Progressive - 10-Q quarterly report FY

 

(Mark One)

(Exact name of registrant as specified in its charter)

     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.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Shares, $1.00 par value: 197,250,475 outstanding at October 31, 2005

 

 

The Progressive Corporation and Subsidiaries
Consolidated Statements of Income
(unaudited)

See notes to consolidated financial statements.

The Progressive Corporation and Subsidiaries
Consolidated Balance Sheets
(unaudited)

The Progressive Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(unaudited)

     See notes to consolidated financial statements.

The Progressive Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited)

Note 1 Basis of Presentation — These financial statements and the notes thereto should be read in conjunction with the Company’s audited financial statements and accompanying notes included in its Annual Report on Form 10-K for the year ended December 31, 2004.

The consolidated financial statements reflect all normal recurring adjustments which, in the opinion of management, were necessary for a fair statement of the results for the interim periods presented. The results of operations for the period ended September 30, 2005, are not necessarily indicative of the results expected for the full year.

Note 2 Stock-Based Compensation —The Company follows the provisions of Statement of Financial Accounting Standards (SFAS) 123, “Accounting for Stock-Based Compensation,” to account for its stock compensation activity in the financial statements. Prior to January 1, 2003, the Company followed the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its stock option activity.

The change to the fair value based method of accounting under SFAS 123 was applied prospectively to all non-qualified stock option awards granted, modified, or settled after January 1, 2003. No stock options were granted after December 31, 2002. As a result, there is no compensation cost for stock options included in net income for 2003 and forward; however, compensation expense would have been recognized if the fair value based method had been used for all awards since the original effective date of SFAS 123 (January 1, 1995). Prior to 2003, the Company granted all options currently outstanding at an exercise price equal to the market price of the Company’s Common Shares at the date of grant and, therefore, under APB 25, no compensation expense was recorded.

The following table shows the effects on net income and earnings per share had the fair value based method been applied to all outstanding and unvested stock option awards for the periods presented. The Company used the modified Black-Scholes pricing model to calculate the fair value of the options awarded as of the date of grant.

In 2003, the Company began issuing restricted stock awards. Compensation expense for restricted stock awards is recognized over the respective vesting periods. The current year expense is not representative of the effect on net income for future years since each subsequent year will reflect expense for additional awards.

Note 3 Supplemental Cash Flow Information — The Company paid income taxes of $571.0 million and $463.0 million during the nine months ended September 30, 2005 and 2004, respectively. Total interest paid was $63.6 million and $70.3 million for the nine months ended September 30, 2005 and 2004, respectively. Non-cash activity includes the liability for deferred restricted stock compensation and the changes in net unrealized gains (losses) on securities.

Note 4 Debt — Debt at September 30 consisted of:

Note 5 Comprehensive Income — Total comprehensive income was $287.5 million and $448.7 million for the quarters ended September 30, 2005 and 2004, respectively, and $1,057.5 million and $1,170.9 million for the nine months ended September 30, 2005 and 2004, respectively.

Note 6 Dividends — On September 30, 2005, the Company paid a quarterly dividend of $.03 per Common Share to shareholders of record as of the close of business on September 9, 2005. The Board of Directors declared the dividend on August 19, 2005.

On October 7, 2005, the Board of Directors declared a quarterly dividend of $.03 per Common Share payable December 31, 2005, to shareholders of record at the close of business on December 9, 2005.

Note 7 Segment Information — The Company’s Personal Lines business units write insurance for private passenger automobiles and recreation vehicles. The Commercial Auto business unit writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses. The Company’s other-indemnity businesses primarily include writing professional liability insurance for community banks and managing the Company’s run-off businesses. The Company’s other-service businesses include providing insurance-related services, primarily processing business for Commercial Auto Insurance Procedures/Plans (CAIP), which are state-supervised plans serving the involuntary market. All revenues are generated from external customers.

Following are the operating results for the periods ended September 30:

The Company’s management uses underwriting margin and combined ratio as primary measures of underwriting profitability. The underwriting margin is the pretax profit (loss) [calculated as net premiums earned less losses and loss adjustment expenses, policy acquisition costs and other underwriting expenses] expressed as a percent of net premiums earned (i.e., revenues). The combined ratio is the complement of the underwriting margin. Following are the underwriting margins and combined ratios for the Company’s underwriting operations for the periods ended September 30:

Note 8 Litigation — The Company is named as defendant in various lawsuits arising out of its insurance operations. All legal actions relating to claims made under insurance policies are considered by the Company in establishing its loss and loss adjustment expense reserves.

In addition, the Company is named as defendant in a number of class action or individual lawsuits, the outcomes of which are uncertain at this time. These cases include those alleging damages as a result of the Company’s total loss evaluation methodology or handling, use of after-market parts, use of consumer reports (such as credit reports) in underwriting and related notice requirements under the federal Fair Credit Reporting Act, charging betterment in first party physical damage claims, the adjusting of personal injury protection and medical payment claims, the use of preferred provider rates for payment of personal injury protection claims, the use of automated database vendors or products to assist in evaluating certain bodily injury claims, policy implementation and renewal procedures and cases challenging other aspects of the Company’s claims and marketing practices and business operations.

The Company plans to contest the outstanding suits vigorously, but may pursue settlement negotiations where appropriate. In accordance with accounting principles generally accepted in the United States of America (GAAP), the Company has established accruals for lawsuits as to which the Company has determined that it is probable that a loss has been incurred and the Company can reasonably estimate its potential exposure. Pursuant to GAAP, the Company has not established reserves for those lawsuits where the loss is not deemed probable and/or the Company is currently unable to estimate the potential exposure. If any one or more of these lawsuits results in a judgment against or settlement by the Company in an amount that is significantly in excess of the reserve established for such lawsuit (if any), the resulting liability could have a material effect on the Company’s financial condition, cash flows and results of operations.

For a further discussion on the Company’s pending litigation, see “Item 3-Legal Proceedings” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Note 9 New Accounting Standards — On April 15, 2005, the Securities and Exchange Commission issued an amendment to Rule 4-01(a) of Regulation S-X, which became effective April 21, 2005, regarding the compliance date for SFAS 123 (revised 2004), “Share-Based Payment.” Pursuant to the amendment, companies are not required to prepare financial statements in accordance with SFAS 123R until the first quarter of the first fiscal year beginning after June 15, 2005, although earlier compliance is permitted. The Company plans to adopt SFAS 123R on January 1, 2006, and, as a result, estimates that net income will be reduced by approximately $.9 million in 2006. The Company will not incur any additional expense relating to currently outstanding stock options in years subsequent to 2006, since the final vesting date of stock options previously granted will be January 1, 2007. The Company does not currently intend to issue additional stock options.

Note 10 Subsequent Event — On October 24, 2005, Hurricane Wilma made landfall in Florida causing catastrophic losses. As a result of this weather-related catastrophe, the Company will incur approximately $73 million of losses in its October 2005 results. See the Company’s Management Discussion and Analysis in this Quarterly Report on Form 10-Q for a more detailed discussion of third quarter catastrophe losses.

For the third quarter 2005, The Progressive Corporation and subsidiaries (the “Company”) generated solid growth and profitability, despite the significant weather-related catastrophes during the period. On a companywide basis, net premiums written increased 5% and the Company generated a combined ratio of 90.4 for the quarter. For the third quarter 2005, net income was $305.3 million, or $1.54 per share.

During the third quarter, the Company continued to see growth flatten, reflecting “soft market conditions” (i.e., represents a highly competitive market where premium rates are relatively stable if not decreasing). At September 30, 2005, the Company had 10 million policies in force on a companywide basis, 10% more than at the same time last year reflecting solid increases in renewals offsetting an overall slight decrease in new applications (i.e., completed sale of a new policy). Policy life expectancy, which is one measure of retention, decreased in most of the Company’s personal auto tiers over the last few months, but was relatively stable for commercial auto. The Company continued to experience a decrease in its premiums per application on both new and renewal business, resulting from market pricing refinements in several states. The Company continues to take actions it believes will enhance its competitiveness and allow the Company to be ready for future growth if and when market conditions change.

On September 30, 2005, the Company entered the New Jersey private passenger auto insurance market through both its Agency and Direct distribution channels. The Company now writes business in 49 states and the District of Columbia. New Jersey represents the seventh largest private passenger auto insurance market in the United States. Although the Company sees this as a growth opportunity, it is also mindful of its objectives of maintaining profitable growth and high quality customer service. The Company plans to offer its Commercial Auto products in the state later this year and add its motorcycle and boat products in 2006.

The Company’s third quarter 2005 results were affected by several catastrophes, including Hurricanes Katrina and Rita. Hurricane Katrina was by far the largest single claim event the Company has ever experienced, and is currently estimated to be 5 ¹/2 times greater than any previous single catastrophe loss. Third quarter results included $173.6 million, or 5.0 points, of Hurricane Katrina losses and $11.9 million, or .3 points, of Hurricane Rita losses. In total, all catastrophes accounted for 5.6 loss ratio points for the third quarter and 2.2 points on a year-to-date basis. Due to the nature of Hurricane Katrina, the Company expects settlement of all losses to take longer than experienced for past storms. The Company will continue to monitor the claims activity closely and adjust reserves as it deems appropriate.

Through the end of October, losses related to Hurricane Katrina, net of estimated salvage, were approximately $185 million; the estimated losses for Hurricane Rita were unchanged. The Company estimates that it incurred $73 million of losses related to Hurricane Wilma, which primarily affected Florida in October 2005.

The Company’s underwriting margins benefited from 2.7 points of favorable reserve development in the third quarter 2005 and 2.9 points year-to-date. This favorable development reflects both actuarial adjustments, as well as other favorable development (e.g., claims settling for less than reserved).

The Company is continuing to benefit from low accident frequency, consistent with the industry’s recent experience. The Company has achieved consistency in its claims quality and processes which allowed it to deploy claims representatives to the Gulf Coast region to assist with catastrophe claims. Through the end of October, the Company has deployed more than 1,300 claims representatives and settled over 90% of the Hurricane Katrina claims.

The Company made no substantial changes in the allocation of its investment portfolio during the quarter. The Company’s investment portfolio produced a fully taxable equivalent total return of .9% for the third quarter 2005 and 2.9% year-to-date, with positive total returns in both fixed-income securities and common stocks for both periods. The Company continued to keep the portfolio’s credit quality high and exposure to interest rate risk low. At September 30, 2005, the fixed-income portfolio duration was 2.9 years, with a weighted average credit quality of AA+.

Progressive’s insurance operations create liquidity by collecting and investing premiums from new and renewal business in advance of paying claims. For the nine months ended September 30, 2005, operations generated a positive cash flow of $1,924.9 million. Operating cash flows decreased 20% from the first nine months last year, primarily reflecting an increase in paid losses, mainly due to the hurricanes, as well as timing differences associated with the payment of accrued expenses and a one-time IRS refund in the first quarter of 2004. During the third quarter 2005, the Company entered into a sale-leaseback arrangement for one of its buildings and is recognizing the estimated $1.5 million gain over the lease term, in compliance with current applicable accounting guidance. During the third quarter 2005, the Company repurchased 855 thousand Common Shares at a total cost of $84.0 million (average cost of $98.28 per share), bringing total year-to-date repurchases to 5.1 million shares, at a total cost of $470.9 million (average cost of $92.38 per share).

The Company has substantial capital resources and believes it has sufficient borrowing capacity and other capital resources to support current and anticipated growth and satisfy scheduled debt and interest payments. The Company’s existing debt covenants do not include any rating or credit triggers.

In June 2005, the Company completed the conversion of a building purchased in Austin, Texas into a call center at an estimated total cost of $40.6 million, including the cost to purchase the building as well as furniture, fixtures and equipment. The Company is currently constructing a data center in Colorado Springs, Colorado at an estimated total cost of $66.7 million, and is looking to buy additional land near this facility for future development. Construction on this data center is expected to be completed in 2006 and the facility is scheduled to become operational in 2007. The Company is also pursuing the acquisition of additional land for future development to support corporate operations near its current corporate headquarters in Mayfield Village, Ohio, with the intent to begin construction in 2006.

The Company currently has a total of 23 centers that provide concierge-level claims service, including 1 facility that is currently inoperable due to Hurricane Katrina and 1 facility that was opened in October 2005. The Company has previously announced a significant expansion of this service and is currently researching, acquiring, and constructing additional sites around the country. The Company expects to more than double the number of sites in the next two years, with a total of approximately 50 additional facilities opened over the next several years. Three additional sites are expected to be opened later in the fourth quarter 2005.

All such projects are, or will be, funded through operating cash flows.

Except for open investment funding commitments, operating leases and service agreements discussed in the notes to the financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, the Company does not have any off-balance-sheet leverage.

During the third quarter 2005, the Company’s contractual obligations did not change materially from those discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Companywide net premiums written represent the premiums generated from policies written during the period less any premiums ceded to reinsurers. Net premiums earned, which are a function of the premiums written in the current and prior periods, are earned into income using a daily earnings convention.

The Company analyzes its growth by reviewing rate levels, new policies and customers, and the retention characteristics of its books of business. During the third quarter 2005, the Company filed 51 auto rate revisions in various states, bringing the total to 142 for the year. The overall effect of these revisions was a slight decrease in filed rates for the year. The Company will continue to assess market conditions on a state-by-state basis, consider rate reductions in states where it will be able to maintain an attractive combination of profit and growth while still maintaining service quality, and seek selective rate increases where necessary to maintain rate adequacy.

In the Company’s Personal Lines business, new business applications were down slightly in the third quarter 2005, but increased modestly on a year-to-date basis, as compared to the same periods last year. Solid increases in renewal business helped contribute to the 10% increase in Personal Lines policies in force. For the Company’s Commercial Auto business, new applications increased in both the third quarter 2005 and year-to-date.

Customer retention is another factor that affects growth. One way to analyze retention is through policy life expectancy (PLE), which is the estimate of the average length of time that the Company expects all of its policies issued in the month to remain in force before cancellation or non-renewal. Similar to loss reserves, PLE’s develop over time and include many factors, such as product, channel, tier and bill plan. As a result, it is difficult to report retention on a companywide basis and specifically identify the cause of changes in such estimates. Nevertheless, with a greater percentage of the Company’s premium coming from renewal business, increasing retention remains an area where the Company is continuing to focus its efforts.

Profitability of the Company’s underwriting operations is defined by pretax underwriting profit, which is calculated as net premiums earned less losses and loss adjustment expenses, policy acquisition costs and other underwriting expenses. The Company also uses underwriting profit margin, which is underwriting profit expressed as a percent of net premiums earned, to analyze the Company’s results. For the three and nine month periods ended September 30, the Company’s underwriting profitability measures were as follows:

The decrease in the underwriting margins for the third quarter 2005 reflects the higher losses incurred as a result of the significant catastrophes during the period, partially offset by favorable reserve development and lower expense ratios. Due to the nature and location of Hurricane Katrina, the Agency business results were more negatively affected than the Direct business. The storm significantly affected the Company’s special lines products, particularly the boat product, which are primarily written through the Agency channel. In addition, approximately 85% of Louisiana’s personal auto business is written through independent agents.

Further underwriting results for the Company’s Personal Lines businesses, including its channel components, the Commercial Auto business and other-indemnity businesses, were as follows (details discussed below):

Claims costs, the Company’s most significant expense, represent payments made, and estimated future payments to be made, to or on behalf of its policyholders, as well as expenses needed to adjust or settle claims. These costs include an estimate for costs related to assignments, based on current and prior writings, under state-mandated automobile insurance programs. Claims costs are influenced by changes in loss severity and frequency, among other factors. Accordingly, anticipated changes in these factors are taken into account when the Company establishes premium rates and loss reserves.

During the third quarter and first nine months of 2005, the Company continued to report historically low loss ratios, despite the significant catastrophic losses incurred during the third quarter. During the third quarter 2005, the Company incurred $194.4 million, or 5.6 loss ratio points, for all catastrophes, of which nearly 90% ($173.6 million) related to Hurricane Katrina. Through the end of October, losses related to Hurricane Katrina, net of estimated salvage, are estimated to be $185 million. For the nine months ended September 30, 2005, the Company’s total catastrophe losses were $221.2 million, or 2.2 loss ratio points. For the third quarter and first nine months of 2004, the Company incurred $53.8 million, or 1.6 points, and $73.5 million, or .8 points, respectively, of catastrophic weather-related losses.

Auto accident frequency remained favorable during the quarter. In general, the Company continues to experience frequency trends similar to the rest of the industry in nearly every coverage. In addition, in the week or so following Hurricane Katrina, the Company experienced reduced claims throughout the country. The Company will continue to analyze these trends to distinguish changes in its experience from external factors, such as the cost of gasoline, versus those resulting from shifts in the mix of the Company’s business.

The Company experienced an increase in severity during the third quarter 2005, compared to the same period last year. Part of the increase reflects the greater severity the Company incurred from Hurricane Katrina due to the nature of the storm (e.g., greater flood damage than experienced in prior storms). Reviewing the Company’s severity trends on a trailing 12-month basis through the second quarter 2005, the Company experienced increases in severity greater than that reported by the industry. The Company has seen injury loss severities increase over the same quarter last year, but at a lower rate than the Company experienced in prior quarters. In general, the Company is seeing severity trends in most coverages no longer being offset entirely by lower frequency. The Company plans to continue to be diligent in its efforts to recognize trend when setting rates and establishing loss reserves.

During the third quarter 2005, the Company maintained adequacy in its claims quality, as indicated by the Company’s internal audit of claims files. The result of achieving more consistency in claims quality and process allowed the Company to more effectively deploy over 1,300 claims representatives to the Gulf Coast to assist with catastrophe claims. Due to the unusual circumstances surrounding Hurricane Katrina and the nature of the storm, the Company was able to settle only approximately 50% of the claims by the end of the third quarter. By the end of October, over 90% of Hurricane Katrina claims were settled.

The Company reported the following loss reserve development for the periods ended September 30:

During the third quarter and first nine months of 2005, the Company experienced 2.7 points and 2.9 points, respectively, of favorable loss reserve development, compared to 1.9 points and .8 points for the same periods last year. Total development consists both of actuarial adjustments and “all other development.” The actuarial adjustments represent the net changes made by the Company to both current and prior accident year reserves based on regularly scheduled reviews. The “all other development” represents claims settling for more or less than reserved, emergence of unreported claims at rates different than reserved and changes in reserve estimates by claims representatives. The continued recognition of lower severity for prior accident years than had been previously estimated contributed to the favorable prior year reserve development in 2005. For the first nine months of 2004, the favorable development was partially offset by unfavorable development in the Company’s personal auto product due to a greater number of late reported claims than anticipated. The Company continues to increase the analysis intensity of its loss reserves to increase accuracy and further understand its business, as evidenced by the fact that the Company has reduced loss reserves following actuarial reviews more during 2005 than in any prior year-to-date period. A detailed discussion of the Company’s loss reserving practices can be found in its Report on Loss Reserving Practices, which was filed in a Form 8-K on June 28, 2005.

Other underwriting expenses and policy acquisition costs expressed as a percent of premiums earned were lower for both the third quarter and first nine months of 2005, as compared to the same periods last year. During the third quarter 2005, the Company benefited .3 points (.1 points year-to-date) from the settlements of state tax liabilities. The “other underwriting expenses,” as shown on the income statement, reflect increases in salaries and other infrastructure costs consistent with premium growth.

The Company’s Personal Lines business units write insurance for private passenger automobiles and recreation vehicles, and represent 87% of the Company’s total year-to-date net premiums written. Personal Lines net premiums written and earned grew 4% and 6%, respectively, for the third quarter and 6% and 7%, respectively, for the first nine months of 2005, compared to the same periods last year. The Personal Lines business is comprised of the Agency business and the Direct business.

The Agency business includes business written by more than 30,000 independent insurance agencies that represent the Company, as well as brokerages in New York and California. The Agency auto business saw a decrease in new applications in both the third quarter and first nine months of 2005 (about 6% and 3%, respectively), as compared to the same periods last year, reflecting soft market conditions. Premiums per application were lower on both new and renewal business for both the third quarter and year-to-date as compared to last year. Both the conversion rate (the percentage of quotes resulting in a sale) and number of quotes were down for the third quarter 2005, compared to the same period last year. For the first nine months of 2005, the conversion rate and number of quotes were flat, compared to the same period last year. In the Agency auto tiers, the Company has seen retention decline over the last few months but still remained greater than September 2004.

The Agency expense ratio decreased .7 points for the third quarter as compared to the same period last year, primarily reflecting the effect of favorable state tax liability settlements in 2005 and costs incurred in the third quarter of 2004 related to the launch of Drive^® Insurance from Progressive, the new Agency brand. On a year-to-date basis, the Agency expense ratio increased .2 points primarily due to a substantial increase in advertising costs associated with the roll out of the Drive Insurance from Progressive brand. Drive commercials are now airing nationally. The Company anticipates that greater brand identity, coupled with its product offerings, systems, and claims and customer service, will support growth in the Agency channel.

The Direct business includes business written directly by the Company over the telephone and on the Internet. The Direct business experienced an increase in new applications in both the third quarter and first nine months of 2005 (about 4% and 11%, respectively). In the third quarter 2004, the Direct business improved its Internet quoting platform by decreasing the amount of time required to complete a quote, which contributed to new application growth through the second quarter 2005. Premiums per

application were lower on both new and renewal business for both the third quarter and year-to-date. For the same periods, the conversion rate on the Direct business was down from last year; however, the number of quotes increased, which the Company believes resulted from the effectiveness of the Progressive Direct ^SM advertising campaign. The use of the Internet, either for complete or partial quoting, continues to grow and is the most significant source of new business activity in the Direct channel. In the Direct auto tiers, retention has decreased over the last few months and was generally down compared to last year.

The Direct expense ratio decreased .1 points and .7 points for the third quarter and first nine months of 2005, respectively, as compared to the same periods last year, primarily reflecting a higher percentage of renewal business. During the third quarter, the Company significantly increased its advertising of the Progressive Direct brand, as compared to the same period last year, reflecting more targeted media buying driven by the favorable response the Company has been experiencing. The Progressive Direct marketing efforts continue to emphasize the ease of doing business with Progressive and credible price comparisons provided to consumers. The Company advertises its Direct brand on a national basis and supplements that coverage by local market media campaigns in over 100 designated market areas.

The Company’s Commercial Auto business unit writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses, with the majority of its customers insuring three or fewer vehicles. The Commercial Auto business represents 13% of the Company’s total year-to-date net premiums written. Although Commercial Auto differs from Personal Lines auto in its customer base and products written, both businesses require the same fundamental skills, including disciplined underwriting and pricing, as well as excellent claims service. The Company’s Commercial Auto business is primarily distributed through the independent agency channel.

The Company experienced solid growth in Commercial Auto during the quarter. The Commercial Auto business expanded into New Hampshire during the year, bringing the total number of markets to 46, and plans on entering New Jersey later this year and one, possibly two, additional states in 2006. Approximately 52% of the Company’s year-to-date Commercial Auto net premiums written were generated in the specialty commercial auto market, which includes dump trucks, logging trucks and other short-haul commercial vehicles. The remainder of the business was written in the light and local commercial auto markets, which include autos, vans and pick-up trucks used by artisans, such as contractors, landscapers and plumbers, and a variety of other small businesses. There are many similarities between the Company’s Commercial Auto and Personal Lines auto businesses; however, since the Commercial Auto policies have higher limits (up to $1 million) than Personal Lines auto, the Company analyzes the limit differences in this product more closely.

New applications increased about 8% and 6% in the Commercial Auto business over the third quarter and first nine months of 2004, respectively. Premiums per application were higher on new business for both the third quarter and first nine months of 2005, as compared to the same periods last year, partially reflecting Commercial Auto’s shift from 6-month to 12-month policies, which has a favorable effect on premiums per application; this shift started at the end of the first quarter 2004 and was substantially completed in the second quarter 2005. For renewal business, premiums per application increased

slightly for the third quarter 2005 and were relatively flat on a year-to-date basis, as compared to the same periods last year. During the third quarter 2005, the Company filed 12 commercial auto rate revisions in various states, bringing the total to 27 for the year. The overall effect of these revisions was a very slight increase in filed rates for the year. In the Commercial Auto tiers, retention has remained relatively flat over the last few months, but has lengthened in every tier over September 2004. The expense ratio in this business decreased .1 points from the third quarter last year. For the year-to-date period, the Commercial Auto expense ratio increased .7 points from last year, partially due to the branding of Commercial Auto under Drive Insurance from Progressive, as well as increased involuntary market assessments in the first quarter 2005, as compared to the prior year.

The Company’s other-indemnity businesses, which represent less than .2% of year-to-date net premiums written, primarily include writing professional liability insurance for community banks and the Company’s run-off businesses. These businesses generated an underwriting profit (loss) of $(.9) million and $7.5 million for the third quarter and first nine months of 2005, respectively, compared to $1.0 million and $(.8) million, respectively, for the same periods last year. The underwriting profit (loss) in these businesses may fluctuate due to the uncertain nature of these products, which may include actuarial adjustments, other reserve development and other costs associated with the run-off businesses.

The other-service businesses primarily provide policy issuance and claims adjusting services for state Commercial Auto Insurance Procedures/Plans (CAIP), which are state-supervised plans serving the involuntary market. Service revenues decreased in both the third quarter and first nine months of 2005, as compared to the same periods last year, reflecting declining CAIP business and the reentry of a servicing carrier into the New Jersey CAIP market during the third quarter 2004. These service businesses generated an operating profit of $3.3 million and $12.8 million for the third quarter and first nine months of 2005, respectively, compared to $6.2 million and $18.6 million for the same periods last year.

The Company’s income tax position, which includes both deferred taxes and income taxes payable, shifted to a net asset at September 30, 2005, as compared to a net liability for prior periods. The shift was partially due to lower net unrealized gains at the end of the quarter, compared to year-end, which reduced the Company’s deferred tax liability, as well as the decrease in income taxes payable, reflecting the decrease in the provision for income taxes for the quarter, as compared to prior periods.

The composition of the investment portfolio at September 30 was:

As of September 30, 2005, the Company’s portfolio had $586.3 million of net unrealized gains, compared to $545.5 million at September 30, 2004 and $669.4 million at December 31, 2004. During the third quarter 2005, the fixed-income portfolio’s valuation decreased $96.5 million reflecting the increase in market interest rates during the period. On the other hand, the common stock portfolio had an increase of $69.6 million during the third quarter, reflecting movement in the market.

The fixed-income portfolio, which includes fixed-maturity securities, preferred stocks and short-term investments, had a duration of 2.9 years at September 30, 2005, December 31, 2004, and September 30, 2004. After adjustments to exclude net unsettled securities transactions, the allocation of fixed-income securities at September 30, 2005, was 85.8% of the total portfolio, compared to 88.1% at September 30, 2004.

The fixed-maturity securities and short-term investments, as reported in the balance sheets, were comprised of the following:

Included in the fixed-income portfolio are $2.5 billion of asset-backed securities. These asset-backed securities were comprised of residential mortgage-backed ($.4 billion), commercial mortgage-backed ($1.0 billion) and other asset-backed ($1.1 billion) securities, with a duration of 1.7 years and a weighted average credit quality of AAA-. The largest components of other asset-backed securities were automobile receivable loans ($.7 billion) and home equity loans ($.2 billion). Substantially all asset-backed securities are liquid with available market quotes and contain no residual interests (the most subordinated class in a pool of securitized assets).

Common equities, as reported in the balance sheets, were comprised of the following:

Common equities comprised 14.2% and 11.9% of the total portfolio, excluding the net unsettled securities transactions, at September 30, 2005 and 2004, respectively. Common stocks are the majority of the common equity portfolio and are managed externally to track the Russell 1000 index within +/- 50 basis points annually. To maintain high correlation with the Russell 1000, the Company held approximately 70% of the common stocks comprising the index at September 30, 2005. Individual holdings are measured based on their contribution to the correlation with the index. The Company’s common equity allocation and management strategy are intended to provide diversification for the total portfolio and focus on changes in value of the equity portfolio relative to the change in value of the index. For the third quarters and first nine months of 2005 and 2004, the GAAP return was within the designated tracking error.

Other risk investments include private equity investments and limited partnership interests in private equity and mezzanine investment funds, which have no off-balance-sheet exposure or contingent obligations, except for $4.8 million of open funding commitments at September 30, 2005.

Trading securities are entered into for the purpose of near-term profit generation. At September 30, 2005 and 2004, the Company did not have any trading securities, with the exception of the derivatives classified as trading discussed below. The Company had no trading security gains or losses during the third quarters and first nine months of 2005 and 2004.

From time to time, the Company invests in derivative instruments, which are primarily used to manage the risks of the available-for-sale portfolio. This is accomplished by modifying the basis, duration, interest rate or foreign currency characteristics of the portfolio, hedged securities or hedged cash flows. The Company had no risk management derivatives at September 30, 2005 or 2004. The Company recognized no gains or losses during the third quarters and first nine months of 2005 or 2004 on risk management derivatives.

Derivative instruments may also be used for trading purposes or classified as trading derivatives due to characteristics of the transaction. During the third quarter 2005, the Company held three credit default protection derivatives, which were sold on three separate issuers and matched with Treasury securities with an equivalent principal and maturity to replicate cash bond positions. These positions had a notional amount of $75.0 million at September 30, 2005. The Company held similar investments in 2004, all of which were closed during the third quarter 2004. For the third quarter and first nine months of 2005, these positions generated a net gain (loss) of $(1.3) million and $.6 million, respectively, compared to $1.7 million and $(1.4) million for the third quarter and first nine months of 2004. The amount and results of the derivative and Treasury positions are immaterial to the Company’s financial condition, cash flows and results of operations and are reported as part of the available-for-sale portfolio, with the net gains (losses) reported as a component of net realized gains (losses) on securities.

Recurring investment income (interest and dividends before investment and interest expenses) increased 11% for the third quarter, compared to the same periods last year, reflecting the change in yield as a result of investing new cash and portfolio turnover at higher rates in the current interest rate environment. For the first nine months of 2005, recurring investment income increased 7%, reflecting both growth in the portfolio and the increase in yields. Investment expenses decreased from the prior year primarily due to the costs associated with the Company’s 2004 tender offer.

The Company reports total return to reflect more accurately management’s philosophy of the portfolio and evaluation of the investment results. The fully taxable equivalent (FTE) total return includes recurring investment income grossed up for certain tax-preferential investments (e.g., municipal debt) and net realized gains (losses) and changes in unrealized gains (losses) on securities. The Company reported the following investment results for the periods ended September 30: