state insurance departments. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (NAIC), as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. As of December 31, 1996, there were no material permitted statutory accounting practices utilized by the Insurance Companies. The NAIC is working on a project to codify statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. When complete, that project will most likely change the definition of prescribed versus permitted statutory accounting practices and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements. The Insurance Companies' statutory net income, as reported to regulatory authorities, was $97,979,000, $86,210,000, and $62,861,000 for the years ended December 31, 1996, 1995 and 1994, respectively. The statutory policyholders' surplus of the Insurance Companies, as reported to regulatory authorities, as of December 31, 1996 and 1995 was $594,799,000 and $479,114,000, respectively. The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1996 according to the formula issued by the NAIC. Each of the companies' policyholders' surplus exceeded the highest level of recommended capital requirements. (11) Commitments and Contingencies The Company is obligated under various noncancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2002. Total rent expense under these lease agreements, all of which are operating leases, was $1,583,000, $1,461,000 and $1,492,000 for the years ended December 31, 1996, 1995 and 1994, respectively. Mercury Casualty 49 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (11) Commitments and Contingencies (Continued) Company will receive minimum future rentals on various noncancellable operating leases on a building in Brea, California. The annual rental commitments, expressed in thousands, are shown as follows:

The Company and its subsidiaries are defendants in various lawsuits generally incidental to their business. In most of these actions, plaintiffs assert claims for exemplary and punitive damages which are not insurable under California judicial decisions. The Company vigorously defends these actions, unless a reasonable settlement appears appropriate. Management does not expect the ultimate disposition of these lawsuits to have a material effect on the Company's consolidated operations or financial position. (12) Profit Sharing Plan The Company, at the option of the Board of Directors, may make annual contributions to an employee profit sharing plan. The contributions are not to exceed the greater of the Company's net income for the plan year or its retained earnings at that date. In addition, the annual contributions may not exceed an amount equal to 15% of the compensation paid or accrued during the year to all participants under the plan. The annual contribution was $1,000,000 for each of the plan years ended December 31, 1996, 1995 and 1994. The Profit Sharing Plan also includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. Company matching contributions, at a rate set by the Board of Directors, totaled $955,000, $773,000, and $762,000 for the plan years ended December 31, 1996, 1995 and 1994. Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan (ESOP) that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP's debt service less dividends received by the ESOP. Dividends received by the ESOP on 50 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 1996 and 1995 (12) Profit Sharing Plan (Continued) unallocated shares are used to pay debt service and the ESOP shares serve as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the debt of the ESOP, which was $3,000,000, $4,000,000 and $5,000,000 at December 31, 1996, 1995 and 1994, respectively, is recorded in the balance sheet as other liabilities. The shares pledged as collateral are reported as unearned ESOP compensation in the shareholders' equity section of the balance sheet. As shares are committed to be released from collateral, the Company reports compensation expense equal to the current market price of the shares, and reduces unearned ESOP compensation by the original cost of the shares. The difference between the market price and cost of the shares is charged to common stock. As shares are committed to be released from collateral, the shares become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings; dividends on unallocated ESOP shares are recorded as a reduction of accrued interest. ESOP compensation expense was $1,509,000, $1,145,000 and $919,000 in 1996, 1995 and 1994, respectively. The ESOP shares as of December 31 were as follows:

(13) Common Stock The Company adopted a stock option plan in October 1985 (the "1985 Plan") under which 2,700,000 shares were reserved for issuance. Options granted during 1985 were exercisable immediately. Subsequent options granted become exercisable 20% per year beginning one year from the date granted. All options were granted at the market price on the date of the grant and expire in 10 years. In May 1995 the Company adopted The 1995 Equity Participation Plan (the "1995 Plan") which succeeds the Company's 1985 Plan. Under the 1995 Plan, 2,700,000 shares of Common Stock are authorized for issuance upon exercise of options, stock appreciation rights and other awards, or upon vesting of restricted or deferred stock awards. During 1995, the Company granted incentive stock options under both the 1995 Plan and the 1985 Plan. The options granted during 1996, 1995 and 1994 become exercisable 20% per year beginning one year from the date granted and were granted at the market price on the date of the grant. The options expire in 10 years. 51 MERCURY GENERAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1996 and 1995 (13) Common Stock (Continued) As explained in Note 1, the Company applies APB Opinion No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Statements of Income. Had compensation cost for the Company's Plans been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's net income would have been reduced by $295,000 and $116,000 in 1996 and 1995, respectively, and earnings per share would have been reduced by $.01 in each year. Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1996 and 1995: dividend yield of 2.0 percent for both years, expected volatility of 30 percent for both years and expected lives of 7 years for both years. The risk-free interest rates used were 5.5 and 6.4 percent for the options granted during 1996 and 7.4 and 6.4 percent for the options granted during 1995. A summary of the status of the Company's plans as of December 31, 1994, 1995 and 1996 and changes during the years ending on those dates is presented below:

The following table summarizes information regarding the stock options outstanding at December 31, 1996:

52 Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- None. PART III Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- Section 16(a) of the Securities Exchange Act of 1934 requires the directors, officers and certain other employees of the registrant, and persons who own more than ten percent of a registered class of the registrant's equity securities, ("Reporting Persons") to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of Common Stock of the registrant. Due dates for these reports have been established and the registrant is required to disclose any failure to file by these dates during 1996. To the registrant's knowledge, all of these requirements were satisfied. Item 11. Executive Compensation ---------------------- Item 12. Security ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- Item 13. Certain Relationships and Related Transactions ---------------------------------------------- Information regarding executive officers of the Company is included in Part I. For this and other information called for by Items 10, 11, 12 and 13, reference is made to the Company's definitive proxy statement for its Annual Meeting of Shareholders, to be held on May 14, 1997, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1996, and which is incorporated herein by reference. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K --------------------------------------------------------------- (a) The following documents are filed as a part of this report: 1. Financial Statements: The Consolidated Financial Statements for the year ended December 31, 1996 are contained herein as listed in the Index to Consolidated Financial Statements on page 29. 2. Financial Statement Schedules: Title ----- Auditors' Report on Financial Statement Schedules Schedule I -- Summary of Investments -- Other than Investments in Related Parties Schedule II -- Condensed Financial Information of Registrant 53 Schedule IV -- Reinsurance All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or Notes thereto. 3. Exhibits: 3.1 Articles of Incorporation of the Company, as amended to date. 3.2@@ By-laws of the Company, as amended to date. 4.1 Shareholders' Agreement dated as of October 7, 1985 among the Company, George Joseph and Gloria Joseph. 10.1 Form of Agency Contract. 10.2# Management Agreement, as amended, effective July 1, 1992, among the Company, Mercury Casualty Company, Mercury Insurance Company and California Automobile Insurance Company. 10.3## Profit Sharing Plan, as Amended and Restated as of March 11, 1994. 10.4## ESOP Feature Trust Agreement between the Company and Wells Fargo Bank, N.A., as Trustee, effective March 1, 1994. 10.5## ESOP Loan Agreement between Union Bank and Wells Fargo Bank, N.A., as Trustee, of the Mercury General Corporation ESOP Feature Trust dated as of March 11, 1994. 10.6## Continuing Guaranty, dated as of March 11, 1994, executed by Mercury General Corporation in favor of Union Bank. 10.7 Amendment 1994-I to the Mercury General Corporation Profit Sharing Plan. 10.8 Amendment 1994-II to the Mercury General Corporation Profit Sharing Plan. 10.9 Amendment 1996-I to the Mercury General Corporation Profit Sharing Plan. 10.10 Amendment 1997-I to the Mercury General Corporation Profit Sharing Plan. 10.11 Revolving Credit Agreement by and among Mercury General Corporation, the Lenders Party Thereto and The Bank of New York, as Agent dated as of November 21, 1996. 10.12 Property Per Risk Excess of Loss Reinsurance Agreement between National Reinsurance Corporation and Mercury Casualty Company, effective April 1, 1995. 10.13** Endorsement No. 1 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.14@@ Endorsement No. 2 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.15@@ Endorsement No. 3 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.16@@ Management Agreement effective January 1, 1995 between the Company and Mercury Insurance Company of Illinois. 10.17@@ Management Agreement effective January 1, 1995 between the Company and Mercury Indemnity Company of Illinois. 10.18@@ Management Agreement effective January 1, 1995 between the Company and Mercury Insurance Company of Georgia. 10.19@@ Management Agreement effective January 1, 1995 between the Company and Mercury Indemnity Company of Georgia. 54 10.20@ The 1995 Equity Participation Plan. 10.21 Stock Purchase Agreement between Mercury General Corporation as Purchaser and AFC as Seller dated November 15, 1996. 21.1 Subsidiaries of the Company. 23.1 Accountants' Consent. 27.1 Financial Data Schedule * This document was filed as an exhibit to Registrant's Registration Statement on Form S-1, File No. 33-899, and is incorporated herein by this reference. # This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1992, and is incorporated herein by this reference. ## This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1993, and is incorporated herein by this reference. ** This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1994, and is incorporated herein by this reference. @ This document was filed as an exhibit to Registrant's Form S-8 filed on March 8, 1996 and is incorporated herein by this reference. @@ This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and is incorporated herein by this reference. (b) Reports on Form 8-K: None 55 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. MERCURY GENERAL CORPORATION By GEORGE JOSEPH ------------------------------------- George Joseph Chief Executive Officer and Chairman of the Board March 22, 1996 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

56

57 AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors Mercury General Corporation: Under date of February 21, 1997, we reported on the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1996, as contained in the annual report on Form 10-K for the year 1996. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed under Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK LLP Los Angeles, California February 21, 1997 S-1 SCHEDULE I MERCURY GENERAL CORPORATION SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1996 AMOUNTS IN THOUSANDS

S-2 SCHEDULE I, CONTINUED MERCURY GENERAL CORPORATION SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1995 AMOUNTS IN THOUSANDS

S-3 SCHEDULE II MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS December 31, 1996 and 1995 Amounts in thousands ASSETS

See notes to condensed financial information S-4 SCHEDULE II, CONTINUED MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME Three years ended December 31, 1996 Amounts in thousands

See notes to condensed financial information. S-5 SCHEDULE II, CONTINUED MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1996 AMOUNTS IN THOUSANDS

See notes to condensed financial information. S-6 SCHEDULE II, Continued MERCURY GENERAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION December 31, 1996 and 1995 The accompanying condensed financial information should be read in conjunction with the consolidated financial statements and notes included in this statement. Management Fee Income Under a management agreement, the Company performs management services for its subsidiaries which include all underwriting and claims servicing functions. The Company is compensated by monthly reimbursement of expenses paid. Dividends Received From Subsidiaries Dividends of $27,700,000, $24,500,000, and $20,000,000 were received by the Company from its wholly-owned subsidiaries in 1996, 1995 and 1994, respectively, and are recorded as a reduction to Investment in Subsidiaries. Cash Overdraft At December 31, 1996 and 1995, the Company had cash overdrafts of $1,056,000 and $1,340,000, respectively which are classified in "other liabilities" in the accompanying condensed balance sheet. S-7 SCHEDULE IV MERCURY GENERAL CORPORATION REINSURANCE THREE YEARS ENDED DECEMBER 31, 1996 AMOUNTS IN THOUSANDS

S-8 EXHIBIT INDEX 3.1 Articles of Incorporation of the Company, as amended to date. 3.2@@ By-laws of the Company, as amended to date. 4.1 Shareholders' Agreement dated as of October 7, 1985 among the Company, George Joseph and Gloria Joseph. 10.1 Form of Agency Contract. 10.2# Management Agreement, as amended, effective July 1, 1992, among the Company, Mercury Casualty Company, Mercury Insurance Company and California Automobile Insurance Company. 10.3## Profit Sharing Plan, as Amended and Restated as of March 11, 1994. 10.4## ESOP Feature Trust Agreement between the Company and Wells Fargo Bank, N.A., as Trustee, effective March 1, 1994. 10.5## ESOP Loan Agreement between Union Bank and Wells Fargo Bank, N.A., as Trustee, of the Mercury General Corporation ESOP Feature Trust dated as of March 11, 1994. 10.6## Continuing Guaranty, dated as of March 11, 1994, executed by Mercury General Corporation in favor of Union Bank. 10.7 Amendment 1994-I to the Mercury General Corporation Profit Sharing Plan. 10.8 Amendment 1994-II to the Mercury General Corporation Profit Sharing Plan. 10.9 Amendment 1996-I to the Mercury General Corporation Profit Sharing Plan. 10.10 Amendment 1997-I to the Mercury General Corporation Profit Sharing Plan. 10.11 Revolving Credit Agreement by and among Mercury General Corporation, the Lenders Party Thereto and The Bank of New York, as Agent dated as of November 21, 1996. 10.12 Property Per Risk Excess of Loss Reinsurance Agreement between National Reinsurance Corporation and Mercury Casualty Company, effective April 1, 1995. 10.13** Endorsement No. 1 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.14@@ Endorsement No. 2 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.15@@ Endorsement No. 3 to the Property Per Risk Excess of Loss Agreement effective April 1, 1995. 10.16@@ Management Agreement effective January 1, 1995 between the Company and Mercury Insurance Company of Illinois. 10.17@@ Management Agreement effective January 1, 1995 between the Company and Mercury Indemnity Company of Illinois. 10.18@@ Management Agreement effective January 1, 1995 between the Company and Mercury Insurance Company of Georgia. 10.19@@ Management Agreement effective January 1, 1995 between the Company and Mercury Indemnity Company of Georgia. 10.20@ The 1995 Equity Participation Plan. 10.21 Stock Purchase Agreement between Mercury General Corporation as Purchaser and AFC as Seller dated November 15, 1996. 21.1 Subsidiaries of the Company. 23.1 Accountants' Consent. 27.1 Financial Data Schedule * This document was filed as an exhibit to Registrant's Registration Statement on Form S-1, File No. 33-899, and is incorporated herein by this reference. # This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1992, and is incorporated herein by this reference. ## This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1993, and is incorporated herein by this reference. ** This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1994, and is incorporated herein by this reference. @ This document was filed as an exhibit to Registrant's Form S-8 filed on March 8, 1996 and is incorporated herein by this reference. @@ This document was filed as an exhibit to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and is incorporated herein by this reference. (b) Reports on Form 8-K: None