EX-13 10 pgr-20181231exhibit13annua.htm EXHIBIT 13 Exhibit


Exhibit 13
 
 
 
THE PROGRESSIVE CORPORATION
2018 ANNUAL REPORT TO SHAREHOLDERS
 
 
 


App.-A-1




The Progressive Corporation and Subsidiaries
Consolidated Statements of Comprehensive Income
For the years ended December 31,
(millions—except per share amounts)
2018

2017

2016

Revenues



Net premiums earned
$
30,933.3

$
25,729.9

$
22,474.0

Investment income
820.5

563.1

478.9

Net realized gains (losses) on securities:



Net realized gains (losses) on security sales
170.7

115.7

155.8

Net holding period gains (losses) on securities
(507.9
)
(1.6
)
(17.9
)
Net impairment losses recognized in earnings
(68.3
)
(64.5
)
(86.8
)
Total net realized gains (losses) on securities
(405.5
)
49.6

51.1

Fees and other revenues
472.2

370.6

332.5

Service revenues
158.5

126.8

103.3

Other gains (losses)
0

(1.0
)
1.6

Total revenues
31,979.0

26,839.0

23,441.4

Expenses



Losses and loss adjustment expenses
21,721.0

18,808.0

16,879.6

Policy acquisition costs
2,573.7

2,124.9

1,863.8

Other underwriting expenses
4,195.8

3,480.7

2,972.0

Investment expenses
24.3

23.9

22.4

Service expenses
134.1

109.5

92.0

Interest expense
166.5

153.1

140.9

Total expenses
28,815.4

24,700.1

21,970.7

Net Income



Income before income taxes
3,163.6

2,138.9

1,470.7

Provision for income taxes
542.6

540.8

413.5

Net income
2,621.0

1,598.1

1,057.2

Net (income) loss attributable to noncontrolling interest (NCI)
(5.7
)
(5.9
)
(26.2
)
Net income attributable to Progressive
2,615.3

1,592.2

1,031.0

Other Comprehensive Income (Loss)



Changes in:
 
 
 
  Total net unrealized gains (losses) on securities
(99.3
)
355.4

130.6

Net unrealized losses on forecasted transactions
0.8

(5.4
)
(1.2
)
Foreign currency translation adjustment
0

1.1

0.4

Other comprehensive income (loss)
(98.5
)
351.1

129.8

Other comprehensive (income) loss attributable to NCI
3.3

(2.3
)
3.2

Comprehensive income attributable to Progressive
$
2,520.1

$
1,941.0

$
1,164.0

Computation of Earnings Per Common Share



Net income attributable to Progressive
$
2,615.3

$
1,592.2

$
1,031.0

Less: Preferred share dividends
21.4

0

0

Net income available to common shareholders
$
2,593.9

$
1,592.2

$
1,031.0

Average common shares outstanding — Basic
582.4

580.8

581.7

Net effect of dilutive stock-based compensation
4.3

4.9

3.3

Total average equivalent common shares — Diluted
586.7

585.7

585.0

Basic: Earnings per common share
$
4.45

$
2.74

$
1.77

Diluted: Earnings per common share
$
4.42

$
2.72

$
1.76

See notes to consolidated financial statements.

App.-A-2




The Progressive Corporation and Subsidiaries
Consolidated Balance Sheets
December 31,
(millions — except per share amount)
2018

 
2017

Assets

 

Available-for-sale, at fair value:

 

        Fixed maturities (amortized cost: $28,255.9 and $20,209.9)
$
28,111.5

 
$
20,201.7

        Short-term investments (amortized cost: $1,795.9 and $2,869.4)
1,795.9

 
2,869.4

Total available-for-sale securities
29,907.4

 
23,071.1

Equity securities, at fair value:

 

    Nonredeemable preferred stocks (cost: $1,002.6 and $698.6)
1,033.9

 
803.8

    Common equities (cost: $1,148.9 and $1,499.0)
2,626.1

 
3,399.8

Total equity securities
3,660.0

 
4,203.6

Total investments
33,567.4

 
27,274.7

Cash and cash equivalents
69.5


265.0

Restricted cash
5.5


10.3

Total cash, cash equivalents, and restricted cash
75.0


275.3

Accrued investment income
190.8

 
119.7

Premiums receivable, net of allowance for doubtful accounts of $252.1 and $210.9
6,497.1

 
5,422.5

Reinsurance recoverables
2,696.1

 
2,273.4

Prepaid reinsurance premiums
309.7

 
203.3

Deferred acquisition costs
951.6

 
780.5

Property and equipment, net of accumulated depreciation of $1,033.2 and $940.6
1,131.7

 
1,119.6

Goodwill
452.7

 
452.7

Intangible assets, net of accumulated amortization of $247.7 and $175.7
294.6

 
366.6

Net deferred income taxes
43.2

 
0

Other assets
365.1

 
412.9

Total assets
$
46,575.0

 
$
38,701.2

Liabilities

 

Unearned premiums
$
10,686.5

 
$
8,903.5

Loss and loss adjustment expense reserves
15,400.8

 
13,086.9

Net deferred income taxes
0

 
135.0

Accounts payable, accrued expenses, and other liabilities1
5,046.5

 
3,481.0

Debt2
4,404.9

 
3,306.3

Total liabilities
35,538.7

 
28,912.7

Redeemable noncontrolling interest (NCI)3
214.5

 
503.7

Shareholders Equity


 


Serial Preferred Shares (authorized 20.0)
 
 
 
Serial Preferred Shares, Series B, no par value (cumulative, liquidation preference $1,000 per share) (authorized, issued, and outstanding 0.5 and 0)
493.9

 
0

Common shares, $1.00 par value (authorized 900.0; issued 797.5, including treasury shares of 214.3 and 215.8)
583.2

 
581.7

Paid-in capital
1,479.0

 
1,389.2

Retained earnings
8,386.6

 
6,031.7

Accumulated other comprehensive income:

 

Net unrealized gains (losses) on securities
(105.6
)
 
1,295.0

Net unrealized losses on forecasted transactions
(17.2
)
 
(14.8
)
Accumulated other comprehensive (income) loss attributable to NCI
1.9

 
2.0

 Total accumulated other comprehensive income attributable to Progressive
(120.9
)
 
1,282.2

Total shareholders equity
10,821.8

 
9,284.8

Total liabilities, redeemable NCI, and shareholders’ equity
$
46,575.0


$
38,701.2

1 See Note 12 – Litigation, Note 13 – Commitments and Contingencies, and Note 14 – Dividends for further discussion.
2 Consists of long-term debt. See Note 4 – Debt for further discussion.
3 See Note 15 – Redeemable Noncontrolling Interest for further discussion.
See notes to consolidated financial statements.

App.-A-3




The Progressive Corporation and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
For the years ended December 31,
 
(millions — except per share amounts)
2018

2017

2016

Serial Preferred Shares, No Par Value
 
 
 
Balance, Beginning of year
$
0

$
0

$
0

Issuance of Serial Preferred Shares, Series B
493.9

0

0

Balance, End of year
493.9

0

0

Common Shares, $1.00 Par Value



Balance, Beginning of year
581.7

579.9

583.6

Treasury shares purchased
(1.4
)
(1.5
)
(6.1
)
Net restricted equity awards issued/vested
2.9

3.3

2.4

Balance, End of year
583.2

581.7

579.9

Paid-In Capital



Balance, Beginning of year
1,389.2

1,303.4

1,218.8

Treasury shares purchased
(3.3
)
(3.4
)
(13.4
)
Net restricted equity awards issued/vested
(2.9
)
(3.3
)
(2.4
)
Amortization of equity-based compensation
76.2

92.9

80.9

Reinvested dividends on restricted stock units
12.2

8.0

6.1

Adjustment to carrying amount of redeemable noncontrolling interest
7.6

(8.4
)
4.2

Tax benefit from vesting of equity-based compensation
0

0

9.2

Balance, End of year
1,479.0

1,389.2

1,303.4

Retained Earnings



Balance, Beginning of year
6,031.7

5,140.4

4,686.6

Net income attributable to Progressive
2,615.3

1,592.2

1,031.0

Treasury shares purchased
(74.3
)
(57.6
)
(173.0
)
Cash dividends declared on common shares ($2.5140, $1.1247, and $0.6808 per share)
(1,466.0
)
(654.2
)
(394.7
)
Cash dividends declared on Serial Preferred Shares, Series B ($27.024 per share, $0, and $0)
(13.5
)
0

0

Reinvested dividends on restricted stock units
(12.2
)
(8.0
)
(6.1
)
   Cumulative effect of change in accounting principle1 
1,300.2

0

0

Reclassification of disproportionate tax effects1 
4.3

0

0

Other, net
1.1

18.9

(3.4
)
Balance, End of year
8,386.6

6,031.7

5,140.4

Accumulated Other Comprehensive Income (Loss) Attributable to Progressive



Balance, Beginning of year
1,282.2

933.4

800.4

Attributable to noncontrolling interest
(0.1
)
(2.3
)
3.2

Other comprehensive income (loss)
(98.5
)
351.1

129.8

   Cumulative effect of change in accounting principle1
(1,300.2
)
0

0

Reclassification of disproportionate tax effects1
(4.3
)
0

0

Balance, End of year
(120.9
)
1,282.2

933.4

Total Shareholders’ Equity
$
10,821.8

$
9,284.8

$
7,957.1

1 See Note 1 – Accounting and Reporting Policies for further discussion.
There are 5.0 million Voting Preference Shares authorized; no such shares have been issued.
See notes to consolidated financial statements.


App.-A-4




The Progressive Corporation and Subsidiaries
Consolidated Statements of Cash Flows
For the years ended December 31,
(millions)
2018

2017

2016

Cash Flows From Operating Activities



Net income
$
2,621.0

$
1,598.1

$
1,057.2

Adjustments to reconcile net income to net cash provided by operating activities:



Depreciation
190.4

169.9

137.4

Amortization of intangible assets
72.0

66.2

62.1

Net amortization of fixed-income securities
34.3

86.2

77.2

Amortization of equity-based compensation
77.2

95.4

85.2

Net realized (gains) losses on securities
405.5

(49.6
)
(51.1
)
Net (gains) losses on disposition of property and equipment
32.1

7.2

6.6

Other (gains) losses
0

1.0

(1.6
)
Net loss on exchange transaction
0

0

4.5

Changes in:



Premiums receivable
(1,074.6
)
(913.2
)
(518.5
)
Reinsurance recoverables
(422.7
)
(388.6
)
(388.2
)
Prepaid reinsurance premiums
(106.4
)
(32.8
)
48.8

Deferred acquisition costs
(171.1
)
(129.3
)
(103.8
)
Income taxes
(158.7
)
(172.6
)
(55.7
)
Unearned premiums
1,783.0

1,434.9

830.7

Loss and loss adjustment expense reserves
2,313.9

1,718.8

1,323.2

Accounts payable, accrued expenses, and other liabilities
746.6

400.0

308.9

Other, net
(57.7
)
(134.8
)
(90.2
)
Net cash provided by operating activities
6,284.8

3,756.8

2,732.7

Cash Flows From Investing Activities



Purchases:



Fixed maturities
(21,153.0
)
(14,587.8
)
(11,610.6
)
Equity securities
(538.8
)
(255.6
)
(434.2
)
Sales:



Fixed maturities
7,835.6

5,382.5

5,694.9

Equity securities
823.5

252.9

484.6

Maturities, paydowns, calls, and other:



Fixed maturities
5,099.8

5,215.8

4,907.4

Equity securities
26.6

50.0

0

Net sales (purchases) of short-term investments
1,116.3

727.6

(1,357.2
)
Net unsettled security transactions
11.7

(33.6
)
50.9

Purchases of property and equipment
(266.0
)
(155.7
)
(215.0
)
Sales of property and equipment
9.4

15.3

6.2

Acquisition of additional shares of ARX Holding Corp.
(296.9
)
0

0

Acquisition of an insurance company, net of cash acquired
0

(18.1
)
0

Net cash disposed in exchange transaction
0

0

(7.7
)
Net cash used in investing activities
(7,331.8
)
(3,406.7
)
(2,480.7
)
Cash Flows From Financing Activities



Net proceeds from debt issuance
1,134.0

841.1

495.6

Net proceeds from issuance of Serial Preferred Shares, Series B
493.9

0

0

Payments of debt
(37.1
)
(49.0
)
(25.5
)
Dividends paid to common shareholders
(654.9
)
(395.4
)
(519.0
)
Dividends paid to preferred shareholders
(13.5
)
0

0

Proceeds from exercise of equity options
3.3

0.5

0

Acquisition of treasury shares for restricted stock tax liabilities
(78.6
)
(57.6
)
(25.1
)
Acquisition of treasury shares acquired in open market
(0.4
)
(4.9
)
(167.4
)
Redemption/reacquisition of subordinated debt
0

(635.6
)
(18.2
)
Tax benefit from vesting of equity-based compensation
0

0

9.2

Net cash provided by (used in) financing activities
846.7

(300.9
)
(250.4
)
Effect of exchange rate changes on cash
0

(0.3
)
0.4

Increase (decrease) in cash, cash equivalents, and restricted cash
(200.3
)
48.9

2.0

Cash, cash equivalents, and restricted cash - Beginning of year
275.3

226.4

224.4

Cash, cash equivalents, and restricted cash - End of year
$
75.0

$
275.3

$
226.4


See notes to consolidated financial statements.

App.-A-5




The Progressive Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2018, 2017, and 2016

1.  REPORTING AND ACCOUNTING POLICIES
Nature of Operations  The Progressive insurance organization began business in 1937. The financial results of The Progressive Corporation include its subsidiaries and affiliates (references to “subsidiaries” in these notes include affiliates as well). Our insurance subsidiaries (collectively the Progressive Group of Insurance Companies) provide personal and commercial auto insurance, residential property insurance, and other specialty property-casualty insurance and related services. Our Personal Lines segment writes insurance for personal autos and recreational vehicles, which we refer to as our special lines products, through both an independent insurance agency channel and a direct channel. Our Commercial Lines segment writes primary liability, physical damage, and other auto-related insurance for automobiles and trucks owned and/or operated predominantly by small businesses through both the independent agency and direct channels. Our Property segment writes residential property insurance for homeowners, other property owners, and renters, through both an independent insurance agency channel and a direct channel. We operate our businesses throughout the United States.

Basis of Consolidation and Reporting The accompanying consolidated financial statements include the accounts of The Progressive Corporation and ARX Holding Corp. (ARX), and their respective wholly owned insurance and non-insurance subsidiaries and affiliates, in which Progressive or ARX has a controlling financial interest. All intercompany accounts and transactions are eliminated in consolidation.

The Progressive Corporation owned 86.8% of the outstanding capital stock of ARX at December 31, 2018, 69.0% at December 31, 2017, and 69.2% at December 31, 2016. The increase in Progressive's ownership of ARX is primarily due to the minority ARX shareholders exercising their rights to "put" a portion of their shares, including exercised stock options, to Progressive pursuant to the ARX stockholders' agreement. See Note 15 – Redeemable Noncontrolling Interest for further discussion.
Estimates  We are required to make estimates and assumptions when preparing our financial statements and accompanying notes in conformity with accounting principles generally accepted in the United States of America (GAAP). As estimates develop into fact, results may, and will likely, differ from those estimates.
Investments  Our fixed-maturity securities and short-term investments are accounted for on an available-for-sale basis. Fixed-maturity securities include debt securities and redeemable preferred stocks, which may have fixed or variable principal payment schedules, may be held for indefinite periods of time, and may be used as a part of our asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs, or other economic factors. These securities are carried at fair value with the corresponding unrealized gains (losses), net of deferred income taxes, reported in accumulated other comprehensive income. Fair values are obtained from recognized pricing services or are quoted by market makers and dealers, with limited exceptions discussed in Note 3 - Fair Value.
Short-term investments may include Eurodollar deposits, commercial paper, repurchase transactions, and other securities expected to mature within one year. From time to time, we may also invest in municipal bonds that have maturity dates that are longer than one year but have either liquidity facilities or mandatory put features within one year.
Equity securities include common stocks, nonredeemable preferred stocks, and other risk investments. These securities are carried at fair value, and as of January 1, 2018, with the changes in fair value reported as a component of net holding period gains (losses) on securities reported in net income. See New Accounting Standards - Adopted below for further discussion.
Trading securities are securities bought principally for the purpose of sale in the near term. We do not hold any trading securities. To the extent we have trading securities, changes in fair value would be recognized in income in the current period. Derivative instruments, which may be used for trading purposes or classified as trading derivatives due to the characteristics of the transaction, are discussed below.
Derivative instruments may include futures, options, forward positions, foreign currency forwards, interest rate swap agreements, and credit default swaps and may be used in the portfolio for general investment purposes or to hedge the exposure to:
Changes in fair value of an asset or liability (fair value hedge),
Foreign currency of an investment in a foreign operation (foreign currency hedge), or
Variable cash flows of a forecasted transaction (cash flow hedge).


App.-A-6




We did not have any derivatives outstanding at December 31, 2018 and 2017. To the extent we have derivatives held for general investment purposes, these derivative instruments are recognized as either assets or liabilities and measured at fair value, with changes in fair value recognized in income as a component of net holding period gains (losses) on securities during the period of change.
Derivatives designated as hedges are required to be evaluated on established criteria to determine the effectiveness of their correlation to, and ability to reduce the designated risk of, specific securities or transactions. Effectiveness is required to be reassessed regularly. Hedges that are deemed to be effective would be accounted for as follows:
Fair value hedge:  changes in fair value of the hedge, as well as the hedged item, would be recognized in income in the period of change while the hedge is in effect.
Foreign currency hedge:  changes in fair value of the hedge, as well as the hedged item, would be reflected as a change in translation adjustment as part of accumulated other comprehensive income. Gains and losses on the foreign currency hedge would offset the foreign exchange gains and losses on the foreign investment as they are recognized into income.
Cash flow hedge:  changes in fair value of the hedge would be reported as a component of accumulated other comprehensive income and subsequently amortized into earnings over the life of the hedged transaction.

If a hedge is deemed to become ineffective or discontinued, the following accounting treatment would be applied:

Fair value hedge:  the derivative instrument would continue to be adjusted through income, while the adjustment in the change in value of the hedged item would be reflected as a change in unrealized gains (losses) as part of accumulated other comprehensive income.
Foreign currency hedge:  changes in the value of the hedged item would continue to be reflected as a change in translation adjustment as part of accumulated other comprehensive income, but the derivative instrument would be adjusted through income for the current period.
Cash flow hedge:  changes in fair value of the derivative instrument would be reported in income for the current period.

For derivatives settled through a clearinghouse, we will need cash to post initial margin and are subject to increases in margin beyond changes in fair value. For bi-lateral derivative positions, net cash requirements are limited to changes in fair values, which may vary as a result of changes in interest rates, currency exchange rates, and other factors. Exposure to credit risk is limited to the carrying value; collateral may be required to limit credit risk. We have elected not to offset fair value amounts that arise from derivative positions with the same counterparty under a master netting arrangement.
Investment securities are exposed to various risks such as interest rate, market, credit, and liquidity risk. Fair values of securities fluctuate based on the nature and magnitude of changing market conditions; significant changes in market conditions could materially affect the portfolio’s value in the near term. We regularly monitor our portfolio for price changes, which might indicate potential impairments, and perform detailed reviews of fixed-maturity securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to: (i) fundamental factors specific to the issuer, such as financial condition, business prospects, or other factors, (ii) market-related factors, such as interest rates, or (iii) credit-related losses, where the present value of cash flows expected to be collected are lower than the amortized cost basis of the security.
We analyze our investment in debt securities that are in a loss position to determine if we intend to sell, or if it is more likely than not that we will be required to sell, the security prior to recovery and, if so, we write down the security to its current fair value, with the entire amount of the write-down recorded to earnings. To the extent that it is more likely than not that we will hold the debt security until recovery (which could be maturity), we determine if any of the decline in value is due to a credit loss (i.e., where the present value of future cash flows expected to be collected is lower than the amortized cost basis of the security) and, if so, we recognize that portion of the impairment as a component of net realized gains (losses) in the comprehensive income statement, with the difference (i.e., non-credit related impairment) recognized as part of our net unrealized gains (losses) in accumulated other comprehensive income.
Investment income consists of interest, dividends, and accretion net of amortization. Interest is recognized on an accrual basis using the effective yield method, except for asset backed securities, discussed below. Depending on the nature of the equity instruments, dividends are recorded at either the ex-dividend date or on an accrual basis.
Asset-backed securities, which are included in our fixed-maturity portfolio, are generally accounted for under the retrospective method. The retrospective method recalculates yield assumptions (based on changes in interest rates or cash flow expectations) historically to the inception of the investment holding period, and applies the required adjustment, if any, to the cost basis, with the offset recorded to investment income. The prospective method is used primarily for interest-only securities, non-investment-

App.-A-7




grade asset-backed securities, and certain asset-backed securities with sub-prime loan exposure or where there is a greater risk of non-performance and where it is possible the initial investment may not be substantially recovered. The prospective method requires a calculation of expected future repayments and resets the yield to allow for future period adjustments; no current period impact to investment income or the security’s cost is made based on the cash flow update. Prepayment assumptions are updated quarterly.
Realized gains (losses) on securities are computed based on the first-in first-out method and include write-downs on available-for-sale securities considered to have other-than-temporary declines in fair value (excluding non-credit related impairments), as well as holding period valuation changes on equity securities, hybrid instruments (e.g., securities with embedded options, where the option is a feature of the overall change in the value of the instrument), derivatives, and trading securities.
Insurance Premiums and Receivables  Insurance premiums written are earned into income on a pro rata basis over the period of risk, based on a daily earnings convention. Accordingly, unearned premiums represent the portion of premiums written that are applicable to the unexpired risk. We provide insurance and related services to individuals and commercial accounts and offer a variety of payment plans. Generally, premiums are collected prior to providing risk coverage, minimizing our exposure to credit risk.
For our vehicle businesses, we perform a policy level evaluation to determine the extent to which the premiums receivable balance exceeds the unearned premiums balance. We then age this exposure to establish an allowance for doubtful accounts based on prior experience.
For our Property business, we do not establish an allowance for doubtful accounts since the risk of uncollectibility is relatively low. If premiums are unpaid by the policy due date, we provide advance notice of cancellation in accordance with each state’s requirements and, if the premiums remain unpaid after receipt of notice, cancel the policy and write off any remaining balance.
Deferred Acquisition Costs  Deferred acquisition costs include commissions, premium taxes, and other variable underwriting and direct sales costs incurred in connection with the successful acquisition or renewal of insurance contracts. These acquisition costs, net of ceding allowances, are deferred and amortized over the policy period in which the related premiums are earned. We consider anticipated investment income in determining the recoverability of these costs. Management believes these costs will be fully recoverable in the near term.
We do not defer any advertising costs. Total advertising costs, which are expensed as incurred, for the years ended
December 31, were:
(millions)
Advertising Costs

2018
$
1,422.4

2017
1,005.4

2016
756.2

Loss and Loss Adjustment Expense Reserves  Loss reserves represent the estimated liability on claims reported to us, plus reserves for losses incurred but not recorded (IBNR). These estimates are reported net of amounts estimated to be recoverable from salvage and subrogation. Loss adjustment expense reserves represent the estimated expenses required to settle these claims and losses. The methods of making estimates and establishing these reserves are reviewed regularly, and resulting adjustments are reflected in income in the current period. Such loss and loss adjustment expense reserves are susceptible to change in the near term.

Reinsurance  Our reinsurance transactions include Regulated plans and Non-Regulated plans. The  Regulated plans in which we participate are governed by insurance regulations and include state-provided reinsurance facilities (e.g., Michigan Catastrophic Claims Association, Florida Hurricane Catastrophe Fund, North Carolina Reinsurance Facility), as well as state-mandated involuntary plans for commercial vehicles (Commercial Automobile Insurance Procedures/Plans CAIP) and federally regulated plans for flood (National Flood Insurance Program NFIP); we act as a servicing agent for CAIP and as a participant in the “Write Your Own” program for the NFIP. The Non-Regulated plans are voluntary contractual arrangements primarily related to the transportation network company business written by our Commercial Lines segment and our Property business. Prepaid reinsurance premiums are earned on a pro rata basis over the period of risk, based on a daily earnings convention, which is consistent with premiums earned. See Note 7 – Reinsurance for further discussion.

Income Taxes  The income tax provision is calculated under the balance sheet approach. Deferred tax assets and liabilities are recorded based on the difference between the financial statement and tax bases of assets and liabilities at the enacted tax rates. The principal items giving rise to such differences are investment securities (e.g., net unrealized gains (losses), net holding

App.-A-8




period gains (losses) on securities, write-downs on securities determined to be other-than-temporarily impaired), loss and loss adjustment expense reserves, unearned premiums reserves, deferred acquisition costs, property and equipment, intangible assets, and non-deductible accruals. We review our deferred tax assets regularly for recoverability. The effects of any changes in the tax rate are recorded to our provision for income taxes, including any changes on items initially recognized in accumulated other comprehensive income. See Note 5 – Income Taxes for further discussion.
Property and Equipment  Property and equipment are recorded at cost, less accumulated depreciation, and include capitalized software developed or acquired for internal use. Depreciation is recognized over the estimated useful lives of the assets using accelerated methods for computer equipment and laptops and the straight-line method for all other fixed assets. We evaluate impairment whenever events or circumstances warrant such a review and write-off the impaired assets if appropriate.
The cost and useful lives for property and equipment at December 31, were:
($ in millions)
2018

2017

Useful Lives
Buildings, improvements, and integrated components
$
928.8

$
962.0

7-40 years
Capitalized software
327.0

273.1

3-10 years
Software licenses (internal use)
259.1

197.0

1-5 years
Land
177.0

203.4

NA
Computer equipment and laptops
123.2

92.8

3 years
All other property and equipment
349.8

331.9

3-15 years
Total cost
2,164.9

2,060.2

 
Accumulated depreciation
(1,033.2
)
(940.6
)
 
Balance at end of year
$
1,131.7

$
1,119.6

 
NA = Not applicable
 
 
 
At December 31, 2018 and 2017, included in other assets in the consolidated balance sheets is $39.3 million and $5.3 million, respectively, of “held for sale” property, which represents the fair value of this property less the estimated costs to sell. The increase primarily reflects our decision to transition away from the use of service centers as part of our claims operating model.
Total capitalized interest, which primarily relates to capitalized software projects, for the years ended December 31, was:
(millions)
Capitalized
Interest

2018
$
1.8

2017
2.8

2016
2.9

Goodwill and Intangible Assets Goodwill is the excess of the purchase price over the estimated fair value of the assets and liabilities acquired and represents the future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. Substantially all of the goodwill recorded as of December 31, 2018 and 2017, relates to the April 1, 2015, acquisition of a controlling interest in ARX.
Intangible assets primarily arose through the acquisition of ARX and mainly represent the future premiums that will be recognized from the policies and agency relationships that existed at the acquisition date. The majority of the intangible assets have finite lives, which, at December 31, 2018, had a remaining life range from 1 to 10 years. See Note 16 – Goodwill and Intangible Assets for further discussion.
We evaluate our goodwill for impairment at least annually using a qualitative approach. If events or changes in circumstances indicate that the carrying value of goodwill or intangible assets may not be recoverable, we will evaluate such items for impairment using a quantitative approach.
Guaranty Fund Assessments  We are subject to state guaranty fund assessments, which provide for the payment of covered claims or other insurance obligations of insurance companies deemed insolvent. These assessments are accrued after a formal determination of insolvency has occurred, and we have written the premiums on which the assessments will be based. Assessments that are available for recoupment from policyholders are capitalized when incurred; all other assessments are expensed.

App.-A-9




Fees and Other Revenues  Fees and other revenues primarily represent fees collected from policyholders relating to installment charges in accordance with our bill plans, as well as late payment and insufficient funds fees and revenue from ceding commissions. Fees and other revenues are generally earned when invoiced, except for excess ceding commissions, which are earned over the policy period.
Service Revenues and Expenses  Our service businesses provide insurance-related services. Service revenues and expenses from our commission-based businesses are recorded in the period in which they are earned or incurred. Service revenues generated from processing business for involuntary CAIP plans are earned on a pro rata basis over the term of the related policies. Service expenses related to these CAIP plans are expensed as incurred.

Equity-Based Compensation We issue time-based and performance-based restricted stock unit awards to key members of management as our form of equity compensation, and time-based restricted stock awards to non-employee directors. Collectively, we refer to these awards as “restricted equity awards.” Compensation expense for time-based restricted equity awards with installment vesting is recognized over each respective vesting period. For performance-based restricted equity awards, compensation expense is recognized over the respective estimated vesting periods. Dividend equivalent units are credited to outstanding restricted stock unit awards, both time-based and performance-based, at the time a dividend is paid to shareholders and paid upon vesting of the underlying award.
We record an estimate for expected forfeitures of restricted equity awards based on our historical forfeiture rates. In addition, we shorten the vesting periods of certain time-based restricted equity awards based on the “qualified retirement” provisions in our equity compensation plans, under which (among other provisions) if the participant satisfies certain age and years-of-service requirements, the vesting and distribution of 50% of outstanding time-based restricted equity awards accelerates upon reaching eligibility for a qualified retirement and shortly after the grant date for each subsequent award.
ARX also has nonqualified and incentive stock options outstanding that were issued prior to April 2015 as a form of equity compensation to certain of the officers and employees of ARX and its subsidiaries. These outstanding stock options are subject to the put/call features contained in the ARX stockholders’ agreement, pursuant to which The Progressive Corporation has the right, and can be required, to purchase all the shares underlying these awards in 2021. The vested stock options, and the shares issuable upon exercise of the stock options, are also subject to repurchase by ARX if the holder’s employment terminates. See Note 15 – Redeemable Noncontrolling Interest for further discussion. These stock options, which are treated for accounting purposes as liability awards, are expensed over the respective vesting periods based on the Black-Scholes value determined at period end.
The total compensation expense recognized for equity-based compensation, including both equity and liability awards, for the years ended December 31, was:
(millions)
2018

2017

2016

Pretax expense
$
77.2

$
95.4

$
85.2

Tax benefit1
16.2

33.4

29.8

1Calculated using the corporate federal tax rate of 21% for 2018 and 35% for 2017 and 2016.
Earnings Per Common Share  Net income attributable to Progressive is reduced by cumulative preferred share dividends to determine net income available to common shareholders, and is used in our calculation of the per common share amounts. Basic earnings per common share is computed using the weighted average number of common shares outstanding during the reporting period, excluding unvested time-based and performance-based restricted equity awards that are subject to forfeiture. Diluted earnings per common share includes common stock equivalents assumed outstanding during the period. Our common stock equivalents include the incremental shares assumed to be issued for:
earned but unvested time-based restricted equity awards, and
performance-based restricted equity awards that satisfied certain contingency conditions for unvested common stock equivalents during the period; it is highly likely that these awards will continue to satisfy the conditions until the date of vesting.

App.-A-10




Supplemental Cash Flow Information  Cash and cash equivalents include bank demand deposits and daily overnight reverse repurchase commitments of funds held in bank demand deposit accounts by ARX’s subsidiaries. The amount of reverse repurchase commitments held by ARX’s subsidiaries at December 31, 2018, 2017, and 2016, were $117.3 million, $247.2 million, and $150.0 million, respectively. Restricted cash on our consolidated balance sheets represents cash that is restricted to pay flood claims under the National Flood Insurance Program’s “Write Your Own” program, for which subsidiaries of ARX are administrators. Non-cash activity includes declared but unpaid dividends.
For the years ended December 31, we paid the following:
(millions)
2018

2017

2016

Income taxes
$
702.6

$
715.6

$
459.4

Interest
154.0

146.3

139.2


New Accounting Standards
Issued
In August 2018, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU), which provides additional guidance on the requirements for capitalizing and amortizing implementation costs incurred in a cloud computing arrangement that does not include a software license. This ASU will be effective for fiscal years (including interim periods within those fiscal years) beginning after December 15, 2019 (2020 for calendar-year companies). We do not expect this standard to have a material impact on our financial condition, cash flows, or results of operations.
In August 2018, the FASB also issued an ASU, which amends the disclosure requirements for fair value measurements. The ASU requires companies to disclose the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The ASU also removes current disclosure requirements for the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the policy for timing of transfers between levels, and the valuation processes for Level 3 fair value measurements. The ASU is effective for fiscal years beginning after December 15, 2019, and should be applied prospectively for the additions to the disclosure requirements and applied retrospectively to all periods presented for all other amendments. As permitted by the ASU, we elected to partially early adopt the removal of current disclosure requirements and will adopt the new disclosure requirements as of the effective date. We do not expect this standard to have an impact on our financial condition, cash flows, or results of operations.
In July 2018, the FASB issued an ASU, which provides targeted improvements to the new lease accounting guidance issued by the FASB in February 2016. The ASU, which eliminates the off-balance-sheet accounting for leases, will require lessees to report their operating leases as both an asset and liability on the statement of financial position and to disclose key information about leasing arrangements in the financial statement footnotes. Under the ASU, there will be no change to the recognition of lease expense in our results of operations. The ASU will be effective for fiscal years (including interim periods within those fiscal years) beginning after December 15, 2018 (2019 for calendar-year companies). Under the ASU, companies will have the option to apply the new lease requirements either as of the effective date (i.e., January 1, 2019), with comparative information presented in accordance with the previous standard, or on a modified retrospective basis, which would restate all financial statement information as of the beginning of the earliest period presented. We adopted this standard as of January 1, 2019, and recorded an increase to assets and liabilities of about $215 million, which reflects the present value of future operating lease payments; comparative information is presented in accordance with the previous standard. The ASU had no impact on our results of operations or cash flows.
In March 2017, the FASB issued an ASU related to premium amortization on purchased callable debt securities. The intent of the standard is to shorten the amortization period for certain purchased callable debt securities held at a premium. Under the ASU, the premium is required to be amortized to the earliest call date. The ASU more closely aligns interest income recorded on bonds held at a premium with the economics of the underlying instrument. The ASU, which is required to be applied on a modified retrospective basis, is effective for fiscal years beginning after December 15, 2018 (2019 for calendar-year companies), and interim periods within those fiscal years. Since we have historically used a yield-to-worst scenario for our securities that were purchased at a premium, and the first call on a premium security most often produces the lowest and most conservative yield, we do not expect this standard to have a significant impact on our financial condition, cash flows, or results of operations.

App.-A-11




In January 2017, the FASB issued an ASU, which eliminates the requirement to determine the implied fair value of goodwill in measuring an impairment loss. Upon adoption, the measurement of a goodwill impairment will represent the excess of the reporting unit’s carrying value over fair value, limited to the carrying value of goodwill. This ASU is effective for goodwill impairment tests in fiscal years beginning after December 15, 2019 (2020 for calendar-year companies), with early adoption permitted. We do not expect this standard to have a material impact on our financial condition or results of operations.

In June 2016, the FASB issued an ASU intended to improve the timing, and enhance the accounting and disclosure, of credit losses on financial assets. Additionally, this update will modify the existing accounting guidance related to the impairment evaluation for available-for-sale debt securities and will result in the creation of an allowance for credit losses as a contra asset account. The ASU will require cumulative-effect changes to retained earnings in the period of adoption, if any occur, and will also require prospective changes on previously recorded impairments. This ASU is effective for fiscal years (including interim periods within those fiscal years) beginning after December 15, 2019 (2020 for calendar-year companies), with early adoption permissible (including interim periods within that fiscal year) beginning after December 15, 2018 (2019 for calendar-year companies). While the ASU creates additional accounting complexities related to the recognition of the impairment losses, and subsequent recoveries, through an allowance for credit losses account, we do not expect the ASU to have a material impact on our current method of evaluating investment securities or reinsurance recoverables for credit losses or the timing or recognition of the amounts of the impairment losses.

Adopted
On January 1, 2018, we adopted the ASU intended to improve the recognition and measurement of financial instruments. Under this update, the changes in fair value of equity securities are recognized as a component of net income. Upon adoption, we recorded a cumulative-effect adjustment of $1.3 billion, which is net of taxes. The cumulative-effect adjustment represents the amount of after-tax net unrealized gains on equity securities that was recorded as part of accumulated other comprehensive income at December 31, 2017. The adoption of this ASU had no impact on comprehensive income. Consistent with our historical presentation, cash flows on equity securities will be reflected as investing activities in the Consolidated Statements of Cash Flows.

In the first quarter 2018, we adopted the ASU related to the reclassification of certain tax effects from accumulated other comprehensive income. This update provided companies with the option to reclassify disproportionate tax effects in accumulated other comprehensive income caused by the legislation commonly known as the Tax Cuts and Jobs Act of 2017 to retained earnings. We opted to make the reclassification, which resulted in a decrease to accumulated other comprehensive income and an offsetting increase to retained earnings of $4.3 million. This reclass was solely due to the effect of the change in the U.S. federal tax rate on our available-for-sale fixed-maturity securities and our hedges on forecasted transactions. There were no disproportionate tax effects related to our equity securities subsequent to adopting the ASU related to classification and measurement discussed above.


App.-A-12




2.  INVESTMENTS
The following tables present the composition of our investment portfolio by major security type, consistent with our classification of how we manage, monitor, and measure the portfolio. Our securities are reported in our Consolidated Balance Sheets at fair value. The changes in fair value for our fixed-maturity securities (other than hybrid securities) are reported as a component of accumulated other comprehensive income, net of deferred income taxes, in our Consolidated Balance Sheets.
The net holding period gains (losses) reported below represent the inception-to-date changes in fair value. The changes in the net holding period gains (losses) between periods for the hybrid securities and, beginning in 2018, equity securities are recorded as a component of net realized gains (losses) on securities in our Consolidated Statements of Comprehensive Income. Prior to 2018, the change in fair value of our equity securities was part of accumulated other comprehensive income (see Note 1 – Reporting and Accounting Policies for further discussion). For comparative purposes, the change in fair value of the hybrid securities that was recognized in 2017 and 2016 was reclassified out of "net realized gains (losses) on security sales" and into "net holding period gains (losses) on securities" to conform to the current year presentation.

($ in millions)
Cost

Gross Unrealized Gains

Gross Unrealized Losses

Net Holding Period Gains (Losses)

Fair Value

% of Total Fair Value

December 31, 2018
 
 
 
 
 
 
Available-for-sale securities:
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
U.S. government obligations
$
9,897.4

$
71.2

$
(52.1
)
$
0

$
9,916.5

29.5
%
State and local government obligations
1,654.6

7.3

(12.8
)
0

1,649.1

4.9

Corporate debt securities
8,808.5

13.6

(125.3
)
(2.5
)
8,694.3

25.9

Residential mortgage-backed securities
733.5

6.0

(5.1
)
0

734.4

2.2

Commercial mortgage-backed securities
3,332.8

7.8

(39.0
)
0

3,301.6

9.8

Other asset-backed securities
3,585.4

3.6

(11.8
)
0.1

3,577.3

10.7

Redeemable preferred stocks
243.7

5.9

(3.5
)
(7.8
)
238.3

0.7

Total fixed maturities
28,255.9

115.4

(249.6
)
(10.2
)
28,111.5

83.7

Short-term investments
1,795.9

0

0

0

1,795.9

5.4

    Total available-for-sale securities
30,051.8

115.4

(249.6
)
(10.2
)
29,907.4

89.1

Equity securities:
 
 
 
 
 
 
Nonredeemable preferred stocks
1,002.6

0

0

31.3

1,033.9

3.1

Common equities
1,148.9

0

0

1,477.2

2,626.1

7.8

    Total equity securities
2,151.5

0

0

1,508.5

3,660.0

10.9

Total portfolio1,2
$
32,203.3

$
115.4

$
(249.6
)
$
1,498.3

$
33,567.4

100.0
%

App.-A-13




($ in millions)
Cost

Gross Unrealized Gains

Gross Unrealized Losses

Net Holding Period Gains (Losses)

Fair Value

% of Total Fair Value

December 31, 2017
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
U.S. government obligations
$
6,688.8

$
1.1

$
(44.0
)
$
0

$
6,645.9

24.4
%
State and local government obligations
2,285.6

20.7

(9.3
)
0.1

2,297.1

8.4

Corporate debt securities
4,997.2

14.8

(14.4
)
0.1

4,997.7

18.3

Residential mortgage-backed securities
828.8

11.3

(3.4
)
0

836.7

3.1

Commercial mortgage-backed securities
2,760.1

11.8

(13.3
)
0

2,758.6

10.1

Other asset-backed securities
2,454.5

4.5

(4.5
)
0.2

2,454.7

9.0

Redeemable preferred stocks
194.9

17.8

(1.5
)
(0.2
)
211.0

0.8

Total fixed maturities
20,209.9

82.0

(90.4
)
0.2

20,201.7

74.1

Short-term investments
2,869.4

0

0

0

2,869.4

10.5

    Total fixed maturities and short-term
23,079.3

82.0

(90.4
)
0.2

23,071.1

84.6

Equity securities:
 
 
 
 
 
 
Nonredeemable preferred stocks
698.6

114.0

(8.8
)
0

803.8

2.9

Common equities
1,499.0

1,901.0

(0.2
)
0

3,399.8

12.5

    Total equity securities
2,197.6

2,015.0

(9.0
)
0

4,203.6

15.4

Total available-for-sale portfolio1,2
$
25,276.9

$
2,097.0

$
(99.4
)
$
0.2

$
27,274.7

100.0
%

1 Our portfolio reflects the effect of unsettled security transactions; at December 31, 2018, $5.9 million was included in “other liabilities,” compared to $5.8 million in “other assets” at December 31, 2017.
2 The total fair value of the portfolio at December 31, 2018 and 2017 included $2.9 billion and $1.6 billion, respectively, of securities held in a consolidated, non-insurance subsidiary of the holding company, net of any unsettled security transactions.
At December 31, 2018, bonds and certificates of deposit in the principal amount of $250.8 million were on deposit to meet state insurance regulatory and/or rating agency requirements. We did not hold any securities of any one issuer, excluding U.S. government obligations, with an aggregate cost or fair value exceeding 10% of total shareholders’ equity at December 31, 2018 or 2017. At December 31, 2018, we did not hold any debt securities that were non-income producing during the preceding 12 months.
Short-Term Investments Our short-term investments may include commercial paper and other investments that are expected to mature or are redeemable within one year.
We did not have any open repurchase or reverse repurchase transactions in our short-term investment portfolio at December 31, 2018 or 2017. To the extent we enter into repurchase or reverse repurchase transactions, and consistent with past practice, we would elect not to offset these transactions and would report them on a gross basis on our balance sheets despite the option to elect to offset these transactions as long as they were with the same counterparty and subject to an enforceable master netting arrangement.
Hybrid Securities Included in our fixed maturities are hybrid securities, which are reported at fair value at December 31:
 
(millions)
2018

 
2017

Fixed Maturities:
 
 
 
State and local government obligations
$
3.6

 
$
6.1

Corporate debt securities
158.9

 
99.8

Other asset-backed securities
4.5

 
6.7

Redeemable preferred stocks
77.7

 
30.3

Total hybrid securities
$
244.7

 
$
142.9

Certain securities in our portfolio are accounted for as hybrid securities because they contain embedded derivatives that are not deemed to be clearly and closely related to the host investments. Since the embedded derivatives (e.g., change-in-control put option, debt-to-equity conversion, or any other feature unrelated to the credit quality or risk of default of the issuer that could

App.-A-14




impact the amount or timing of our expected future cash flows) do not have observable intrinsic values, we have elected to record the changes in fair value of these securities through income as realized gains or losses.
Fixed Maturities  The composition of fixed maturities by maturity at December 31, 2018, was:
 
(millions)
Cost

 
Fair Value

Less than one year
$
4,880.1

 
$
4,867.0

One to five years
17,719.4

 
17,652.0

Five to ten years
5,581.3

 
5,517.5

Ten years or greater
75.1

 
75.0

Total
$
28,255.9

 
$
28,111.5

Asset-backed securities are classified in the maturity distribution table based upon their projected cash flows. All other securities that do not have a single maturity date are reported based upon expected average maturity. Contractual maturities may differ from expected maturities because the issuers of the securities may have the right to call or prepay obligations.

Gross Unrealized Losses  As of December 31, 2018, we had $249.6 million of gross unrealized losses in our fixed-maturity securities. A review of these securities indicated that the issuers were current with respect to their interest obligations and that there was no evidence of deterioration of the current cash flow projections that would indicate we would not receive the remaining principal at maturity.
The following tables show the composition of gross unrealized losses by major security type and by the length of time that individual securities have been in a continuous unrealized loss position:

 
Total No. of Sec.

Total
Fair
Value
Gross Unrealized Losses

Less than 12 Months
 
12 Months or Greater
($ in millions)
No. of Sec.

Fair
Value

Unrealized Losses

 
No. of Sec.

Fair
 Value

Unrealized Losses

December 31, 2018
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
U.S. government obligations
51

$
4,438.0

$
(52.1
)
2

$
126.6

$
(0.1
)
 
49

$
4,311.4

$
(52.0
)
State and local government obligations
299

972.4

(12.8
)
49

192.7

(0.3
)
 
250

779.7

(12.5
)
Corporate debt securities
368

6,723.3

(125.3
)
133

2,613.3

(33.4
)
 
235

4,110.0

(91.9
)
Residential mortgage-backed securities
228

450.2

(5.1
)
32

248.8

(0.8
)
 
196

201.4

(4.3
)
Commercial mortgage-backed securities
140

2,328.5

(39.0
)
48

741.2

(8.9
)
 
92

1,587.3

(30.1
)
Other asset-backed securities
203

2,691.3

(11.8
)
84

1,551.7

(3.2
)
 
119

1,139.6

(8.6
)
Redeemable preferred stocks
3

48.5

(3.5
)
1

18.9

(0.6
)
 
2

29.6

(2.9
)
Total fixed maturities
1,292

$
17,652.2

$
(249.6
)
349

$
5,493.2

$
(47.3
)
 
943

$
12,159.0

$
(202.3
)
 

App.-A-15




 
Total No. of Sec.

Total
Fair
Value

Gross
Unrealized
Losses

Less than 12 Months
 
12 Months or Greater
($ in millions)
No. of Sec.

Fair
Value

Unrealized
Losses

 
No. of Sec.

Fair
Value

Unrealized
Losses

December 31, 2017
 
 
 
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
U.S. government obligations
58

$
5,817.0

$
(44.0
)
41

$
4,869.3

$
(34.6
)
 
17

$
947.7

$
(9.4
)
State and local government obligations
358

1,200.3

(9.3
)
230

737.6

(4.4
)
 
128

462.7

(4.9
)
Corporate debt securities
222

2,979.4

(14.4
)
171

2,072.9

(9.1
)
 
51

906.5

(5.3
)
Residential mortgage-backed securities
201

300.9

(3.4
)
30

75.1

(0.2
)
 
171

225.8

(3.2
)
Commercial mortgage-backed securities
105

1,682.3

(13.3
)
63

1,221.2

(5.9
)
 
42

461.1

(7.4
)
Other asset-backed securities
197

1,837.3

(4.5
)
134

1,377.8

(3.3
)
 
63

459.5

(1.2
)
Redeemable preferred stocks
2

21.8

(1.5
)
1

10.8

(0.1
)
 
1

11.0

(1.4
)
Total fixed maturities
1,143

13,839.0

(90.4
)
670

10,364.7

(57.6
)
 
473

3,474.3

(32.8
)
Equity securities:
 
 
 
 
 
 
 
 
 
 
Nonredeemable preferred stocks
4

127.8

(8.8
)
1

56.5

(0.5
)
 
3

71.3

(8.3
)
Common equities
19

13.4

(0.2
)
18

13.4

(0.2
)
 
1

0

0

Total equity securities
23

141.2

(9.0
)
19

69.9

(0.7
)
 
4

71.3

(8.3
)
Total portfolio
1,166

$
13,980.2

$
(99.4
)
689

$
10,434.6

$
(58.3
)
 
477

$
3,545.6

$
(41.1
)

During 2018, the number of securities in our fixed-maturity portfolio with unrealized losses increased slightly as a result of rising interest rates. We had no material decreases in valuation as a result of credit rating downgrades during the year and all of the securities in the table above are current with respect to required principal and interest payments.

Other-Than-Temporary Impairment (OTTI)  The following table shows the total non-credit portion of the OTTI recorded in accumulated other comprehensive income, reflecting the original non-credit loss at the time the credit impairment was determined (i.e., unadjusted for valuation changes subsequent to the original write-down):
 
 
December 31,
(millions)
2018

2017

Fixed maturities:
 
 
Residential mortgage-backed securities
$
(19.7
)
$
(19.7
)
Commercial mortgage-backed securities
(0.1
)
(0.3
)
Total fixed maturities
$
(19.8
)
$
(20.0
)

App.-A-16




The following tables provide rollforwards of the amounts related to credit losses recognized in earnings for the periods ended December 31, 2018, 2017, and 2016, for which a portion of the OTTI losses were also recognized in accumulated other comprehensive income at the time the credit impairments were determined and recognized:
 
(millions)
Residential
Mortgage-
Backed

Commercial
Mortgage-
Backed

Total

Total at December 31, 2017
$
0

$
0.5

$
0.5

Credit losses for which an OTTI was not previously recognized
0

0

0

Reductions for securities sold/matured
0

0

0

Change in recoveries of future cash flows expected to be collected1
0

0

0

Total at December 31, 2018
$
0

$
0.5

$
0.5

(millions)
Residential
Mortgage-
Backed

Commercial
Mortgage-
Backed

Total

Total at December 31, 2016
$
11.1

$
0.4

$
11.5

Credit losses for which an OTTI was not previously recognized
0

0.4

0.4

Reductions for securities sold/matured
(10.9
)
(0.3
)
(11.2
)
Change in recoveries of future cash flows expected to be collected1
(0.2
)
0

(0.2
)
Total at December 31, 2017
$
0

$
0.5

$
0.5


(millions)
Residential
Mortgage-
Backed

Commercial
Mortgage-
Backed

Total

Total at December 31, 2015
$
12.4

$
0.4

$
12.8

Credit losses for which an OTTI was not previously recognized
0

0

0

Reductions for securities sold/matured
0

0

0

Change in recoveries of future cash flows expected to be collected1
(1.3
)
0

(1.3
)
Total at December 31, 2016
$
11.1

$
0.4

$
11.5

1 Reflects expected recovery of prior period impairments that will be accreted into income over the remaining life of the security.
Although we determined it is more likely that we will not be required to sell the securities prior to the recovery of their respective cost bases (which could be maturity), we are required to measure the amount of potential credit losses on the securities that were in an unrealized loss position. In that process, we considered a number of factors and inputs related to the individual securities. The methodology and significant inputs used to measure the amount of credit losses in our portfolio included: current performance indicators on the business model or underlying assets (e.g., delinquency rates, foreclosure rates, and default rates); credit support (via current levels of subordination); historical credit ratings; and updated cash flow expectations based upon these performance indicators. In order to determine the amount of credit loss, if any, the net present value of the cash flows expected (i.e., expected recovery value) was calculated using the current book yield for each security, and was compared to its current amortized value. In the event that the net present value was below the amortized value, a credit loss would be deemed to exist, and the security would be written down. We did not have any credit impairment write-downs for the year ended December 31, 2018.








App.-A-17




Realized Gains (Losses)  The components of net realized gains (losses) for the years ended December 31, were:

 
(millions)
2018

2017

2016

Gross realized gains on security sales
 
 
 
Available-for-sale securities:
 
 
 
U.S. government obligations
$
6.7

$
6.2

$
24.6

State and local government obligations
9.5

10.5

16.0

Corporate and other debt securities
2.4

20.3

43.3

Residential mortgage-backed securities
0

23.8

2.5

Commercial mortgage-backed securities
2.0

4.9

13.3

Other asset-backed securities
0.1

0.3

0

Redeemable preferred stocks
4.5

8.5

20.9

                  Short-term investments
0

0

0.1

Total available-for-sale securities
25.2

74.5

120.7

Equity securities:
 
 
 
Nonredeemable preferred stocks
4.1

58.4

11.9

Common equities
286.6

43.0

61.3

Total equity securities
290.7

101.4

73.2

Subtotal gross realized gains on security sales
315.9

175.9

193.9

Gross realized losses on security sales
 
 
 
Available-for-sale securities:
 
 
 
U.S. government obligations
(98.7
)
(28.7
)
(2.4
)
State and local government obligations
(2.9
)
(0.1
)
(1.6
)
Corporate and other debt securities
(10.4
)
(5.1
)
(2.5
)
Residential mortgage-backed securities
(0.1
)
(0.4
)
(0.2
)
Commercial mortgage-backed securities
(6.3
)
(5.3
)
(5.6
)
Other asset-backed securities
(1.1
)
(0.4
)
0

Redeemable preferred stocks
(0.1
)
(6.4
)
(6.6
)
                  Short-term investments
0

(0.2
)
(0.1
)
Total available-for-sale securities
(119.6
)
(46.6
)
(19.0
)
Equity securities:
 
 
 
Nonredeemable preferred stocks
(3.9
)
(5.9
)
(5.3
)
Common equities
(21.7
)
(12.2
)
(15.7
)
Total equity securities
(25.6
)
(18.1
)
(21.0
)
Subtotal gross realized losses on security sales
(145.2
)
(64.7
)
(40.0
)
Net realized gains (losses) on security sales
 
 
 
Available-for-sale securities:
 
 
 
U.S. government obligations
(92.0
)
(22.5
)
22.2

State and local government obligations
6.6

10.4

14.4

Corporate and other debt securities
(8.0
)
15.2

40.8

Residential mortgage-backed securities
(0.1
)
23.4

2.3

Commercial mortgage-backed securities
(4.3
)
(0.4
)
7.7

Other asset-backed securities
(1.0
)
(0.1
)
0

Redeemable preferred stocks
4.4

2.1

14.3

                  Short-term investments
0

(0.2
)
0

Total available-for-sale securities
(94.4
)
27.9

101.7

Equity securities:
 
 
 
Nonredeemable preferred stocks
0.2

52.5

6.6

Common equities
264.9

30.8

45.6

Total equity securities
265.1

83.3

52.2

Litigation settlements and other gains (losses)
0

1.2

0.4

Subtotal net realized gains (losses) on security sales
170.7

112.4

154.3

Net holding period gains (losses)
 
 
 
Hybrid securities
(10.4
)
(1.6
)
2.1

Equity securities
(497.5
)
0

0

Derivatives
0

0

(20.0
)
Subtotal net holding period gains (losses)
(507.9
)
(1.6
)
(17.9
)
Other-than-temporary impairment losses
 
 
 
Fixed maturities:
 
 
 
Commercial mortgage-backed securities
0

(0.4
)
0

Redeemable preferred stocks
0

0

(25.3
)
Total fixed maturities
0

(0.4
)
(25.3
)
Equity securities:
 
 
 
Common equities
0

(11.2
)
(0.3
)
Subtotal investment other-than-temporary impairment losses
0

(11.6
)
(25.6
)
Other asset impairment
(68.3
)
(49.6
)
(59.7
)
Subtotal other-than-temporary impairment losses
(68.3
)
(61.2
)
(85.3
)
Total net realized gains (losses) on securities
$
(405.5
)
$
49.6

$
51.1



App.-A-18




Gross realized gains in 2018 were predominantly in common equities as we sold a portion of our holdings twice during the year in an effort to reduce the portfolio’s overall risk profile. Gross realized losses in 2018 were primarily in treasury securities, within our fixed-maturity portfolio. Treasury securities are used to manage our overall portfolio duration and with the volatility in interest rates during 2018, we were active in managing the portfolio’s duration to limit potentially significant negative impacts to the fixed-maturity portfolio’s overall valuation. Also included are holding period gains and losses, related to valuation changes on equity securities and hybrid securities, recoveries from litigation settlements related to investments, and write-downs for securities determined to be other-than-temporarily impaired. The other asset impairment relates to renewable energy investments, which are reflected in “other assets” on the balance sheet, under which the future pretax cash flows are expected to be less than the carrying value of the assets. See Note 5 - Income Taxes for the tax benefits related to these investments.

The following table reflects our holding period realized gains (losses) on equity securities recognized for the year ended December 31, 2018 for equity securities held at year end:
(millions)
2018

Total net gains (losses) recognized during the period on equity securities
$
(232.4
)
Less: Net gains (losses) recognized on equity securities sold during the period
265.1

Net holding period gains (losses) recognized during the period on equity securities held at period end
$
(497.5
)
Note: Comparative disclosure for the prior year period is not meaningful.
Net Investment Income  The components of net investment income for the years ended December 31, were:
 
(millions)
2018

2017

2016

Available-for-sale securities:
 
 
 
Fixed maturities:
 
 
 
U.S. government obligations
$
196.8

$
72.7

$
18.2

State and local government obligations
37.7

51.5

52.3

Foreign government obligations
0

0.3

0.4

Corporate debt securities
217.9

125.2

110.7

Residential mortgage-backed securities
27.6

34.7

47.3

Commercial mortgage-backed securities
93.9

79.6

81.6

Other asset-backed securities
75.7

47.1

28.0

Redeemable preferred stocks
12.3

11.8

14.9

Total fixed maturities
661.9

422.9

353.4

Short-term investments
52.9

37.8

19.7

    Total available-for-sale securities
714.8

460.7

373.1

Equity securities:
 
 
 
Nonredeemable preferred stocks
45.9

44.1

48.6

Common equities
59.8

58.3

57.2

    Total equity securities
105.7

102.4

105.8

Investment income
820.5

563.1

478.9

Investment expenses
(24.3
)
(23.9
)
(22.4
)
Net investment income
$
796.2

$
539.2

$
456.5


The amount of investment income (interest and dividends) we recognize varies based on the average assets held during the year and the book yields of the securities in our portfolio. The increases in net investment income in 2018 and 2017, were due to a combination of an increase in average assets and an increase in portfolio yields. The increase in average assets was due to strong underwriting growth and profitability, as well as the proceeds from debt and preferred stock issuances. The increase in portfolio yields was a result of our decisions to hold a short-duration portfolio, which allowed us to reinvest significant maturities and paydowns of principal at higher yields, and to increase the portfolio duration from 2.2 years at December 31, 2016 to 2.5 years at December 31, 2017, and finally to 2.8 years at December 31, 2018, as interest rates generally rose.


App.-A-19




Trading Securities  At December 31, 2018 and 2017, we did not hold any trading securities and we did not have any net realized gains (losses) on trading securities for the years ended December 31, 2018, 2017, and 2016.
Derivative Instruments  At December 31, 2018, 2017, and 2016, we had no open derivative positions.
During 2018, we reclassified $1.0 million of net unrealized losses from accumulated other comprehensive income to interest expense on our closed debt issuance cash flow hedges, compared to net unrealized gains of $0.3 million and $1.9 million during 2017 and 2016, respectively.
During March 2017, we entered into a forecasted debt issuance hedge, against a possible rise in interest rates, in conjunction with the $850 million of 4.125% Senior Notes due 2047 issued in April 2017. Upon issuance, we closed the hedge and recognized, as part of accumulated other comprehensive income, a pretax unrealized loss of $8.0 million in April 2017.
From time to time, we use interest rate swaps and treasury futures contracts to manage the fixed-income portfolio duration. During 2016, we closed interest rate swaps and treasury futures contracts with notional values of $750 million and $135 million, respectively. We recorded a net realized loss of $19.0 million on the interest rate swaps and a net realized gain of $0.3 million on the treasury futures.
3. FAIR VALUE
We have categorized our financial instruments, based on the degree of subjectivity inherent in the method by which they are valued, into a fair value hierarchy of three levels, as follows:

Level 1:  Inputs are unadjusted, quoted prices in active markets for identical instruments at the measurement date (e.g., U.S. government obligations, which are continually priced on a daily basis, active exchange-traded equity securities, and certain short-term securities).
Level 2:  Inputs (other than quoted prices included within Level 1) that are observable for the instrument either directly or indirectly (e.g., certain corporate and municipal bonds and certain preferred stocks). This includes: (i) quoted prices for similar instruments in active markets, (ii) quoted prices for identical or similar instruments in markets that are not active, (iii) inputs other than quoted prices that are observable for the instruments, and (iv) inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3:  Inputs that are unobservable. Unobservable inputs reflect our subjective evaluation about the assumptions market participants would use in pricing the financial instrument (e.g., certain structured securities and privately held investments).

Determining the fair value of the investment portfolio is the responsibility of management. As part of the responsibility, we evaluate whether a market is distressed or inactive in determining the fair value for our portfolio. We review certain market level inputs to evaluate whether sufficient activity, volume, and new issuances exist to create an active market. Based on this evaluation, we concluded that there was sufficient activity related to the sectors and securities for which we obtained valuations.

App.-A-20




The composition of the investment portfolio by major security type and our outstanding debt was:
 
 
Fair Value
 
(millions)
Level 1

Level 2

Level 3

Total

Cost

December 31, 2018
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
U.S. government obligations
$
9,916.5

$
0

$
0

$
9,916.5

$
9,897.4

State and local government obligations
0

1,649.1

0

1,649.1

1,654.6

Corporate debt securities
0

8,694.3

0

8,694.3

8,808.5

Subtotal
9,916.5

10,343.4

0

20,259.9

20,360.5

Asset-backed securities:
 
 
 
 
 
Residential mortgage-backed
0

734.4

0

734.4

733.5

Commercial mortgage-backed
0

3,301.6

0

3,301.6

3,332.8

Other asset-backed
0

3,577.3

0

3,577.3

3,585.4

Subtotal asset-backed securities
0

7,613.3

0

7,613.3

7,651.7

Redeemable preferred stocks:
 
 
 
 
 
Financials
0

78.2

0

78.2

79.3

Utilities
0

0

0

0

0

Industrials
9.5

150.6

0

160.1

164.4

Subtotal redeemable preferred stocks
9.5

228.8

0

238.3

243.7

Total fixed maturities
9,926.0

18,185.5

0

28,111.5

28,255.9

Short-term investments
1,722.1

73.8

0

1,795.9

1,795.9

    Total available-for-sale securities
11,648.1

18,259.3

0

29,907.4

30,051.8

Equity securities:
 
 
 
 
 
Nonredeemable preferred stocks:
 
 
 
 
 
Financials
71.9

887.1

25.1

984.1

951.6

Utilities
0

44.8

0

44.8

46.0

Industrials
0

0

5.0

5.0

5.0

Subtotal nonredeemable preferred stocks
71.9

931.9

30.1

1,033.9

1,002.6

Common equities:
 
 
 
 
 
Common stocks
2,625.8

0

0

2,625.8

1,148.6

Other risk investments
0

0

0.3

0.3

0.3

Subtotal common equities
2,625.8

0

0.3

2,626.1

1,148.9

    Total equity securities
2,697.7

931.9

30.4

3,660.0

2,151.5

Total portfolio
$
14,345.8

$
19,191.2

$
30.4

$
33,567.4

$
32,203.3

Debt
$
0

$
4,532.3

$
0

$
4,532.3

$
4,404.9



App.-A-21




 
Fair Value
 
(millions)
Level 1

Level 2

Level 3

Total

Cost

December 31, 2017
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
U.S. government obligations
$
6,645.9

$
0

$
0

$
6,645.9

$
6,688.8

State and local government obligations
0

2,297.1

0

2,297.1

2,285.6

Corporate debt securities
0

4,997.7

0

4,997.7

4,997.2

Subtotal
6,645.9

7,294.8

0

13,940.7

13,971.6

Asset-backed securities:
 
 
 
 
 
Residential mortgage-backed
0

836.7

0

836.7

828.8

Commercial mortgage-backed
0

2,758.6

0

2,758.6

2,760.1

Other asset-backed
0

2,454.7

0

2,454.7

2,454.5

Subtotal asset-backed securities
0

6,050.0

0

6,050.0

6,043.4

Redeemable preferred stocks:
 
 
 
 
 
Financials
0

64.1

0

64.1

61.3

Utilities
0

11.4

0

11.4

10.1

Industrials
0

135.5

0

135.5

123.5

Subtotal redeemable preferred stocks
0

211.0

0

211.0

194.9

Total fixed maturities
6,645.9

13,555.8

0

20,201.7

20,209.9

Short-term investments
1,824.4

1,045.0

0

2,869.4

2,869.4

                                     Total fixed maturities and short-term
8,470.3

14,600.8

0

23,071.1

23,079.3

Equity securities:
 
 
 
 
 
Nonredeemable preferred stocks:
 
 
 
 
 
Financials
80.6

718.2

0

798.8

693.6

Utilities
0

0

0

0

0

Industrials
0

0

5.0

5.0

5.0

Subtotal nonredeemable preferred stocks
80.6

718.2

5.0

803.8

698.6

Common equities:
 
 
 
 
 
Common stocks
3,399.5

0

0

3,399.5

1,498.7

Other risk investments
0

0

0.3

0.3

0.3

Subtotal common equities
3,399.5

0

0.3

3,399.8

1,499.0

       Total equity securities
3,480.1

718.2

5.3

4,203.6

2,197.6

             Total available-for-sale portfolio
$
11,950.4

$
15,319.0

$
5.3

$
27,274.7

$
25,276.9

Debt
$
0

$
3,606.5

$
37.1

$
3,643.6

$
3,306.3

Our portfolio valuations, excluding short-term investments, classified as either Level 1 or Level 2 in the above tables are priced exclusively by external sources, including: pricing vendors, dealers/market makers, and exchange-quoted prices.
Our short-term security holdings classified as Level 1 are highly liquid, actively marketed, and have a very short duration, primarily 90 days or less to redemption. These securities are held at their original cost, adjusted for any accretion of discount, since that value very closely approximates what an active market participant would be willing to pay for such securities. The remainder of our short-term securities are classified as Level 2 and are not priced externally since these securities continually trade at par value. These securities are classified as Level 2 since they are primarily longer-dated securities issued by municipalities that contain either liquidity facilities or mandatory put features within one year.
At December 31, 2018, vendor-quoted prices represented 79% of our Level 1 classifications (excluding short-term investments), compared to 66% at December 31, 2017. The securities quoted by vendors in Level 1 primarily represent our holdings in U.S. Treasury Notes, which are frequently traded and the quotes are considered similar to exchange-traded quotes. The balance of our Level 1 pricing comes from quotes obtained directly from trades made on active exchanges.

App.-A-22




At December 31, 2018, vendor-quoted prices comprised 99% of our Level 2 classifications (excluding short-term investments), while dealer-quoted prices represented 1%, compared to 98% and 2% at December 31, 2017, respectively. In our process for selecting a source (e.g., dealer or pricing service) to provide pricing for securities in our portfolio, we reviewed documentation from the sources that detailed the pricing techniques and methodologies used by these sources and determined if their policies adequately considered market activity, either based on specific transactions for the particular security type or based on modeling of securities with similar credit quality, duration, yield, and structure that were recently transacted. Once a source is chosen, we continue to monitor any changes or modifications to their processes by reviewing their documentation on internal controls for pricing and market reviews. We review quality control measures of our sources as they become available to determine if any significant changes have occurred from period to period that might indicate issues or concerns regarding their evaluation or market coverage.
As part of our pricing procedures, we obtain quotes from more than one source to help us fully evaluate the market price of securities. However, our internal pricing policy is to use a consistent source for individual securities in order to maintain the integrity of our valuation process. Quotes obtained from the sources are not considered binding offers to transact. Under our policy, when a review of the valuation received from our selected source appears to be outside of what is considered market level activity (which is defined as trading at spreads or yields significantly different than those of comparable securities or outside the general sector level movement without a reasonable explanation), we may use an alternate source’s price. To the extent we determine that it may be prudent to substitute one source’s price for another, we will contact the initial source to obtain an understanding of the factors that may be contributing to the significant price variance, which often leads the source to adjust their pricing input data for future pricing.
To allow us to determine if our initial source is providing a price that is outside of a reasonable range, we review our portfolio pricing on a weekly basis. When necessary, we challenge prices from our sources when a price provided does not match our expectations based on our evaluation of market trends and activity. Initially, we perform a review of our portfolio by sector to identify securities whose prices appear outside of a reasonable range. We then perform a more detailed review of fair values for securities disclosed as Level 2. We review dealer bids and quotes for these and/or similar securities to determine the market level context for our valuations. We then evaluate inputs relevant for each class of securities disclosed in the preceding hierarchy tables.
For our structured debt securities, including commercial, residential, and asset-backed securities, we evaluate available market-related data for these and similar securities related to collateral, delinquencies, and defaults for historical trends and reasonably estimable projections, as well as historical prepayment rates and current prepayment assumptions and cash flow estimates. We further stratify each class of our structured debt securities into more finite sectors (e.g., planned amortization class, first pay, second pay, senior, subordinated, etc.) and use duration, credit quality, and coupon to determine if the fair value is appropriate.

For our corporate debt and preferred stock (redeemable and nonredeemable) portfolios, as well as the notes issued by The Progressive Corporation (see Note 4 Debt), we review securities by duration, coupon, and credit quality, as well as changes in interest rate and credit spread movements within that stratification. The review also includes recent trades, including: volume traded at various levels that establish a market, issuer specific fundamentals, and industry specific economic news as it comes to light.
For our municipal securities (e.g., general obligations, revenue, and housing), we stratify the portfolio to evaluate securities by type, coupon, credit quality, and duration to review price changes relative to credit spread and interest rate changes. Additionally, we look to economic data as it relates to geographic location as an indication of price-to-call or maturity predictors. For municipal housing securities, we look to changes in cash flow projections, both historical and reasonably estimable projections, to understand yield changes and their effect on valuation.
Lastly, for our short-term securities, we look at acquisition price relative to the coupon or yield. Since our short-term securities are typically 90 days or less to maturity, with the majority listed in Level 2 being 30 days or less to redemption, we believe that acquisition price is the best estimate of fair value.
We also review data assumptions as supplied by our sources to determine if that data is relevant to current market conditions. In addition, we independently review each sector for transaction volumes, new issuances, and changes in spreads, as well as the overall movement of interest rates along the yield curve to determine if sufficient activity and liquidity exists to provide a credible source for our market valuations.
During each valuation period, we create internal estimations of portfolio valuation (performance returns), based on current market-related activity (i.e., interest rate and credit spread movements and other credit-related factors) within each major sector of our portfolio. We compare our internally generated portfolio results with those generated based on quotes we receive externally and research material valuation differences. We compare our results to index returns for each major sector adjusting

App.-A-23




for duration and credit quality differences to better understand our portfolio’s results. Additionally, we review on a monthly basis our external sales transactions and compare the actual final market sales prices to previous market valuation prices. This review provides us further validation that our pricing sources are providing market level prices, since we are able to explain significant price changes (i.e., greater than 2%) as known events occur in the marketplace and affect a particular security’s price at sale.
This analysis provides us with additional comfort regarding the source’s process, the quality of its review, and its willingness to improve its analysis based on feedback from clients. We believe this effort helps ensure that we are reporting the most representative fair values for our securities.
Except as described below, our Level 3 securities are also priced externally; however, due to several factors (e.g., nature of the securities, level of activity, and lack of similar securities trading to obtain observable market level inputs), these valuations are more subjective in nature. Certain private equity investments and fixed-income investments included in the Level 3 category are valued using external pricing supplemented by internal review and analysis.
After all the valuations are received and our review is complete, if the inputs used by vendors are determined to not contain sufficient observable market information, we will reclassify the affected security valuations to Level 3. At December 31, 2018 and 2017, we did not have any securities in our fixed-maturity portfolio listed as Level 3.
At December 31, 2018, we owned two privately held nonredeemable preferred securities with a combined value of $30.1 million that were priced internally, compared to one private nonredeemable preferred security with a value of $5.0 million that was priced internally at December 31, 2017. At December 31, 2018, and 2017, we held one Level 3 other risk investment with a value of $0.3 million.
We review the prices from our external sources for reasonableness using internally developed assumptions to derive prices for the Level 3 securities, which are then compared to the prices we received. During 2018 or 2017, there were no material assets or liabilities measured at fair value on a nonrecurring basis. Based on our review, all prices received from external sources remained unadjusted. Due to the relative size of the Level 3 securities’ fair values compared to the total portfolio’s fair value, any changes in pricing methodology would not have a significant change in valuation that would materially impact net or comprehensive income.
The following tables provide a summary of changes in fair value associated with Level 3 assets for the years ended December 31, 2018 and 2017:
 
 
Level 3 Fair Value
(millions)
Fair Value at Dec. 31, 2017

Calls/
Maturities/
Paydowns

Purchases

Sales

Net Realized
(Gain)/Loss
on Sales

Change in
Valuation

Net
Transfers
In (Out) 

Fair Value at Dec. 31, 2018

Fixed maturities:
 
 
 
 
 
 
 
 
Asset-backed securities:
 
 
 
 
 
 
 
 
Commercial mortgage-backed
$