Selective Insurance - 10-Q quarterly report FY

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

(Mark one)

For the transition period from  __________ to __________

Commission file number:  0-8641

SELECTIVE INSURANCE GROUP, INC.
(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 report), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X]            No [  ]

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

Yes [X]            No [  ]

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date:

Common stock, par value $2 per share, outstanding as of September 30, 2004: 27,770,976

2

3

5

NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS

1.                      Basis of Presentation
The interim consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) are unaudited, but reflect all adjustments which, in the opinion of management, are necessary to provide a fair statement of the results of Selective Insurance Group, Inc. and its consolidated subsidiaries for the interim periods presented.  References herein to "Selective" or "Company" are to Selective Insurance Group, Inc. and its subsidiaries.  All such adjustments are of a normal recurring nature.  The results of operations for any interim period are not necessarily indicative of results for a full year.  These interim consolidated financial statements cover the third quarters ended September 30, 2004 (Third Quarter 2004) and September 30, 2003 (Third Quarter 2003) as well as the nine-month periods ended September 30, 2004 (Nine Months 2004) and September 30, 2003 (Nine Months 2003).  This document should be read in conjunction with the consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

2.                      Reclassifications
Certain amounts in the Company's prior year interim consolidated financial statements and related footnotes have been reclassified to conform to the 2004 presentation.  Such reclassification had no effect on the Company's net income or stockholders' equity.

3.                      Current and Pending Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (FASB) issued revised FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46R), which is a revised interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements". FIN 46R is required to be applied starting with fiscal years beginning after December 15, 2003. FIN 46R requires the consolidation of a variable interest entity (VIE) by an enterprise if that enterprise either absorbs a majority of the VIE's expected losses or receives a majority of the VIE's expected residual returns as a result of ownership, contractual or other financial interests in the VIE.  Prior to FIN 46R, entities were generally consolidated by an enterprise that had a controlling financial interest through ownership of a majority voting interest in the entity. FIN 46R defines a VIE as an entity in which equity investors do not have the characteristics of a controlling financial interest nor do they have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support.  The Company has no interests in VIEs or potential VIEs commonly referred to as special-purpose entities and as such, the adoption of this revised interpretation on January 1, 2004 has had no effect on the Company's results of operations or financial condition.

In March 2004, the Emerging Issues Task Force (EITF or Task Force) of the FASB reached a consensus on Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments."   This consensus provides recognition and measurement guidance for determining when an investment is other-than-temporarily impaired, specifically when the investor has the ability and intent to hold an investment until recovery.  When originally issued, this guidance was to be effective for reporting periods beginning after June 15, 2004. In September 2004, the FASB decided to delay the effective date of the requirement to record impairment losses caused by the effect of increases in interest rates or sector spreads on debt securities subject to paragraph 16 of EITF 03-01 and to exclude minor impairments from the requirement as well. In addition, the scope of the Task Force's consensus, which was limited to certain debt securities, now includes all types of securities within the scope of EITF 03-01. The disclosure requirements as presently prescribed by EITF 03-01 and SEC Staff Accounting Bulletin No. 59, "Accounting for Noncurrent Marketable Equity Securities" remain in effect for public companies until new guidance is issued and becomes effective. Until such guidance is determined, the Company is unable to determine the impact any such guidance would have on its results of operations or financial condition.  The adoption of the proposed accounting literature could cause the Company: (i) to recognize impairment losses in the Consolidated Statements of Income that are not recognized currently; (ii) to recognize impairment losses, especially those due to increases in interest rates, in earlier periods; and (iii) alter its recognition of investment income on impaired securities.  Such an impact will likely increase earnings volatility in future periods.  However, since fluctuations in the fair value for available-for-sale-securities are already recorded in Accumulated Other Comprehensive Income, adoption of this standard in any form is not expected to have a significant impact on stockholders' equity. Further information on the Company's investments is provided in Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations," in this report beginning on page 23.

6

On October 13, 2004, the FASB concluded that the Proposed Statement 123R, "Share-Based Payment" (FAS 123R), which would require all companies to measure compensation expense on the income statement for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. Retroactive application of the requirements of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) to the beginning of the fiscal year that includes the effective date would be permitted, but not required.  The Proposed Statement 123R is expected to be finalized either later this year or in early 2005. The pro forma results presented in Note 7 are in accordance with the required disclosures under Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (FAS 148), which should provide for a reasonable approximation of the impact the Proposed Statement 123R will have on the Company.

Also on October 13, 2004, the FASB ratified EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share."  As of September 30, 2004, the Company accounted for its Senior Convertible Notes in accordance with the FASB Statements of Financial Accounting Standards No. 128 "Earnings per share." Accordingly, the 3.9 million shares issuable upon conversion of the Convertible Notes are included in the diluted earnings per share calculation in the quarter when the contingency is met as well as the following quarter when the  convertible notes are actually convertible.  Therefore, the shares have been included in diluted earnings per share calculation for the Third Quarter 2004 as well as for the Nine Months 2004, but excluded from the calculation for periods prior to January 1, 2004, for which the contingency criteria was not met dating back to date of issuance in September 2002. EITF Issue No. 04-8, which will require that all shares issuable under a convertible security be included in the diluted earnings per share calculation upon issuance of the instrument, is expected to become effective for periods ending after December 15, 2004 and must be applied by restating all periods during which the instrument was outstanding regardless of whether the market price contingency was met or not. The implementation of this guidance is not anticipated to have any impact on our 2004 diluted earnings per share calculation, but it is likely to result in the restatement of our 2003 and 2002 diluted earnings per share calculations.

4.                      Acquisition of Wholly-Owned Subsidiary
On January 1, 2004, the Company purchased a property and casualty insurance company, domiciled in Maine, with approximately $5.0 million in surplus that was not then writing any business, for $5.3 million. The acquisition has been accounted for using the purchase method of accounting as prescribed by FASB Statement of Financial Accounting Standards No. 141, "Business Combinations."  The acquisition included assets of approximately $4.9 million in cash and cash equivalents, $0.1 million in bonds and $0.3 million of goodwill, which is being accounted for in accordance with FASB Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." There were no liabilities acquired in connection with this acquisition.

5.                      Concentration of Credit Risk
The Company's concentration of credit risk includes accounts receivable due by clients to its human resource administration outsourcing operations, Selective HR Solutions (SHRS).  By law and/or by contract, SHRS assumes substantial employer rights, responsibilities, and risks related to certain employees of its clients and becomes a co-employer of the client's employees. Earned but unpaid wages related to SHRS's co-employees are recognized as an accrued payroll liability, as well as an account receivable, during the period in which such wages are earned.  Subsequent to the end of each period, such wages are paid and the related co-employer service fees are billed.  Accrued co-employer payroll and related service fees were $17.4 million as of September 30, 2004 and $15.5 million as of December 31, 2003.  Certain states limit a co-employer's liability for earned payroll to minimum wage and, accordingly, SHRS's potential liability for accrued co-employer payroll could be reduced.

7

If a client does not pay its related payroll and service fees prior to the applicable payroll date, SHRS has the right to cancel the co-employer contract or, at its option, require letters of credit or other collateral. SHRS generally has not required such collateral.  As of September 30, 2004, the maximum exposure to any one account for earned payroll was approximately $0.6 million.  If the financial condition of a client were to deteriorate rapidly, resulting in nonpayment, SHRS's accounts receivable balances could grow and SHRS could be required to provide for allowances, which would decrease net income in the period that such determination was made.

The Company's Insurance Operations and SHRS segments are subject to geographic concentration.  Approximately 37% of net premiums written are related to insurance policies written in New Jersey, while 39% of HR outsourcing co-employer service fees are related to business in Florida.  Substantially all of the Company's remaining revenues come from the states of Connecticut, Delaware, Georgia, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Missouri, New York, North Carolina, Ohio Pennsylvania, Rhode Island, South Carolina, Virginia, and Wisconsin, Consequently, changes to economic or regulatory conditions in these states could adversely affect the Company.

For a discussion regarding reinsurance recoverables and related concentration of credit risk see Note 6, "Reinsurance" to the September 30, 2004 unaudited interim consolidated financial statements.

6.                      Reinsurance
The Company's consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions.  Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance entities have underwritten.  Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) the Company has underwritten to other insurance companies who agree to share these risks.  The primary purpose of ceded reinsurance is to protect the Company from potential losses in excess of the amount it is prepared to accept.  The reinsurance recoverable from American Re-Insurance Company represents 8% and 7% of the Company's uncollateralized consolidated reinsurance recoverables as of September 30, 2004 and December 31, 2003, respectively. As of September 30, 2004, collateral in the amount of $37.7 million is held in a trust fund for the benefit of the Company related to the reinsurance contracts with American Re-Insurance Company.  In addition, just over 60% of the Company's uncollateralized net reinsurance recoverable balances are ceded to two state or federally sponsored pools (New Jersey Unsatisfied Claims Judgment Fund and the National Flood Insurance Program).

The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies.  On an ongoing basis, the Company reviews amounts outstanding, length of collection period, changes in reinsurance credit standing and other relevant factors to determine collectibility of reinsurance recoverables. During the Third Quarter 2004, there were rating downgrades and substantial reserve developments within the reinsurance industry that could affect our ability to collect under certain reinsurance contracts.  As a result, we increased our loss reserves by $2.5 million and exercised the special termination provision, which is effective in October 2004, on two of our reinsurance contracts due to rating agency downgrades of specific reinsurers that could adversely affect our ability to collect under certain reinsurance contracts.  We eliminated one carrier and added two highly rated carriers to our Property Catastrophe Excess of Loss and Terrorism Aggregate Excess of Loss treaties. We believe these actions will enhance and strengthen our reinsurance program.

8

The following table is a listing of direct, assumed and ceded amounts by income statement caption:

Flood business, which we cede 100% to the National Flood Insurance Program, is included in the above amounts as follows:

Assumed written and earned premiums increased primarily due to an increase in mandatory pool assumptions and an increase in writings of voluntary municipal pool business.  Offsetting the increases in our flood business, ceded written and earned premiums decreased primarily as a result of the termination of the New Jersey Unsatisfied Claims Judgment Fund (UCJF). The New Jersey UCJF was a mandatory reinsurance program, which provided for personal injury protection (PIP) coverage for New Jersey auto policies.  The UCJF assumed unlimited New Jersey PIP losses in excess of $75,000 up to $250,000 per person/ per occurrence from January 1, 1991 through December 31, 2003.  Effective January 1, 2004 the program was terminated for all new policies with carriers being responsible for 100% of the coverage, which remains capped at $250,000. A final adjustment to the prior treaty year UCJF premium resulted in a return of premium previously ceded of $2.4 million recorded by the Company in this quarter.

Increases in assumed losses were influenced primarily by increases in losses assumed from mandatory pools.  The increases in these assumptions are related to the Company's increased participations in the mandatory pools and general growth of the National Council on Compensation Insurance (NCCI) pool. Increases in ceded incurred losses were primarily attributable to increases in business ceded to the National Flood Insurance program and increased losses ceded to the casualty treaties.

9

7.             Stock-Based Compensation
The FASB Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123) establishes financial accounting and reporting standards for stock-based compensation plans. As permitted by FAS 123, the Company uses the accounting method prescribed by Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) to account for its stock-based compensation plans. Companies using APB 25 are required to make pro forma note disclosures of net income and earnings per share as if the fair value method of accounting, as defined in FAS 123, had been applied.

The FASB Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" (FAS 148) amends FAS 123 to provide alternative methods of transition to FAS 123's fair value method of accounting for stock-based compensation.  The Company has adopted the pro forma footnote disclosure-only provisions of FAS 148. Based on the fair value method consistent with the provisions of FAS 148, the Company's net income and earnings per share would have been the following pro forma amounts indicated below:

8.             Senior Convertible Notes
In 2002, the Company issued $305 million aggregate principal amount of 1.6155% senior convertible notes (Senior Convertible Notes), due September 24, 2032, at a discount of 61.988% resulting in an effective yield of 4.25%. The carrying value of these notes was $115.9 million at September 30, 2004 and December 31, 2003.  The Senior Convertible Notes are convertible at the option of the holders, if the conditions for conversion are satisfied, into 12.9783 shares of the Company's common stock per $1,000 principal amount of notes surrendered at a conversion price of $29.29.  The conditions for conversion are satisfied when the price of the Company's common stock has maintained a 20% premium to the conversion price of  $29.29, or $35.15, for 20 of 30 consecutive trading days ending on the last trading day of a calendar quarter. As previously reported, the conditions of conversion were met for the quarters ended March 31, 2004 (First Quarter 2004) and June 30, 2004 (Second Quarter 2004), and as such the holders were able to surrender the Senior Convertible Notes for conversion into shares of common stock, or cash at the Company's option, on any business day during the Second and Third quarters 2004, respectively. As of September 30, 2004, no such conversions had occurred.  On October 26, 2004, in accordance with the provisions of the Indenture, the Company's Board of Directors voted to permanently waive the stock price contingency provision.

In accordance with the FASB Statements of Financial Accounting Standards No. 128 "Earnings per share," the 3.9 million shares issuable upon conversion of the Senior Convertible Notes have been included in the diluted earnings per share calculation for Third Quarter and Nine Months 2004.  Additionally, as a result of the actions taken by the Board of Directors the shares issuable upon conversion of the Senior Convertible Notes will continue to be included in the diluted earnings per share calculation until the Senior Convertible Notes reach maturity or are otherwise extinguished. 

10

On October 13, 2004, the FASB ratified EITF Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share."  EITF 04-8 will require that convertible shares be included in the diluted earnings per share calculation upon issuance of the instrument. This guidance is expected to become effective for periods ending after December 15, 2004 and must be applied by restating all periods during which the instrument was outstanding regardless of whether the market price contingency was met or not. The implementation of this guidance is not anticipated to have any impact on our 2004 diluted earnings per share calculation, but it is likely to result in the restatement of our 2003 and 2002 diluted earnings per share calculations.

The Senior Convertible Notes are redeemable by the Company in whole or in part, at any time on or after September 24, 2007, at a price equal to the sum of the issue price, plus the call premium, if any, plus accrued original issue discount and accrued and unpaid cash interest, if any, on such Senior Convertible Notes to the applicable redemption date. The holders of the Senior Convertible Notes may require the Company to purchase all or a portion of their Senior Convertible Notes on either September 24, 2009, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. The Company may pay the purchase price in cash or shares of Company common stock or in a combination of cash and shares of Company common stock at the Company's option.

9.             Stockholders' Equity
On November 4, 2003, the Board of Directors authorized a 2.5 million-share common stock repurchase program scheduled to expire on November 30, 2005. The Company acquired approximately 141,000 shares for $4.9 million under that program during the Third Quarter and Nine Months 2004 leaving a remaining authorization of 2.4 million shares.

10.          Segment Information
The Company is primarily engaged in writing property and casualty insurance. The Company has classified its business into three segments, which is at the same level of disaggregation as that reviewed by senior management: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services (flood insurance, human resource administration outsourcing and managed care).  Insurance Operations are evaluated based on accounting principles generally accepted in the United States of America (GAAP) underwriting results, as well as statutory combined ratios.  Investments are evaluated based on after-tax investment returns, and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations in accordance with GAAP.  The Company does not aggregate any of its operating segments.

The GAAP underwriting results of the Insurance Operations segment are determined taking into account net premiums earned, incurred losses and loss expenses, policyholders dividends, policy acquisition costs and other underwriting expenses. Management of the Investments segment is separate from the Insurance Operations segment and, therefore, has been classified as a separate segment. The operating results of the Investments segment takes into account net investment income and net realized gains and losses.  Also classified as a segment are the Diversified Insurance Services operations, which are managed separately from the other segments due to the fact that these businesses create a fee-based source of revenue that is not dependent on insurance underwriting cycles.  

These businesses fit into our business model in one of two ways: complementary (they share a common marketing or distribution system) or vertically (one company uses the other's products or services in its own product or supply output).  The flood and HR administration outsourcing products are sold through our independent agent distribution channel, while our managed care businesses provide a service used by our insurance claims operation, as well as by other insurance carriers. The segment results are determined taking into account the net revenues generated in each of the businesses, less the costs of operations.

Selective and its subsidiaries provide services to each other in the normal course of business.  These transactions totaled $7.8 million for Third Quarter 2004 and $21.3 million for Nine Months 2004, compared with $7.0 million for Third Quarter 2003 and $20.1 million for Nine Months 2003.  These transactions were eliminated in all consolidated statements.

In computing the results of each segment, no adjustment is made for interest expense, net general corporate expenses or federal income taxes. The Company does not maintain separate investment portfolios for the segments and, therefore, does not allocate assets to the segments.

11

The following summaries present revenues (net investment income and net realized gains or losses in the case of the Investments segment) and pre-tax income (loss) for the individual segments:

12

11.                    Retirement Plans
As of December 31, 2003, the Company adopted the revised FASB statement of Financial Accounting Standards No. 132R, "Employers' Disclosures about Pensions and Other Postretirement Benefits" (FAS 132R).  FAS 132R addresses disclosure items only and does not address measurement or recognition.  FAS 132R requires additional interim disclosures that were not required by the original statement, all of which are included for all periods presented.

13

12.                   Federal Income Tax

During Third Quarter 2004, the Company received a favorable ruling from the Internal Revenue Service (IRS) regarding our ability to take interest deductions on debt at the holding company, while also holding municipal bonds at the insurance subsidiary level.  This favorable ruling allowed us to reverse our previously accrued $2.3 million in tax expense, which was slightly offset by an increase in tax expense in Third Quarter 2004 for $0.5 million for potential tax exposure items.  The result of this activity was that the effective tax rate remained flat for Third Quarter 2004 compared to the same period a year ago even though the Company experienced marked improvement in its underwriting results.  Although the IRS ruling in the Third Quarter 2004 also favorably impacted the effective tax rate for the Nine Months 2004, the improved underwriting results for the year more than offset this favorable impact as they resulted in an increase in the effective tax rate for Nine Months 2004 compared to the same period a year ago.

13.                   Commitments and Contingencies
Included in other investments is approximately $39.7 million of investments in limited partnerships as of September 30, 2004, and $35.6 million as of December 31, 2003. At September 30, 2004 the Company has an additional limited partnership investment commitment of up to $39.1 million.  There is no certainty that any additional investment will be required. The Company satisfied $0.9 million of our future commitments in the Third Quarter 2004 and $2.3 million for the Nine Months 2004.

14.                   Litigation
Like other companies in the insurance business, the Company is routinely party to litigation.  The Company does not believe that any pending litigation will have a material adverse effect on its financial condition, results of operations, or liquidity.

Three of the Company's subsidiaries, Consumer Health Network Plus, LLC (CHN), Alta Services, LLC (Alta) and Selective Insurance Company of America (SICA), were named as defendants, together with ten other unrelated parties, in Berlin Medical Associates PA, et al. v. CMI New Jersey Operating Corp., et al, a purported class action filed on May 21, 2003, by several non-hospital health care providers in the Superior Court of New Jersey, Law Division - Camden County.

The lawsuit alleges that the defendants breached the terms of their participating provider agreements and/or the terms of New Jersey automobile personal injury protection policies by reducing payments for plaintiffs' services pursuant to provider discount schedules when paying claims and were unjustly enriched.  The complaint does not specify monetary damages.  The defendants, including CHN, Alta, and SICA, are vigorously defending this lawsuit and, together with the other defendants, filed a motion to dismiss.  After a hearing on the motion, the court ordered the plaintiffs to amend their complaint.  In March 2004, the plaintiffs filed an amended complaint, which no longer named Alta as a defendant.  In May 2004, all remaining defendants, including CHN and SICA, moved to dismiss the amended complaint.  In July, they also filed a motion to dismiss the class action allegations.  The court has scheduled argument on both such motions in January 2005.

14

Given the early stages of the litigation, it is extremely difficult to provide a meaningful estimate or range of any potential loss.  CHN and SICA will continue to vigorously defend the case.  At this time, however, the Company believes that, should the case ultimately be decided unfavorably, it would not have a material adverse effect on the Company's financial condition, results of operations, or liquidity.

One of the Company's insurance subsidiaries, Selective Insurance Company of the Southeast (SISE), is one of nine property and casualty insurance company defendants in Howell et all v. State Farm et al., a purported class action filed on May 18, 2004 in the United States District Court for the District of Maryland, Baltimore Division.  The court has not yet ruled on class certification.  The plaintiffs hold Standard Flood Insurance Policies (SFIP) issued by the defendant insurers, who are participants in the Write Your Own (WYO) Program of the Federal Insurance Administration's (FIA) National Flood Insurance Program (NFIP).  The FIA is an agency within the Federal Emergency Management Administration (FEMA).  All claims under SFIPs are 100% reinsured by FEMA.

The suit alleges that the insurers underpaid flood claims arising from Hurricane Isabel in breach of their contractual obligations, fiduciary duties, and the implied covenant of good faith and fair dealing and seeks damages.  The complaint does not specify monetary damages.  The insurers, including SISE, have denied the allegations, noting that they adjusted the claims as fiduciary agents of the U.S. Government in accordance with specific federal guidelines.  The insurers also have filed a motion to dismiss certain of the claims, which the court has not yet decided.

Given the early stages of the litigation, it is extremely difficult to provide a meaningful estimate or range of any potential loss.  FEMA's Office of the General Counsel, however, has advised the defendant carriers that, in its opinion, the claims were adjusted in accordance with the law and that FEMA will indemnify and reimburse the defense costs of the defendant insurers, including SISE.  Consequently, the Company believes that its exposure in the case is minimal.

15

FORWARD-LOOKING STATEMENTS
In this Quarterly Report on Form 10-Q, Selective and its management discuss and make statements regarding their intentions, beliefs, current expectations, and projections regarding Selective's future operations and performance. Such statements are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are often identified by words such as "anticipates," "believes," "expects," "will," "should" and "intends" and their negatives. Selective and its management caution prospective investors that such forward-looking statements are not guarantees of future performance. Risks and uncertainties are inherent in Selective's future performance. Factors that could cause actual results to differ materially from those indicated by such forward-looking statements include, but are not limited to, those discussed under "Business Risks" in "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" in Selective's Annual Report on Form 10-K for 2003 ("Annual Report"). Those portions of the Annual Report are incorporated by reference into this report.  Selective and its management make forward-looking statements based on currently available information and assume no obligation to update these statements due to changes in underlying factors, new information, future developments, or otherwise.

Factors that could cause our actual results to differ materially from those projected, forecasted or estimated by us in forward-looking statements, include, but are not limited to:

• the frequency and severity of catastrophic events, including, but not limited to, hurricanes, tornadoes, windstorms, earthquakes, hail, severe winter weather, fires, explosions and terrorism;

• adverse economic, market or regulatory conditions;

• the concentration of our business in a number of east coast and midwestern states;

• the adequacy of our loss reserves;

• the cost and availability of reinsurance;

• our ability to collect on reinsurance and the solvency of our reinsurers;

• uncertainties related to insurance premium rate increases and business retention;

• changes in insurance regulations that impact our ability to write and/or cease writing insurance policies in one or more states particularly changes in New Jersey automobile insurance laws and regulations;

• our ability to maintain favorable ratings from A.M. Best, Standard & Poor's, Moody's and Fitch;

• fluctuations in interest rates and the performance of the financial markets;

• our entry into new markets and businesses; and

• other risks and uncertainties we identify in this report and other filings with the Securities and Exchange Commission.

ITEM 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations
The Company is primarily engaged in writing property and casualty insurance. The Company has classified its businesses into three segments, which is at the same level of disaggregation as that reviewed by senior management: Insurance Operations (commercial lines underwriting, personal lines underwriting), Investments, and Diversified Insurance Services (flood insurance, human resource administration outsourcing and managed care). Insurance Operations are evaluated based on underwriting results determined in accordance with Generally Accepted Accounting Principles (GAAP); Investments are evaluated based on after-tax investment returns; and the Diversified Insurance Services are evaluated based on several measures including, but not limited to, results of operations determined in accordance with GAAP. For an additional description of our critical accounting policies and estimates, refer to Item 8. "Financial Statements and Supplementary Data," Note 2 to our consolidated financial statements of our Annual Report on Form 10-K for the year-ended December 31, 2003 and the discussion beginning on page 31 of this report on Form 10-Q.  See Note 10 to the September 30, 2004 unaudited interim consolidated financial statements on pages 11 through 13 of this report on Form 10-Q for revenues and related income before federal income tax for each individual segment discussed below.

The following discussion relates to our results of operations, financial condition, liquidity and capital resources, off-balance sheet arrangements, contractual obligations and contingent liabilities and commitments and critical accounting policies for the interim periods indicated.

16

Results of Operations
The following discussion is a comparison of the third quarter ended September 30, 2004 (Third Quarter 2004) and the nine-month period ended September 30, 2004 (Nine Months 2004) to the third quarter ended September 30, 2003 (Third Quarter 2003) and the nine-month period ended September 30, 2003 (Nine Months 2003), respectively.

Our net income increased 92% to $28.3 million, or $0.90 per diluted share, for Third Quarter 2004, compared to $14.7 million, or $0.53 per diluted share, for Third Quarter 2003. For the Nine Months 2004, our net income increased 99% to $84.7 million, or $2.70 per diluted share, compared to $42.5 million, or $1.54 per diluted share, for Nine Months 2003. Included in net income are net realized capital gains, after-tax, of $1.1 million for Third Quarter 2004 and $4.6 million for Nine Months 2004, compared to $0.7 million for Third Quarter 2003 and $5.4 million for Nine Months 2003. These results increased our annualized return on average equity (annualized net income divided by average equity) as of the Nine Months 2004 to 14.3%, which substantially exceeded our 9.5% return on average equity for the full year of 2003.

Insurance Operations

Net premiums written increased by approximately $38.9 million or 12%, to $356.5 million in Third Quarter 2004 and by $133.2 million, or 14%, to $1.1 billion in Nine Months 2004 when compared to the same periods in 2003. Net premiums earned increased by $47.4 million or 16%, to $337.1 million in Third Quarter 2004 and by $145.5 million, or 17%, to $1.0 billion in Nine Months 2004 when compared to the same periods in 2003. These increases were largely attributable to commercial lines renewal premium  price increases, including exposure, that averaged 9.4% in Third Quarter 2004 and 9.5% in the Nine Months 2004 compared to 12.0% in Third Quarter 2003 and 13.2% in the Nine Months 2003.  As expected, these price increases have decelerated over the nine months of 2004 and we expect this trend to continue over the remainder of the year; however, commercial lines earned price increases outpaced loss trends by 2.8 points for the Third Quarter 2004 and 3.9 points for the Nine Months 2004.  Combined ratios and ultimately net income would be unfavorably impacted if earned price increases cease to outpace loss costs trends in the future. However, underwriting improvements resulting in lower loss ratios could partially offset the unfavorable impact of increased loss trends.

Additional factors contributing to growth in net premiums written were: (i) net new business written of $68.9 million for the Third Quarter 2004 compared with $69.2 million in Third Quarter 2003 and $213.4 million in net new business written in the Nine Months 2004 compared with $206.0 million for Nine Months 2003 and (ii) commercial lines year-on-year retention improvement of 1 point to 81% in Third Quarter 2004 and 3 points to 83% in Nine Months 2004 compared with 80% for Third Quarter 2003 and Nine Months 2003.

17

The loss and loss expense ratio decreased 3.8 points to 66.7% for Third Quarter 2004 and 5.3 points to 65.9% for Nine Months 2004 when compared with the same periods in 2003. The improvements were primarily due to increased premium rates coupled with underwriting improvements in both our commercial lines and personal lines businesses. Additionally, the loss and loss expense ratio declined due to lower catastrophe losses in the quarter and for the nine months. Weather-related catastrophe losses were  $12.2 million or 3.6 points in Third Quarter 2004 compared with $13.5 million or 4.7 points for Third Quarter 2003. Weather-related catastrophe losses accounted for $19.5 million in incurred losses and added 2.0 points to the loss and loss expense ratio for the Nine Months 2004, compared with $25.3 million and 3.0 points for Nine Months 2003.

The underwriting expense ratio decreased 0.4 points to 31.0% for Third Quarter 2004 and 0.5 points to 31.0% for Nine Months 2004 compared with the same periods last year.  Overall productivity, as measured by fiscal year net premiums written per insurance operations employee, increased approximately 18% to $781,000 compared to $662,000 for the same period a year ago. Contributing to the productivity gains are our strategic initiatives that are designed to either reduce costs and/or increase business, which include: (i) streamlined processing for small commercial lines accounts (One & Done) and (ii) web-based commercial lines and personal lines automated systems. These technology enhancements allow agents to initiate and self-service a portion of our business from their offices. At the end of the Third Quarter 2004, agents were processing approximately 50% of all endorsements through our commercial lines system, while underwriting templates automatically renewed over 30% of commercial lines policies. Additionally, agents are issuing 76% of new automobile policies directly on-line in the personal lines underwriting system.

The combined ratio decreased 4.1 points to 98.1% for Third Quarter 2004 and 6.0 points to 97.2% for Nine Months 2004 compared with the same periods last year.  The decrease in the combined ratio is attributable to the decreases in the loss and loss expense ratio and the underwriting expense ratio discussed above.

Commercial Lines Results

18

Commercial Lines underwriting accounted for approximately 84% of net premiums written in Nine Months 2004 compared to 82% in Nine Months 2003. Net premiums written increased $36.1 million, or 14%, to $297.5 million for Third Quarter 2004 and $127.5 million, or 16%, to $908.3 million for Nine Months 2004 compared with the same periods in 2003.  Net premiums earned increased by approximately $44.1 million or 19%, to $279.7 million in Third Quarter 2004 and by $134.6 million, or 20%, to $809.5 million in Nine Months 2004 when compared to the same periods in 2003. These increases were largely attributable to commercial lines renewal premium price increases, including exposure, that averaged 9.4% in Third Quarter 2004 and 9.5% in the Nine Months 2004 compared to 12.0% in Third Quarter 2003 and 13.2% in the Nine Months 2003.  As expected, these price increases have decelerated over the nine months of 2004 and we expect this trend to continue over the remainder of the year; however, commercial lines earned price increases outpaced loss trends by 2.8 points for the Third Quarter 2004 and 3.9 points for the Nine Months 2004.  Combined ratios and ultimately net income would be unfavorably impacted if earned price increases cease to outpace loss costs trends in the future. However, underwriting improvements resulting in lower loss ratios could partially offset the unfavorable impact of increased loss trends.

Additional factors contributing to growth in premiums written were: (i) net new business written of $60.1 million for the Third Quarter 2004 compared with $60.2 million in Third Quarter 2003 and $190.1 million in net new business written in the Nine Months 2004 compared with $180.1 million for Nine Months 2003 and (ii) commercial lines year-on-year retention improvement of 1 point to 81% in Third Quarter 2004 and 3 points to 83% in Nine Months 2004 compared with 80% for Third Quarter 2003 and Nine Months 2003.

The Commercial Lines loss and loss expense ratio decreased 2.8 points to 65.4% for Third Quarter 2004 and 5.7 points to 64.3% for Nine Months 2004 when compared with the same periods in 2003. This improvement reflects fewer large losses that amounted to $3.3 million during the quarter compared to $7.7 million for the same period a year ago in our property line of business as well as the success of our long-term strategy that incorporates higher pricing, continued underwriting enhancements, and heightened loss control efforts - all of which led to a better overall mix of business. The Third Quarter 2004 loss and loss expense ratio included an impact of 3.9 points or $11.1 million of weather-related catastrophe losses compared with 3.7 points in Third Quarter 2003. The Nine Months 2004 loss and loss expense ratio included an impact of 2.1 points or $17.2 million as the result of weather-related catastrophes compared with an impact of 2.8 points or $18.7 million for Nine Months 2003. Partially offsetting improvements in the Commercial Lines loss and loss expense ratio was an increase to our loss reserves of $2.5 million adding 0.9 points to the ratio for Third Quarter 2004 and 0.3 points for Nine Months 2004.  This was due to rating agency downgrades of specific reinsurers, which could adversely affect our ability to collect under reinsurance contracts.

The Commercial Lines underwriting expense ratio increased by 0.5 points to 31.9% for Third Quarter 2004 and 0.2 points to 31.9% for the Nine Months 2004 compared to the same period a year ago. Improvements in productivity were more than offset by increases in profit-based compensation for agents and employees of 2.4 points for Third Quarter 2004 and 0.8 points for Nine Months 2004 compared with the same periods a year ago.

The Commercial Lines combined ratio decreased 2.3 points, to 97.7%, for Third Quarter 2004 and 5.7 points, to 96.6%, for Nine Months 2004 when compared to a combined ratio of 100.0% in Third Quarter 2003 and 102.3% for Nine Months 2003. These favorable results were driven primarily by improvements in the loss and loss expense ratio as discussed above.

                          Commercial Automobile Business
Commercial automobile, which accounted for 28% of commercial lines statutory net premiums earned in Third Quarter 2004 and Nine Months 2004 compared to 28% in Third Quarter and Nine Months 2003 registered another strong quarter, with a statutory loss and loss expense ratio that improved 11.4 points to 52.1% in Third Quarter 2004 and 7.9 points to 55.4% for Nine Months 2004 compared to 63.5% in Third Quarter 2003 and 63.3% for Nine Months 2003. This line has been favorably impacted by price increases, stricter underwriting standards, and the removal of certain classes of business that we determined to be unprofitable.

19

                          Workers' Compensation Business
Our workers' compensation business accounted for 24% of commercial lines statutory net premiums earned in Third Quarter and Nine Months 2004 compared to 23% in Third Quarter 2003 and 24% in Nine Months 2003.  Our workers' compensation business posted a statutory loss and loss expense ratio of 85.1% for Third Quarter 2004 and 83.4% for Nine Months 2004, compared with 82.5% for Third Quarter 2003 and 84.9% for Nine Months 2003. Rating agency downgrades of certain reinsurers caused us to reevaluate our ability to collect under certain reinsurance contracts, which resulted in an increase to our loss reserves of $1.3 million to this line of business adding 1.9 points to the statutory loss and loss expense ratio for the Third Quarter 2004 and 0.7 points for the Nine Months 2004.  This line of business also continues to be impacted by unfavorable external factors, including: a regulatory climate that makes it difficult to obtain rate increases in some states; rising medical costs; increasing indemnity benefits; and a decreasing number of workers' compensation-only providers who can provide our agents with alternative markets for this line of business.  Although results for this line of business are not at an acceptable level, the Company continues to maintain an underwriting position for the workers' compensation business that focuses on low-to-medium hazard business.  In addition, our underwriting measures also include requiring job site inspections and increasing the number of our trained loss control representatives from 61 as of Third Quarter 2003 to 65 as of Third Quarter 2004.  Our workers' compensation pricing has increased by 40% since 2000 through a combination of rate increases, credit and dividend reductions, and moving business to higher-priced tiers. However, the rate increases that we have been able to get approved have just kept pace with loss trends.  Since 2000, commercial lines policy counts have risen almost 13% while workers' compensation policy counts have risen  less than 1%.  Given the Company's broad desire for business, it is essential that we write this business, where appropriate, to meet the overall account needs of agents and their clients.  However, when it is appropriate, we encourage our agents to place this line elsewhere.  Currently, less than 5% of the business is unsupported by another commercial line. Our underwriting and pricing actions are ongoing, including a focus on low-to-medium hazard business, limiting growth in policy counts, and a forecasted 11.6% overall price increase in 2004.

                          General Liability Business
Our general liability business, which accounted for 28% of commercial lines statutory net premiums earned in Third Quarter and Nine Months 2004 and 28% in Third Quarter and Nine Months 2003, posted a statutory loss and loss expense ratio of 68.5% for Third Quarter 2004 and 64.2% for Nine Months 2004, compared to 65.3% for Third Quarter 2003 and 66.8% for Nine Months 2003. Rating agency downgrades of certain reinsurers caused us to reevaluate our ability to collect under certain reinsurance contracts, which resulted in an increase to our loss reserves of $1.2 million to this line of business adding 1.5 points to the statutory loss and loss expense ratio for the Third Quarter 2004 and 0.5 points for the Nine Months 2004. Our favorable performance in this line through the Nine Months 2004 reflects our long-term improvement strategy that incorporates higher pricing, heightened loss control efforts and continued underwriting enhancements, which includes contractual underwriting procedures. 

                          Commercial Property Business
Our commercial property business, which accounted for 14% of commercial lines statutory net premiums earned in Third Quarter and Nine Months 2004 as well as Third Quarter and Nine Months 2003, posted a statutory loss and loss expense ratio of 50.8% for Third Quarter 2004 and 48.4% for Nine Months 2004, compared with 61.5% for Third Quarter 2003 and 64.4% for Nine Months 2003. The Third Quarter 2004 loss and loss expense ratio included 26.2 points or $10.2 million of weather-related catastrophe losses compared with 19.6 points or $6.7 million in Third Quarter 2003. The Nine Months 2004 loss and loss expense ratio included 13.0 points or $14.7 million as the result of weather-related catastrophes compared with 16.3 points or $15.4 million for Nine Months 2003.  Improvements in the Third Quarter 2004 were largely due to substantially lower frequency and severity of claims when compared to the same period a year ago.  Additionally, we continue to implement ongoing pricing and underwriting actions to improve results in this line of business, which include: better insurance to value estimates across our book of business; a shift to risks of better construction quality and newer buildings; and an overall focus on low-to-medium hazard property exposures.

20

Personal Lines underwriting accounted for approximately 16% of net premiums written for Nine Months 2004 compared to 18% for Nine Months 2003. Personal Lines Underwriting net premiums written increased $2.9 million, or 5%, to $59.0 million for Third Quarter 2004 and $5.7 million, or 3%, to $172.7 million for Nine Months 2004 when compared to the same periods in 2003.  The principal factors contributing to this growth were: (i) personal lines renewal premium price increases averaging 5.6% in Third Quarter 2004 and 5.4% in the Nine Months 2004 compared to 4.7% in Third Quarter 2003 and 4.6% in the Nine Months 2003 and (ii) net new business written of $8.8 million in Third Quarter 2004 compared to $8.9 million in Third Quarter 2003.  Net new business written in Nine Months 2004 was $23.3 million compared with $25.8 million written in Nine Months 2003.

The Personal Lines loss and loss expense ratio decreased 7.5 points, to 72.9%, for Third Quarter 2004 and 3.1 points, to 73.3%, for Nine Months 2004 when compared to the same periods in 2003. The Third Quarter 2004 included 2.0 points of weather-related catastrophe losses compared with 9.0 points in Third Quarter 2003, while the Nine Months 2004 included 1.4 points of weather-related catastrophes compared with 4.2 points for the Nine Months 2003. Additionally, we added $2.0 million to our homeowners' reserves, which partially offset the improvements in the Personal Lines loss and loss expense ratio for the Third Quarter 2004 and Nine Months 2004.  This action resulted from unfavorable trends in claims for groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey.  Increased frequency was triggered, in part, by the state's robust real estate market, leading to an increase in home tank inspections.  Overall claim severity has been low, with average claim payments of $22,000, and there has been almost no similar claim activity in our other operating states.  To address this issue, we began restricting writings of policies with coverage for underground heating oil storage tanks, company-wide, more than 18 months ago, and are reviewing possible coverage changes for existing business.  Further improvements in the Personal Lines loss and loss expense ratio were attributable to price increases. During Third Quarter 2004, we implemented a new rate filing that allows us to use credit scoring for New Jersey auto business, as well as tier changes, which reduce rates by an average of approximately 2.5%.  These enhancements will lead to greater savings for our best risks, while improving the overall book of business.

The Personal Lines underwriting expense ratio showed improvement of 4.1 points, to 27.2%, for Third Quarter 2004 and 4.0 points, to 26.8%, for the Nine Months 2004 compared to the same periods a year ago. These improvements are attributable to increased pricing and a change in deferred acquisition cost amortization estimates, which were revised last year to better match acquisition expenses and earned premiums.

The Personal Lines Underwriting combined ratio decreased 11.6 points, to 100.1%, for Third Quarter 2004 and 7.1 points, to 100.1%, for Nine Months 2004 compared with the same periods last year. The decrease in the combined ratio was primarily attributable to the decreases in the loss and loss expense ratio as well as the underwriting expense ratio discussed above.

21

                          Personal Automobile Business
Our personal automobile line of business represented 82% of our personal lines statutory net premiums earned for Third Quarter 2004 and Nine Months 2004, compared with 82% for Third Quarter 2003 and 83% for Nine Months 2003. New Jersey accounted for 75% of our overall personal automobile net premiums written for Third Quarter 2004 and 74% for Nine Months 2004 compared to 72% for Third Quarter 2003, and 73% for Nine Months 2003.The personal automobile statutory loss and loss expense ratio decreased 4.2 points to 69.0% for Third Quarter 2004 and 3.7 points to 70.3% for Nine Months 2004 when compared with the same periods in 2003. This improvement reflects continued progress in our New Jersey personal automobile business resulting from significant actions taken over the last four years, including aggressive pricing initiatives; a redesign of our rating tiers; and an improving political and regulatory climate.   Most recently, to remain competitive for the best risks, we have implemented a new rate filing that allows us to use credit scoring for New Jersey auto business, as well as tier changes to reduce rates by an average of approximately 2.5%. These enhancements will lead to greater savings for our best risks.  Additionally, further improvements in our loss costs can also be attributed to benefits derived as a result of the verbal tort threshold, which has reduced the number and severity of litigated claims, as modified by the New Jersey Automobile Insurance Cost Reduction Act (AICRA).

                          Homeowners Business
Our homeowners line of business, which accounted for 15% of personal lines statutory net premiums earned for Third Quarter 2004 and Nine Months 2004, compared with 15% for Third Quarter 2003 and Nine Months 2003,had a statutory loss and loss expense ratio of 101.6% for Third Quarter 2004 and 86.4% for the Nine Months 2004 compared to 127.6% for Third Quarter 2003 and 97.1% for the Nine Months 2003.Weather-related catastrophes added 10.3 points in the Third Quarter 2004 and 8.1 points for the Nine Months 2004 compared to 54.7 points in the Third Quarter 2003 and 26.1 points for the Nine Months 2003.  In addition, we added $2.0 million to our homeowners' reserves.  This action resulted from unfavorable trends in claims related to groundwater contamination caused by leakage of certain underground heating oil storage tanks in New Jersey, which added 23.0 points to the statutory loss and loss expense ratio for Third Quarter 2004 and 7.9 points for Nine Months 2004. Increased frequency of claims was triggered, in part, by the state's robust real estate market, leading to an increase in home tank inspections.  Overall claim severity has been low, with average claim payments of $22,000, and there has been almost no similar claim activity in our other operating states.  We began restricting writings of policies with coverage for underground heating oil storage tanks, company-wide, more than 18 months ago, and are reviewing possible coverage changes for existing business. Further improvements in this line have been driven by the results of the plan initiated three years ago, which included: (i) double-digit rate increases in six states; (ii) expanding the use of credit history to apply discounts and surcharges for new and renewal business; (iii) continuing the rollout of higher wind and hail deductibles in coastal and selected inland territories; and (iv) expanding the account credit, where appropriate, to encourage agents to write entire accounts.

Reinsurance
The Insurance Subsidiaries follow the customary practice of ceding a portion of their risks and paying to reinsurers a portion of the premiums received under the policies.  This reinsurance program permits greater diversification of business and the ability to offer increased coverage while limiting maximum net losses.  The Insurance Subsidiaries are parties to reinsurance contracts under which certain types of policies are automatically reinsured without the need for approval by the reinsurer of individual risks covered (treaty reinsurance), reinsurance contracts handled on an individual policy or per-risk basis requiring the agreement of the reinsurer as to each risk insured (facultative reinsurance).  Reinsurance does not legally discharge an insurer from its liability for the full face amount of its policies, but does make the reinsurer liable to the insurer to the extent of the reinsurance ceded.

Our Property and Casualty Excess of Loss treaties were successfully renewed effective July 1, 2004, with a modest reduction to the prior year's cession rates.  The ceded premium for the renewed treaties is expected to decrease by approximately $300,000 as compared to the prior treaty year.  However, we are expecting to retain approximately $3.0 million more in losses due to an increase in our co-participation in the first layer of the Casualty Excess of Loss treaty.

22

Our Casualty Excess of Loss treaty provides per occurrence coverage of $48.0 million in excess of $2.0 million retention of any casualty loss.  Selective retains 50%, or $1.5 million, of the first $3.0 million excess of $2.0 million layer.  Our co-participation in this layer was 25% in the prior year.  The casualty treaty distinguishes between certified (Terrorism Risk Insurance Act of 2002 (TRIA) events or foreign acts) and non-certified (all other or domestic) terrorism losses. Non-certified terrorism losses are treated like any other losses.  The annual aggregate limit for certified terrorism losses is capped at two times each layer's occurrence limit, or $96.0 million.  Consistent with the 2003 treaty: nuclear, biological and chemical losses are excluded from the casualty excess of loss treaty; however, our Terrorism Excess of Loss treaty covers these exposures once our $15.0 million annual aggregate deductible is met. There are no exclusions for mold or cyber risks in this treaty.

Our Property Excess of Loss treaty provides coverage on each property risk of $18 million in excess of $2.0 million retention.  Under the 2004 treaty, the Company cedes 100% of $18.0 million per risk in excess of the $2.0 million retention.  This is a change from the prior year treaty where the Company retained 25% of the $5.0 million excess of the $5.0 million second layer for a total coverage of $16.7 million per risk in excess of the $2.0 million retention.  As with the casualty treaty, the property treaty distinguishes between certified (TRIA) and non-certified terrorism losses. The treaty provides annual aggregate certified terrorism limits for all risks of $9.0 million for the first layer, $15.0 million for the second layer and $20.0 million for the third layer.  The provision in last year's treaty that limited coverage for TRIA losses for all risks up to $75.0 million in total insured value per location was eliminated with the July 1, 2004 renewal.  Claims arising from non-certified terrorist acts are treated like any other losses.  Consistent with the 2003 contract: nuclear, biological and chemical losses are excluded from the Property Excess of Loss treaty; however, our Terrorism Excess of Loss Treaty covers these exposures once our $15.0 million annual aggregate deductible is met. There are no exclusions for mold or cyber risks in this contract.

Effective January 1, 2004 the New Jersey Unsatisfied Claims Judgment Fund (UCJF) was terminated for all new policies with carriers being responsible for 100% of the coverage, which is capped at $250,000. The New Jersey UCJF was a mandatory reinsurance program, which provided for personal injury protection (PIP) coverage for New Jersey auto policies.  The UCJF assumed unlimited New Jersey PIP losses in excess of $75,000 up to $250,000 per person/per occurrence from January 1, 1991 through December 31, 2003.  A final adjustment to the prior treaty year UCJF premium resulted in a return of premium previously ceded of $2.4 million, which was recorded by the Company in the Third Quarter 2004.

Additionally, during Third Quarter 2004, we exercised the special termination provision, which is effective in October 2004, on two of our reinsurance contracts due to rating agency downgrades of specific reinsurers that could adversely affect our ability to collect under certain reinsurance contracts. We eliminated one carrier and added two highly rated carriers to our Property Catastrophe Excess of Loss and Terrorism Aggregate Excess of Loss treaties. We believe these actions will enhance and strengthen our reinsurance program.

Investments
After-tax investment income increased  9% , to $22.0 million, for Third Quarter 2004, up from $20.2 million for Third Quarter 2003.  The increase reflects an increased asset base as our overall investment portfolio reached $2.7 billion at September 30, 2004, compared with $2.4 billion at September 30, 2003.  The increased asset base was driven by improved underwriting results generating $266.2 million of net operating cash flow and an increase in net securities payable of $56.9 million for Nine Months 2004 compared with $207.5 million of net operating cash flow and an increase in net securities payable of $16.3 million for Nine Months 2003.  Also contributing to the increase on a year-to-date basis were our limited partnership investments.  These investments, which are subject to market fluctuations, added $2.7 million, after-tax, to investment income for Nine Months 2004 compared with $1.7 million for Nine Months 2003.  The overall after-tax portfolio yield was 3.4%, compared with 3.7% for the same period last year, reflecting downward pressure from maturing bonds that are being replaced by bonds with lower interest rates.

We continue to maintain a conservative, diversified investment portfolio, with our debt securities representing 85% of invested assets. Approximately 63% of our debt securities portfolio is rated "AAA." Our portfolio has an average rating of "AA," with less than 1% of the portfolio rated below investment grade.

23

At September 30, 2004 our investment portfolio included non-investment grade securities, all of which were in unrealized gain positions, with an amortized cost of $7.2 million, or less than 1% of the portfolio, and a fair value of $7.3 million.  At December 31, 2003, non-investment grade securities in our investment portfolio represented 1% of the portfolio, with an amortized cost of $25.2 million and a fair value of $27.2 million. The non-investment grade securities in unrealized loss positions represented 5% of our total gross unrealized loss at December 31, 2003.  The fair value of these securities was determined by independent pricing services or bid prices provided by various broker dealers.  The Company did not have a material investment in non-traded securities at September 30, 2004, or at December 31, 2003. The Company also regularly reviews the diversification of the investment portfolio compared with an investment grade corporate index.

The Company regularly reviews its entire investment portfolio for declines in value.  If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in accumulated other comprehensive income. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss in our consolidated statements of income.  Our assessment of a decline in value includes our current judgment as to the financial position and future prospects of the entity that issued the investment security.  Broad changes in the overall market or interest rate environment generally will not lead to a write-down.  If our judgment about an individual security changes in the future we may ultimately record a realized loss after having originally concluded that the decline in value was temporary, which could have a material impact on our net income and financial position of future periods.

In evaluating potential impairment of debt securities, we evaluate certain factors, including but not limited to the following:

• Whether the decline appears to be issuer or industry specific;

• The degree to which an issuer is current or in arrears in making principal and interest payments on the debt securities in question;

• The issuer's current financial condition and its ability to make future scheduled principal and interest payments on a timely basis;

• Buy/hold/sell recommendations published by outside investment advisors and analysts; and

• Relevant rating history, analysis and guidance provided by rating agencies and analysts.

In evaluating potential impairment of equity securities, we evaluate certain factors, including but not limited to the following:

• Whether the decline appears to be issuer or industry specific;

• The relationship of market prices per share to book value per share at the date of acquisition and date of evaluation;

• The price-earnings ratio at the time of acquisition and date of evaluation;

• The financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer's operations;

• The recent income or loss of the issuer;

• The independent auditors' report on the issuer's recent financial statements;

• The dividend policy of the issuer at the date of acquisition and the date of evaluation;

• Any buy/hold/sell recommendations or price projections published by outside investment advisors; and

• Any rating agency announcements.

Realized Gains and Losses
Realized gains and losses are determined on the basis of the amortized cost of specific investments sold or written-down, and are credited or charged to income. Management's decision to sell securities is based on portfolio management considerations, which include security valuations, credit concerns and certain underlying  financial indicators. We also consider sector weightings, tax management, and general economic factors. Decisions to sell securities are made to benefit the overall investment portfolio. We sell securities to enhance portfolio risk/reward and to maximize future investment returns. Liquidity is a consideration when buying or selling securities, but because of the high quality of our investment portfolio, the securities sold have not diminished the overall liquidity of our portfolio.

24