Income Taxes

Income tax provision

The Company and its subsidiaries file a consolidated federal income tax return. The provision for income tax expense consists of the following components:



	Year Ended December 31,
	2012		2011			2010
	(Amounts in thousands)
Federal
Current	$	9,340	$	31,390		$	23,699
Deferred	6,238		20,518			9,964
	$	15,578	$	51,908		$	33,663
State
Current	$	2,079	$	2,934		$	(3,225	)
Deferred	742		(907		)	(246		)
	$	2,821	$	2,027		$	(3,471	)
Total
Current	$	11,419	$	34,324		$	20,474
Deferred	6,980		19,611			9,718
Total	$	18,399	$	53,935		$	30,192

The income tax provision reflected in the consolidated statements of operations is reconciled to the federal income tax on income before income taxes based on a statutory rate of 35% as shown in the table below:



	Year Ended December 31,
	2012			2011			2010
	(Amounts in thousands)
Computed tax expense at 35%	$	47,359		$	85,785		$	63,837
Tax-exempt interest income	(27,789		)	(31,414		)	(33,966		)
Dividends received deduction	(1,482		)	(1,704		)	(1,463		)
State tax expense (benefit)	1,918			1,299			(3,580		)
Other, net	(1,607		)	(31		)	5,364
Income tax expense	$	18,399		$	53,935		$	30,192

Deferred Income Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Realization of deferred tax assets is dependent on generating sufficient taxable income of an appropriate character prior to their expiration. The Company believes it has the ability and intent, through the use of prudent tax planning strategies and the generation of capital gains, to generate income sufficient to avoid losing the benefits of its deferred tax assets. Significant components of the Company’s net deferred tax assets and liabilities are as follows:



	December 31,
	2012			2011
	(Amounts in thousands)
Deferred tax assets:
20% of net unearned premium	$	66,353		$	61,039
Capital loss carryforward	0			7,108
Discounting of loss reserves and salvage and subrogation recoverable for tax purposes	15,019			15,034
Write-down of impaired investments	1,723			4,638
Tax credit carryforward	37,557			20,060
Expense accruals	10,910			11,632
Other deferred tax assets	4,860			3,568
Total gross deferred tax assets	136,422			123,079
Deferred tax liabilities:
Deferred acquisition costs	(65,069		)	(60,000		)
Tax liability on net unrealized gain on securities carried at fair value	(48,483		)	(31,997		)
Tax depreciation in excess of book depreciation	(10,191		)	(15,164		)
Undistributed earnings of insurance subsidiaries	(4,499		)	(3,962		)
Tax amortization in excess of book amortization	(914		)	(442		)
Other deferred tax liabilities	(7,711		)	(5,003		)
Total gross deferred tax liabilities	(136,867		)	(116,568		)
Net deferred tax (liabilities) assets	$	(445	)	$	6,511

Uncertainty in Income Taxes

The Company recognizes tax benefits related to positions taken, or expected to be taken, on a tax return once a “more-likely-than-not” threshold has been met. For a tax position that meets the recognition threshold, the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement is recognized in the financial statements.

There were no material changes to the total amount of unrecognized tax benefits related to tax uncertainties during 2012. The Company does not expect any changes in such unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states. Tax years that remain subject to examination by major taxing jurisdictions are 2009 through 2011 for federal taxes and 2003 through 2011 for California state taxes. Tax year 2010 is currently under examination by the Internal Revenue Service. The Company is currently under examination by the California Franchise Tax Board (“FTB”) for tax years 2003 through 2010. The FTB has issued Notices of Proposed Assessments to the Company for tax years 2003 through 2006. The Company has filed protests with the FTB in response to these assessments and presented its case in a hearing before the FTB. No assessments have been received for tax years 2007 through 2010. Management believes that the resolution of these examinations and assessments will not have a material impact on the consolidated financial statements.

A reconciliation of the beginning and ending balances of unrecognized tax benefits is as follows:



	2012			2011
	(Amounts in thousands)
Balance at January 1	$	4,567		$	3,823
Additions based on tax positions related to:
Current year	330			1,011
Prior years	1,539			0
Reductions based on tax positions related to prior years	(308		)	(267		)
Reductions as a result of as lapse of the applicable statute of limitations	(202		)	0
Balance at December 31	$	5,926		$	4,567

As presented above, the balances of unrecognized tax benefits were $5.9 million and $4.6 million at December 31, 2012 and 2011, respectively. Of these totals, $3.5 million and $3.6 million represent unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would impact the Company’s effective tax rate.

Management does not expect the Company’s total amount of unrecognized tax benefits to materially increase within the next twelve months related to its ongoing California state tax apportionment factor issues.

The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. During the years ended December 31, 2012, 2011, and 2010, the Company recognized net interest and penalty expense or (benefit), excluding refunds, of $111,000, $106,000, and ($872,000), respectively. The Company carried an accrued interest and penalty balance of $945,000 and $834,000 at December 31, 2012 and 2011, respectively.