Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of PICO Holdings, Inc. and subsidiaries (collectively, the “Company” or “PICO”) have been prepared in accordance with the interim reporting requirements of Form 10-Q, pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for complete consolidated financial statements.

In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation of the financial statements presented have been included and are of a normal recurring nature. Operating results presented are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 filed with the SEC.

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses for each reporting period. The significant estimates made in the preparation of the Company’s consolidated financial statements relate to the assessment of other-than-temporary impairments, the application of the equity method of accounting, unpaid losses and loss adjustment expenses, assessment of impairment of real estate and water assets, deferred income taxes, stock-based compensation, fair value of derivatives, and contingent liabilities. While management believes that the carrying value of such assets and liabilities are appropriate as of September 30, 2012, and December 31, 2011, it is reasonably possible that actual results could differ from the estimates upon which the carrying values were based.

Discontinued Operations:

During the nine months ended September 30, 2012, the Company signed an agreement to sell the two companies that comprise the insurance in run-off segment. As a result of the pending transaction, the assets and liabilities of the insurance segment qualify as held for sale at September 30, 2012 and have been classified as discontinued operations in the accompanying condensed consolidated financial statements as of the earliest period presented. Consequently, prior periods presented have been recast from amounts previously reported to reflect the insurance segment as discontinued operations. See Note 7 for additional detail.

Debt:

PICO Northstar Hallock, LLC ("Northstar"), the Company's canola oil crushing subsidiary, is required to maintain certain debt covenants under its credit agreement, the most significant of which are a debt to adjusted capitalization ratio of not more than 0.60 to 1.00, a debt service coverage ratio less than 1.75 to 1.00, and a minimum net worth of the borrower of $60 million. Under the terms of the credit agreement, Northstar may make a one-time deposit of $5 million into a reserve account upon failure to comply with any financial debt covenant. Making such a contribution would preclude a failure to comply from constituting an event of default. During the third quarter of 2012, the subsidiary breached the debt to adjusted capitalization ratio due to continued operating losses; the ratio was 0.62 to 1.00 at September 30, 2012. The lenders have the option to declare all or any portion of the $89.5 million outstanding principal amounts due and payable and also can demand that Northstar deposit, as cash collateral, 105% of the unused line of credit of $10.5 million; however, the lenders have not made any such declarations or demands and management is in discussions with the lenders to cure the breach by converting PICO's $10.5 million loan to preferred capital, such that there would no longer be a failure to comply and no event of default. It is possible that PICO would be required to invest additional capital in Northstar beyond the $10.5 million to ensure no further breaches of this covenant in the future. The Company anticipates resolution of this matter during the fourth quarter of 2012.

Stock-Based Compensation:

Stock-based compensation expense is measured at the grant date based on the fair values of the awards and is recognized as expense over the period in which the share-based compensation vests.

At September 30, 2012, the Company had one stock-based compensation arrangement:

The PICO Holdings, Inc. 2005 Long Term Incentive Plan (the "Plan"). The Plan provides for the grant or award of various equity incentives to PICO employees, non-employee directors, and consultants. A total of 2,654,000 shares of common stock are issuable under the Plan and it provides for the issuance of incentive stock options, non-statutory stock options, free-standing stock-settled stock appreciation rights (“SAR”), restricted stock awards (“RSA”), performance shares, performance units, restricted stock units (“RSU”), deferred compensation awards, and other stock-based awards. The Plan allows for broker assisted cashless exercises and net-settlement of income taxes and employee withholding taxes. Upon exercise of a SAR and RSU, the employee will receive newly issued shares of PICO Holdings common stock with a fair value equal to the in-the-money value of the award, less applicable federal, state and local withholding and income taxes (however, the holder of an RSU can elect to pay withholding taxes in cash).

A summary of activity of the RSU and RSA is as follows:



	RSU			RSA
Outstanding at January 1, 2012	594,000			5,046
Granted	13,716
Vested	(140,000		)	(5,046		)
Outstanding at September 30, 2012	467,716			—
Unrecognized compensation cost (in thousands)	$	7,457		$	—

Restricted Stock Units (RSU):

Granted in 2012:

In June of 2012, as part of a duly adopted revised director annual compensation program, the Company issued 2,286 RSU, to each of the six non-employee directors of the Company for a total of 13,716 awards. Each award vests one year from the date of grant. The RSU were valued at the Company’s closing stock price on the date of grant and the compensation expense is recognized over the vesting period of the award.

The Company recorded stock based compensation expense of $946,000 and $2.9 million, for the three and nine months ended September 30, 2012, respectively for the RSU outstanding during the period. During the three and nine months ended September 30, 2011, the company recorded $1.1 million and $3.3 million of stock-based compensation expense, respectively for the RSU outstanding during the period.

During the nine months ended September 30, 2012, 140,000 RSU vested which resulted in delivery of 94,176 newly issued shares of PICO common stock.

Restricted Stock Awards (RSA):

The Company had issued 700 RSA (or a proration of such amount based on the director’s start date) to each non-employee director of the Company from 2008 to 2011. Each award vested one year from the date of grant. Until vested, the awards were held in escrow; however, the shares were voted and the holder was entitled to any dividends. Once vested, common stock of the Company was distributed to the recipient. Each award was valued at the Company’s closing stock price on the date of grant and the compensation expense was recognized over the vesting period of the award.

Stock-Settled Stock Appreciation Rights (SAR):

There were no SAR granted or exercised during the nine months ended September 30, 2012 or 2011. There was no stock-based compensation expense recognized for SAR during the three and nine months ended September 30, 2012 or 2011 as there were no unvested SAR in those periods.

A summary of SAR activity is as follows:



	SAR	Weighted Average Exercise Price		Weighted Average Contractual Term
Outstanding at January 1, 2012	1,812,079	$	36.16	4.5 years

Outstanding and exercisable at September 30, 2012	1,812,079	$	36.16	4 years

At September 30, 2012, none of the outstanding SAR were in-the-money.

Deferred Compensation:

The Company reports the investment returns generated in the deferred compensation accounts in revenues with a corresponding increase in the trust assets (except in the case of PICO stock, which is reported as treasury stock, at cost). There is an increase in the deferred compensation liability when there is appreciation in the market value of the assets held, with a corresponding expense recognized in operating and other costs. In the event the trust assets decline in value, the Company reverses previously expensed compensation. The assets of the plan are held in Rabbi Trust accounts. Such accounts hold various investments that are consistent with the Company’s investment policy, and are accounted for and reported as available-for-sale securities in the accompanying condensed consolidated balance sheets. Assets of the trust will be distributed according to predetermined payout elections established by each participant.

At September 30, 2012 and December 31, 2011, the Company had $38.8 million and $36.3 million, respectively, recorded as deferred compensation payable to various members of management and certain non-employee members of the board of directors of the Company.

The deferred compensation liability increased by $2.5 million during the nine months ended September 30, 2012 primarily due to an increase in the fair value of the assets of $2.3 million. Included in operating and other costs in the accompanying condensed consolidated statements of operations and comprehensive income or loss for the three and nine months ended September 30, 2012 is compensation expense of $880,000 and $2.3 million, respectively. For the three and nine months ended September 30, 2011, operating and other costs included a recovery of expense of $918,000 and expense of $1.3 million, respectively.

Accumulated Other Comprehensive Income (Loss):

The components of accumulated other comprehensive income or loss are as follows (in thousands):



	September 30, 2012			December 31, 2011

Net unrealized appreciation on available-for-sale investments	$	4,627		$	4,681
Foreign currency translation	(5,935		)	(5,640		)
Accumulated other comprehensive loss	$	(1,308	)	$	(959	)

The unrealized appreciation on available-for-sale investments is net of a deferred income tax liability of $2.3 million at September 30, 2012 and $2.5 million at December 31, 2011. The foreign currency translation is net of a deferred income tax asset of $3 million at September 30, 2012 and $3 million at December 31, 2011.

Real Estate and Water Assets:

The Company's real estate and water assets include certain intangible assets which consist primarily of certain water rights, water credits, and the exclusive right to use assets that the Company constructed and later dedicated to various municipalities located in select markets in Nevada, primarily in Washoe and Lyon counties. The rights have indefinite useful lives and are therefore not amortized. Intangible assets with indefinite lives are tested for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired, by comparing the fair value of the assets to their carrying amounts. During the third quarter of 2011, the Company recorded a $16.2 million impairment charge on intangible water assets. No such impairment charge was recorded in 2012.

All real estate and tangible water assets are classified as held and used until management commits to a plan to sell the asset, the asset can be sold in its present condition, is being actively marketed for sale, and it is probable that the asset will be sold within the next 12 months. At September 30, 2012 and December 31, 2011, the Company had real estate of $16.2 million and $6.5 million, respectively, classified as held for sale.

Inventory:

The Company classifies its canola seed as raw material inventory and canola oil and meal as finished goods inventory. Such inventory is carried at net realizable value as it is considered a readily marketable agricultural commodity that is readily convertible to cash because of its commodity characteristics, widely available markets, and international pricing mechanisms. This agricultural commodity inventory has quoted market prices in active markets or is directly correlated to an active market, may be sold without significant further processing and has predictable and insignificant disposal costs. Changes in the fair values of agricultural commodities inventories are recognized in earnings as a component of cost of canola oil and meal sold. At September 30, 2012, the Company had $5.9 million in inventory, the majority of which is considered readily marketable.

Derivatives:

In the normal course of business, the Company uses derivative instruments to manage its exposure to movements associated with agricultural commodity prices. The Company generally uses exchange traded futures to minimize the effects of changes in the prices of agricultural commodities in its agricultural commodity inventories and forward purchase and sale contracts. The Company recognizes each of its derivative instruments as either assets or liabilities at fair value in its consolidated balance sheets. While the Company considers exchange traded futures and forward purchase and sale contracts to be effective economic hedges, the Company does not designate or account for its commodity contracts as hedges. Changes in the fair value of these contracts and related readily marketable agricultural commodity inventories are included in cost of canola oil and meal sold in the consolidated statements of operations and comprehensive income or loss.

Accounting for Income Taxes:

The Company's provision for income tax expense includes federal, foreign and state income taxes currently payable and those deferred because of temporary differences between the income tax and financial reporting bases of the assets and liabilities. The liability method of accounting for income taxes also requires the Company to reflect the effect of a tax rate change on accumulated deferred income taxes in income in the period in which the change is enacted.

In assessing the realization of deferred income taxes, management considers whether it is more likely than not that any deferred income tax assets will be realized. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the period in which temporary differences become deductible. If it is more likely than not that some or all of the deferred income tax assets will not be realized, a valuation allowance is recorded.

The Company recognizes any uncertain income tax positions on income tax returns at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized unless it has a greater than 50% likelihood of being sustained. The Company recognizes any interest and penalties related to uncertain tax positions in income tax expense.

The Company reported an income tax benefit of $403,000 and $1.5 million for the three and nine months ended September 30, 2012, respectively, and income tax expense of $25.8 million and $22.1 million for the three and nine months ended September 30, 2011, respectively. The effective income tax rate for continuing operations was 5% and 6% for the three and nine months ended September 30, 2012, and 141% and 85% for the three and nine months ended September 30, 2011, respectively. For the three and nine months ended September 30, 2012 and 2011, the effective rate differs from the statutory rate of 35% primarily due to recording a full valuation allowance on the net deferred tax assets.

Treasury Stock:

During the nine months ended September 30, 2012, the Company retired 1.4 million shares of PICO common stock owned by PICO Holdings that was classified as treasury stock. The transactions reduced treasury stock and additional paid-in-capital by $22.9 million. The transactions also reduced the number of shares issued and outstanding, and the number of treasury shares by 1.4 million, but did not affect net shares outstanding or earnings per share of the Company.

Related Party Transactions:

On August 6, 2012, the Company entered into a severance agreement with each of Maxim C. W. Webb, Executive Vice President and Chief Financial Officer, and John T. Perri, Vice President and Chief Accounting Officer. Each agreement provides for the payment of two years base salary and a pro rata portion of the annual cash incentive payment, as well as reimbursement of up to one year of COBRA expenses, in the event of an involuntary termination of employment (other than for “cause”) or a resignation for “good reason.” Each agreement has a term of two years and will automatically renew for an additional two year term unless, at least 90 days before the expiration of the then current term, the compensation committee decides to terminate or amend the agreement.

Recent Accounting Pronouncements

In July 2012, the FASB issued guidance on testing indefinite-lived intangible assets for impairment. The amended guidance simplifies how entities test for impairment of indefinite-lived intangible assets. The amendments permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of the asset is less than its carrying amount as a basis for determining if performing a quantitative test is necessary. The amendments do not change the measurement of impairment losses. The amendments are effective for the Company's first quarter of the fiscal year ending December 31, 2013. The Company does not expect the adoption of these provisions to have a material impact on the consolidated financial statements.