EX-13 26 dex13.htm 2009 ANNUAL REPORT TO SHAREHOLDERS 2009 Annual Report to Shareholders

 

Exhibit 13

 

THE PROGRESSIVE CORPORATION

2009 ANNUAL REPORT TO SHAREHOLDERS

 

 

App.-A-1

 


 

The Progressive Corporation and Subsidiaries

Consolidated Statements of Income

For the years ended December 31,

 

(millions — except per share amounts)   2009      2008      2007

Revenues

       

Net premiums earned

  $ 14,012.8      $ 13,631.4      $ 13,877.4

Investment income

    507.0        637.7        680.8

Net realized gains (losses) on securities:

       

Other-than-temporary impairment (OTTI) losses:

       

Total OTTI losses

    (80.9             

Less: portion of OTTI losses recognized in other comprehensive income

    40.1               
                       

Net impairment losses recognized in earnings

    (40.8             

Net realized gains (losses) on securities

    67.9        (1,445.1      106.3
                       

Total net realized gains (losses) on securities

    27.1        (1,445.1      106.3

Service revenues

    16.7        16.1        22.3
 

Total revenues

    14,563.6        12,840.1        14,686.8
 

Expenses

       

Losses and loss adjustment expenses

    9,904.9        10,015.0        9,926.2

Policy acquisition costs

    1,364.6        1,358.1        1,399.9

Other underwriting expenses

    1,567.7        1,523.4        1,526.2

Investment expenses

    11.1        8.8        12.4

Service expenses

    19.4        20.4        20.5

Interest expense

    139.0        136.7        108.6
 

Total expenses

    13,006.7        13,062.4        12,993.8
 

Net Income (Loss)

       

Income (loss) before income taxes

    1,556.9        (222.3      1,693.0

Provision (benefit) for income taxes

    499.4        (152.3      510.5
 

Net income (loss)

  $ 1,057.5      $ (70.0    $ 1,182.5
       

Computation of Earnings Per Share

       

Basic:

       

Average shares outstanding

    666.8        668.0        710.4
       

Per share

  $ 1.59      $ (.10    $ 1.66
       

Diluted:

       

Average shares outstanding

    666.8        668.0        710.4

Net effect of dilutive stock-based compensation

    5.4        5.9        8.1
 

Total equivalent shares

    672.2        673.9        718.5
       

Per share1

  $ 1.57      $ (.10    $ 1.65
       

 

1

For 2008, amount represents basic earnings per share since diluted earnings per share was antidilutive due to the net loss for the year.

See notes to consolidated financial statements.

App.-A-2

 


 

The Progressive Corporation and Subsidiaries

Consolidated Balance Sheets

December 31,

 

(millions)   2009     2008  

Assets

   

Investments — Available-for-sale, at fair value:

   

Fixed maturities (amortized cost: $11,717.0 and $10,295.3)

  $ 11,563.4     $ 9,946.7  

Equity securities:

   

Nonredeemable preferred stocks (cost: $665.4 and $1,131.3)

    1,255.8       1,150.0  

Common equities (cost: $598.4 and $553.6)

    816.2       727.8  

Short-term investments (amortized cost: $1,078.0 and $1,153.6)

    1,078.0       1,153.6  
   

Total investments

    14,713.4       12,978.1  

Cash

    160.7       2.9  

Accrued investment income

    110.4       125.7  

Premiums receivable, net of allowance for doubtful accounts of $116.4 and $113.7

    2,454.8       2,408.6  

Reinsurance recoverables, including $35.4 and $44.0 on paid losses and loss adjustment expenses

    564.8       288.5  

Prepaid reinsurance premiums

    69.3       62.4  

Deferred acquisition costs

    402.2       414.0  

Income taxes

    416.7       821.6  

Property and equipment, net of accumulated depreciation of $595.8 and $653.6

    961.3       997.1  

Other assets

    195.7       151.6  
   

Total assets

  $ 20,049.3     $ 18,250.5  
         

Liabilities and Shareholders’ Equity

   

Unearned premiums

  $ 4,172.9     $ 4,175.9  

Loss and loss adjustment expense reserves

    6,653.0       6,177.4  

Accounts payable, accrued expenses, and other liabilities1 

    1,297.6       1,506.4  

Debt

    2,177.2       2,175.5  
   

Total liabilities

    14,300.7       14,035.2  
   

Common Shares, $1.00 par value (authorized 900.0; issued 797.8 and 797.9, including treasury shares of 125.2 and 121.4)

    672.6       676.5  

Paid-in capital

    939.7       892.9  

Retained earnings

    3,683.1       2,697.8  

Accumulated other comprehensive income (loss):

   

Net unrealized gains (losses) on securities

    456.3       (76.8

Portion of OTTI losses recognized in other comprehensive income

    (26.1       
   

Total net unrealized gains (losses) on securities

    430.2       (76.8

Net unrealized gains on forecasted transactions

    21.6       24.9  

Foreign currency translation adjustment

    1.4         
   

Total accumulated other comprehensive income (loss)

    453.2       (51.9
   

Total shareholders’ equity

    5,748.6       4,215.3  
   

Total liabilities and shareholders’ equity

  $ 20,049.3     $ 18,250.5  
         

 

1

See Note 12 – Litigation and Note 13 – Commitments and Contingencies 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)   2009     2008     2007  

Retained Earnings

           

Balance, Beginning of year

  $ 2,697.8       $ 2,927.7       $ 4,646.9    

Cumulative effect of change in accounting principle

    189.6                      

Net income (loss)

    1,057.5     $ 1,057.5       (70.0   $ (70.0     1,182.5     $ 1,182.5  
                             

Cash dividends declared on common shares ($.1613, $0, and $2.1450 per share)

    (108.5                (1,507.6  

Treasury shares purchased

    (154.5       (157.1       (1,388.4  

Other, net

    1.2         (2.8       (5.7  
   

Balance, End of year

  $ 3,683.1       $ 2,697.8       $ 2,927.7    
   

Accumulated Other Comprehensive Income (Loss), Net of Tax

           

Balance, Beginning of year

  $ (51.9     $ 492.8       $ 604.3    

Cumulative effect of change in accounting principle

    (189.6                    

Changes in:

           

Net unrealized gains (losses) on securities

      722.7         (541.8       (131.8

Portion of OTTI losses recognized in other comprehensive income (loss)

      (26.1                  
                             

Total net unrealized gains (losses) on securities

      696.6         (541.8       (131.8

Net unrealized gains on forecasted transactions

      (3.3       (2.9       20.3  

Foreign currency translation adjustment

      1.4                    
                             

Other comprehensive income (loss)

    694.7       694.7       (544.7     (544.7     (111.5     (111.5
   

Balance, End of year

  $ 453.2       $ (51.9     $ 492.8    
   

Comprehensive Income (Loss)

    $ 1,752.2       $ (614.7     $ 1,071.0  
                             

Common Shares, $1.00 Par Value

           

Balance, Beginning of year

  $ 676.5       $ 680.2       $ 748.0    

Stock options exercised

    3.5         3.5         3.4    

Treasury shares purchased

    (11.1       (9.9       (72.9  

Restricted stock issued, net of forfeitures

    3.7         2.7         1.7    
   

Balance, End of year

  $ 672.6       $ 676.5       $ 680.2    
   

Paid-In Capital

           

Balance, Beginning of year

  $ 892.9       $ 834.8       $ 847.4    

Stock options exercised

    15.3         23.5         27.4    

Tax benefits from exercise/vesting of stock-based compensation

    9.7         11.1         15.5    

Treasury shares purchased

    (15.0       (12.4       (87.1  

Restricted stock issued, net of forfeitures

    (3.7       (2.7       (1.7  

Amortization of stock-based compensation

    39.2         35.1         28.0    

Other

    1.3         3.5         5.3    
   

Balance, End of year

  $ 939.7       $ 892.9       $ 834.8    
   

Total Shareholders’ Equity

  $ 5,748.6       $  4,215.3       $ 4,935.5    
         

There are 20.0 million Serial Preferred Shares authorized; no such shares are issued or outstanding.

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)   2009     2008     2007  

Cash Flows From Operating Activities

     

Net income (loss)

  $ 1,057.5     $ (70.0   $ 1,182.5  

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

     

Depreciation

    87.3       99.1       106.9  

Amortization of fixed-income securities

    230.8       249.6       284.1  

Amortization of stock-based compensation

    40.3       34.5       26.5  

Net realized (gains) losses on securities

    (27.1     1,445.1       (106.3

Net loss on disposition of property and equipment

    13.3       1.6       .4  

Changes in:

     

Premiums receivable

    (46.2     (13.5     103.1  

Reinsurance recoverables

    (276.3     46.6       98.7  

Prepaid reinsurance premiums

    (6.9     7.4       19.7  

Deferred acquisition costs

    11.8       12.3       14.7  

Income taxes

    29.7       (423.8     (30.3

Unearned premiums

    (3.0     (34.5     (124.6

Loss and loss adjustment expense reserves

    475.6       234.7       217.7  

Accounts payable, accrued expenses, and other liabilities

    (71.8     (101.2     2.4  

Other, net

    (28.2     61.3       (4.5
   

Net cash provided by operating activities

    1,486.8       1,549.2       1,791.0  
   

Cash Flows From Investing Activities

     

Purchases:

     

Fixed maturities

    (10,046.3     (7,593.9     (8,184.6

Equity securities

    (624.2     (598.3     (1,490.3

Short-term investments – auction rate securities

           (631.5     (7,156.6

Sales:

     

Fixed maturities

    7,950.0       5,629.5       8,327.6  

Equity securities

    919.4       1,401.0       775.2  

Short-term investments – auction rate securities

           631.5       7,325.4  

Maturities, paydowns, calls, and other:

     

Fixed maturities

    842.5       505.5       557.9  

Equity securities

    15.7       34.9       10.7  

Net sales (purchases) of short-term investments – other

    75.6       (771.0     30.0  

Net unsettled security transactions

    (246.5     177.2       35.1  

Purchases of property and equipment

    (66.6     (98.5     (136.3

Sales of property and equipment

    1.8       1.1       2.0  
   

Net cash provided by (used in) investing activities

    (1,178.6     (1,312.5     96.1  
   

Cash Flows From Financing Activities

     

Proceeds from exercise of stock options

    18.8       27.0       30.8  

Tax benefits from exercise/vesting of stock-based compensation

    9.7       11.1       15.5  

Proceeds from debt1 

                  1,021.7  

Dividends paid to shareholders

           (98.3     (1,406.5

Acquisition of treasury shares

    (180.6     (179.4     (1,548.4
   

Net cash used in financing activities

    (152.1     (239.6     (1,886.9
   

Effect of exchange rate changes on cash

    1.7                
   

Increase (decrease) in cash

    157.8       (2.9     .2  

Cash, Beginning of year

    2.9       5.8       5.6  
   

Cash, End of year

  $ 160.7     $ 2.9     $ 5.8  
         

 

1

2007 includes a pretax gain received upon closing a forecasted debt issuance hedge. See Note 4 – Debt for further discussion.

See notes to consolidated financial statements.

 

App.-A-5

 


 

The Progressive Corporation and Subsidiaries

Notes to Consolidated Financial Statements

December 31, 2009, 2008, and 2007

1.  REPORTING AND ACCOUNTING POLICIES

Nature of Operations  The Progressive Corporation, an insurance holding company formed in 1965, owned 53 subsidiaries and had 1 mutual insurance company affiliate as of December 31, 2009. Our insurance subsidiaries provide personal and commercial automobile insurance and other specialty property-casualty insurance and related services. Our Personal Lines segment writes insurance for personal autos and recreational vehicles through both an independent insurance agency channel and a direct channel. Our Commercial Auto segment writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses through both the independent agency and direct channels. We operate our businesses throughout the United States; in December 2009, we began selling personal auto physical damage insurance via the Internet in Australia.

Basis of Consolidation and Reporting  The accompanying consolidated financial statements include the accounts of The Progressive Corporation, its subsidiaries, and affiliate. All of the subsidiaries and the mutual company affiliate are wholly owned or controlled. We achieve control of our mutual company affiliate through a 100% reinsurance contract and a management service contract between a wholly-owned insurance subsidiary and such affiliate. All intercompany accounts and transactions are eliminated in consolidation.

Subsequent events have been evaluated through March 1, 2010, the date the financial statements were issued via filing our Annual Report on Form 10-K with the Securities and Exchange Commission.

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 (e.g., losses are paid), results may, and will likely, differ from those estimates.

Investments  Progressive’s fixed-maturity securities, equity securities, and short-term investments are accounted for on an available-for-sale basis. See Note 2 – Investments for the detailed composition of our investment portfolio.

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.

Included in the fixed-maturity portfolio are asset-backed securities. The asset-backed securities are generally accounted for under the retrospective method. Under the current accounting guidance, the prospective method is used primarily for interest-only securities, non-investment-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 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 requires a calculation of future expected repayments and resets the yield to allow for future period adjustments; no current period impact to investment income or the securities cost is made based on the cash flow update. Prepayment assumptions are based on market expectations and are updated quarterly.

Equity securities include common stocks, nonredeemable preferred stocks, and other risk investments and are reported at quoted fair values. Changes in fair value of these securities, net of deferred income taxes, are reflected as unrealized gains (losses) in accumulated other comprehensive income. To the extent we hold any foreign equities or foreign currency hedges, any change in value due to exchange rate fluctuations would be limited by foreign currency hedges, if any, and would be recognized in income in the current period.

App.-A-6

 


 

Short-term investments can include auction rate securities (i.e., certain municipal bonds and preferred stocks). Due to the nature of auction rate securities, these securities are classified as short-term based upon their expected auction date (generally 7-49 days) rather than on their contractual obligation (which is greater than one year at original issuance). In the event that an auction fails, the security may need to be reclassified from short term. In addition to auction rate securities, short-term investments may include Eurodollar deposits, commercial paper, reverse repurchase transactions, and other securities expected to mature within one year. Changes in fair value of these securities, net of deferred income taxes, are reflected as unrealized gains (losses) in accumulated other comprehensive income.

Trading securities are securities bought principally for the purpose of sale in the near term. 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).

To the extent we have derivatives held or issued 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 realized 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 was 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 (see Note 4 – Debt for discussion regarding a forecasted debt issuance hedge we held in 2007).

If a hedge is deemed to become ineffective and 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 all derivative positions, net cash requirements are limited to changes in fair values, which may vary based upon changes in interest rates, currency exchange rates, and other factors. Exposure to credit risk is limited to the carrying value;

 

App.-A-7

 


 

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 securities with unrealized losses based on predetermined guidelines. 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 equity market declines, 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 debt securities 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 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 in earnings, with the balance (i.e., non-credit related impairment in 2009) recognized as part of our net unrealized gains (losses) in accumulated other comprehensive income. When an equity security (common equity and nonredeemable preferred stock) in our investment portfolio has an unrealized loss in fair value that is deemed to be other-than-temporary, we reduce the book value of such security to its current fair value, recognizing the decline as a realized loss in the income statement. Any future changes in fair value, either increases or decreases, are reflected as changes in unrealized gains (losses) as part of accumulated other comprehensive income.

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 derivatives, trading securities, and hybrid instruments (securities with embedded call options, where the call option is a feature of the overall change in the value of the instrument).

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 is applicable to the unexpired risk. We provide insurance and related services to individuals and small commercial accounts and offer a variety of payment plans. Generally, premiums are collected prior to providing risk coverage, minimizing our exposure to credit risk. 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.

Deferred Acquisition Costs  Deferred acquisition costs include commissions, premium taxes, and other variable underwriting and direct sales costs incurred in connection with writing business. These costs 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 that these costs will be fully recoverable in the near term. We do not defer any direct-response advertising costs.

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 currently. Such loss and loss adjustment expense reserves are susceptible to change in the near term.

Reinsurance  Our reinsurance transactions primarily include premiums written under state-mandated involuntary plans for commercial vehicles (Commercial Auto Insurance Procedures/Plans – “CAIP”) and premiums ceded to state-provided reinsurance facilities (e.g., Michigan Catastrophic Claims Association, North Carolina Reinsurance Facility) (collectively, “State Plans”), for which we retain no loss indemnity risk (see Note 7 – Reinsurance for further discussion). We also cede a portion of the premiums in our non-auto programs to limit our exposure in those particular markets. 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 written.

App.-A-8

 


 

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 assets and liabilities giving rise to such differences are write-downs of investment securities determined to be other-than-temporarily impaired, net unrealized gains (losses) on securities, loss reserves, unearned premiums reserves, deferred acquisition costs, and non-deductible accruals. We review our deferred tax assets regularly for recoverability. See Note 5 – Income Taxes for further discussion.

Property and Equipment  Property and equipment are recorded at cost, less accumulated depreciation. Depreciation is recognized over the estimated useful lives of the assets using accelerated methods for computer equipment and the straight-line method for all other fixed assets. The useful lives range from 3 to 4 years for computer equipment, 10 to 40 years for buildings and improvements, and 3 to 10 years for all other property and equipment. Land and buildings comprised 77% and 78% of total property and equipment at December 31, 2009 and 2008, respectively. Property and equipment include capitalized software developed or acquired for internal use. Total interest capitalized was $2.6 million in 2009, $5.0 million in 2008, and $2.4 million in 2007, relating to capitalized computer software costs and construction projects.

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.

Service Revenues and Expenses  Our service businesses provide insurance-related services. 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 include acquisition expenses, which are deferred and amortized over the period in which the related revenues are earned. Other service business revenues and expenses are recorded in the period in which they are earned or incurred.

Stock-Based Compensation  We issue restricted stock awards, both time-based and performance-based, as our form of equity compensation to key members of management and non-employee directors. We currently do not issue stock options as a form of equity compensation, although there are vested options still outstanding as of December 31, 2009. Compensation expense for restricted stock awards is recognized over the respective vesting periods. For the years ended December 31, 2009, 2008, and 2007, the pretax expense of our stock-based compensation was $40.3 million, $34.5 million, and $26.5 million, respectively (tax benefit of $14.1 million, $12.1 million, and $9.3 million).

We record an estimate for expected forfeitures of restricted stock based on our historical forfeiture rates. In addition, we shorten the vesting periods of certain stock-based awards based on the “qualified retirement” provisions in our incentive compensation plans, under which (among other provisions) the vesting of 50% of outstanding time-based restricted stock awards will accelerate upon retirement if the participant is 55 years of age or older and satisfies certain years-of-service requirements.

Earnings Per Share  Basic earnings per share are computed using the weighted average number of common shares outstanding, excluding both the time-based and performance-based unvested restricted stock awards that are subject to forfeiture. Diluted earnings per share include common stock equivalents assumed outstanding during the period. Our common stock equivalents include stock options and time-based restricted stock awards accounted for as equity awards. In periods where we report a net loss, the calculated diluted earnings per share is antidilutive, therefore, basic earnings per share is reported.

Supplemental Cash Flow Information  Cash includes only bank demand deposits. We paid income taxes, net of recoverables received, if any, of $461.7 million, $258.0 million, and $526.0 million in 2009, 2008, and 2007, respectively. Total interest paid was $144.7 million during both 2009 and 2008 and $110.1 million during 2007. Non-cash activity includes declared but unpaid dividends.

New Accounting Standards  During 2009, the Financial Accounting Standards Board (FASB) issued updated guidance on accounting for transfers of financial assets. This guidance eliminates the concept of a qualifying special-purpose entity and its exemption from consolidation in the transferor’s financial statements. It also establishes conditions for reporting a transfer of financial assets as sales and requires additional disclosure. This guidance is effective for fiscal years beginning after November 15, 2009 (January 2010 for calendar-year companies). Based on our current investment portfolio, we do not expect the guidance to have any impact on our financial condition, cash flows, or results of operations.

 

App.-A-9

 


 

During 2009, the FASB issued guidance which: (i) replaces the quantitative-based risks and rewards calculation for determining whether an enterprise is the primary beneficiary in a variable interest entity with an approach that is primarily qualitative; (ii) requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity; and (iii) requires additional disclosures about an enterprise’s involvement in variable interest entities. This guidance is effective for fiscal years beginning after November 15, 2009 (January 2010 for calendar-year companies). Based on our current investment portfolio, we do not expect the guidance to have any impact on our financial condition, cash flows, or results of operations.

2.  INVESTMENTS

The following table presents the composition of our investment portfolio by major security type, consistent with our internal classification of how we manage, monitor, and measure the portfolio:

 

($ in millions)   Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Net
Realized
Gains
(Losses)1 
   

Fair

Value

   % of
Total
Fair
Value
 
December 31, 2009               

Fixed maturities:

              

U.S. government obligations

  $ 4,939.6    $ 6.4    $ (128.5   $      $ 4,817.5    32.8

State and local government obligations

    1,974.2      55.1      (5.3            2,024.0    13.8  

Corporate debt securities

    1,244.9      43.4      (6.9            1,281.4    8.7  

Residential mortgage-backed securities

    592.0      4.3      (79.9            516.4    3.5  

Commercial mortgage-backed securities

    1,572.0      37.0      (18.9            1,590.1    10.8  

Other asset-backed securities

    721.9      6.1      (1.8            726.2    4.9  

Redeemable preferred stocks

    671.3      20.7      (85.3            606.7    4.1  

Other debt obligations

    1.1                         1.1      
   

Total fixed maturities

    11,717.0      173.0      (326.6            11,563.4    78.6  

Equity securities:

              

Nonredeemable preferred stocks

    665.4      597.6             (7.2     1,255.8    8.5  

Common equities

    598.4      220.1      (2.3            816.2    5.6  

Short-term investments - other

    1,078.0                         1,078.0    7.3  
   

Total portfolio2,3

  $ 14,058.8    $ 990.7    $ (328.9   $ (7.2   $ 14,713.4    100.0
         
($ in millions)   Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Net
Realized
Gains
(Losses)1 
   

Fair

Value

   % of
Total
Fair
Value
 
December 31, 2008               

Fixed maturities:

              

U.S. government obligations

  $ 3,565.7    $ 129.0    $ (1.1   $      $ 3,693.6    28.5

State and local government obligations

    3,041.4      53.1      (90.1            3,004.4    23.1  

Foreign government obligations

    16.2      .2                    16.4    .1  

Corporate debt securities

    692.1      1.6      (54.4            639.3    4.9  

Residential mortgage-backed securities

    758.7      1.4      (137.1            623.0    4.8  

Commercial mortgage-backed securities

    1,692.7      1.0      (243.7            1,450.0    11.2  

Other asset-backed securities

    139.2           (10.1            129.1    1.0  

Redeemable preferred stocks

    387.2      8.7      (8.0            387.9    3.0  

Other debt obligations

    2.1      .9                    3.0      
   

Total fixed maturities

    10,295.3      195.9      (544.5            9,946.7    76.6  

Equity securities:

              

Nonredeemable preferred stocks

    1,131.3      73.5      (17.3     (37.5     1,150.0    8.9  

Common equities

    553.6      203.5      (29.3            727.8    5.6  

Short-term investments - other

    1,153.6                         1,153.6    8.9  
   

Total portfolio2,3

  $ 13,133.8    $ 472.9    $ (591.1   $ (37.5   $ 12,978.1    100.0
         

 

1

Represents net holding period gains (losses) on certain hybrid securities (discussed below).

 

2

At December 31, 2009 and 2008, we had $7.7 million and $254.2 million, respectively, of net unsettled security transactions offset in other liabilities.

 

3

Includes $2.2 billion and $1.0 billion at December 31, 2009 and 2008, respectively, of securities in the portfolio of a consolidated, non-insurance subsidiary of the holding company, net of any unsettled security transactions.

App.-A-10

 


 

Our fixed-maturity securities include debt securities and redeemable preferred stocks. At December 31, 2009 and 2008, the nonredeemable preferred stock portfolio included $66.3 million and $53.0 million, respectively, of hybrid securities (i.e., perpetual preferred stocks that have call features with fixed-rate coupons, whereby the change in value of the call feature is a component of the overall change in value of the preferred stock). Common equities include common stocks and other risk investments (e.g., private equity investments). Our other short-term investments include Eurodollar deposits, commercial paper, and other investments which are expected to mature within one year. At December 31, 2009, our other short-term investments also included $0.9 million in treasury bills issued by the Australian government.

At December 31, 2009, bonds and certificates of deposit in the principal amount of $131.9 million were on deposit to meet state insurance regulatory and/or rating agency requirements. We did not have 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, 2009 or 2008. At December 31, 2009, we had fixed-maturity securities with a fair value of $1.1 million that were non-income producing during the preceding 12 months.

Fixed Maturities  The composition of fixed maturities by maturity at December 31, 2009 was:

 

(millions)   Cost    Fair Value

Less than one year

  $ 1,231.1    $ 1,220.9

One to five years

    7,419.7      7,443.0

Five to ten years

    3,013.1      2,857.2

Ten years or greater

    53.0      42.2
 

Total

  $ 11,716.9    $ 11,563.3
       

 

1

Excludes $0.1 million of gains on the open interest rate swap position.

Asset-backed securities are classified in the maturity distribution table based upon their projected cash flows. All other securities which do not have a single maturity date are reported at 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.

Net Investment Income  The components of net investment income for the years ended December 31, were:

 

(millions)   2009     2008     2007  

Fixed maturities:

     

U.S. government obligations

  $ 79.6     $ 54.1     $ 115.0  

State and local government obligations

    91.9       126.5       135.9  

Corporate debt securities

    48.2       53.4       52.7  

Residential mortgage-backed securities

    33.4       47.1       40.3  

Commercial mortgage-backed securities

    90.7       102.1       94.8  

Other asset-backed securities

    9.7       6.9       6.7  

Redeemable preferred stocks

    47.5       47.0       32.0  

Other debt obligations

    .3       1.3       1.2  
   

Total fixed maturities

    401.3       438.4       478.6  

Equity securities:

     

Nonredeemable preferred stocks

    89.7       144.5       126.9  

Common equities

    13.3       38.9       46.2  

Short-term investments:

     

Auction-rate municipal obligations

           1.4       2.6  

Auction-rate preferred stocks

                  .8  

Other short-term investments

    2.7       14.5       25.7  
   

Investment income

    507.0       637.7       680.8  

Investment expenses

    (11.1     (8.8     (12.4
   

Net investment income

  $ 495.9     $ 628.9     $ 668.4  
         

 

App.-A-11

 


 

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

 

(millions)   2009     2008     2007  
Gross realized gains on security sales      

Fixed maturities:

     

U.S. government obligations

  $ 103.1      $ 243.2      $ 100.2   

State and local government obligations

    35.2       17.3       3.1  

Corporate and other debt securities

    20.5       5.5       7.1  

Commercial mortgage-backed securities

    .8                

Redeemable preferred stocks

                  2.9  
   

Total fixed maturities

    159.6       266.0       113.3  

Equity securities:

     

Nonredeemable preferred stocks

    32.6       11.6       2.1  

Common equities

    148.5       320.7       55.4  

Short-term investments - other

                  .1  
   

Subtotal gross realized gains on security sales

    340.7       598.3       170.9  
   
Gross realized losses on security sales      

Fixed maturities:

     

U.S. government obligations

    (2.1     (.7     (14.2

State and local government obligations

    (7.6            (.8

Corporate and other debt securities

    (.5     (13.1     (4.0

Residential mortgage-backed securities

    (3.2            (1.0

Commercial mortgage-backed securities

    (9.9     (1.4     (.3

Other asset-backed securities

    (.7     (.4       

Redeemable preferred stocks

           (1.8     (1.4
   

Total fixed maturities

    (24.0     (17.4     (21.7

Equity securities:

     

Nonredeemable preferred stocks

    (57.3     (541.8     (2.2

Common equities

    (40.0     (179.3     (33.4
   

Subtotal gross realized losses on security sales

    (121.3     (738.5     (57.3
   
Net realized gains (losses) on security sales      

Fixed maturities:

     

U.S. government obligations

    101.0       242.5       86.0  

State and local government obligations

    27.6       17.3       2.3  

Corporate and other debt securities

    20.0       (7.6     3.1  

Residential mortgage-backed securities

    (3.2            (1.0

Commercial mortgage-backed securities

    (9.1     (1.4     (.3

Other asset-backed securities

    (.7     (.4       

Redeemable preferred stocks

           (1.8     1.5  
   

Total fixed maturities

    135.6       248.6       91.6  

Equity securities:

     

Nonredeemable preferred stocks

    (24.7     (530.2     (.1

Common equities

    108.5       141.4       22.0  

Short-term investments - other

                  .1  
   

Subtotal net realized gains (losses) on security sales

    219.4       (140.2     113.6  
   
Other-than-temporary impairment losses      

Fixed maturities:

     

Corporate and other debt securities

           (69.0       

Residential mortgage-backed securities

    (32.0     (38.2     (1.7

Commercial mortgage-backed securities

    (.9     (.6     (.2

Redeemable preferred stocks

    (6.1     (301.0       
   

Total fixed maturities

    (39.0     (408.8     (1.9

Equity securities:

     

Nonredeemable preferred stocks

    (158.8     (941.3     (17.4

Common equities

    (10.3     (43.0     (.3
   

Subtotal other-than-temporary impairment losses

    (208.1     (1,393.1     (19.6
   
Net holding period gains (losses)      

Hybrid preferred stocks

    14.5       (73.6     (7.4

Derivative instruments

    1.3       161.8       19.7  
   

Subtotal net holding period gains (losses)

    15.8       88.2       12.3  
   

Total net realized gains (losses) on securities

  $ 27.1      $ (1,445.1   $ 106.3   
         

App.-A-12

 


 

Gross realized gains and losses were the result of traditional investment sales transactions in our fixed-income portfolio, affected by movements in credit spreads and interest rates, sales of our common stocks to reduce our risk exposure, rebalancing of our equity-indexed portfolio, tax management, and holding period valuation changes on hybrids and derivatives. In addition, in 2007, gains and losses also reflected the sale of securities to fund our $1.4 billion extraordinary dividend payment in September 2007. Also included are write-downs for securities determined to be other-than-temporarily impaired in our fixed-maturity and/or equity portfolios. These write-downs were the result of fundamental matters related to either specific issues or issuers and/or the significant decline in the credit and mortgage-related markets.

Other-than-Temporary Impairment (OTTI)  During 2009, we adopted the new accounting standards related to OTTI that provide guidance in determining whether impairments in debt securities are other-than-temporary and require additional disclosures relating to OTTI and unrealized losses on investments; the new standards did not change the impairment model for equity securities.

The new guidance required that, during the initial period of adoption, we record a cumulative effect of change in accounting principle to reclassify the non-credit component of a previously recognized OTTI from retained earnings to other comprehensive income. Based on our review of OTTI losses on securities held at March 31, 2009, we reclassified $189.6 million (or $291.8 million on a pretax basis) from retained earnings to accumulated other comprehensive income (loss) during the second quarter 2009.

The following table shows our OTTI losses separated between those related to a credit loss and the portion that was a non-credit related impairment for the period since the adoption of the new guidance (second quarter 2009):

 

(millions)   Total
OTTI
   Credit Related
and Other OTTI
(Income Statement)
   Non-Credit
Related OTTI

(Balance Sheet)

  
  

1  

Fixed maturities:

       

Residential mortgage-backed:

       

Bifurcated

  $56.6    $16.9    $39.7   

Non-bifurcated2  

  14.2    14.2      
   

Total residential mortgage-backed

  70.8    31.1    39.7   

Commercial mortgage-backed - bifurcated

  1.3    .9    .4   

Other asset-backed - non-bifurcated2 

  .2    .2      
   

Total fixed maturities

  72.3    32.2    40.1   

Nonredeemable preferred stocks

  6.9    6.9    NA   

Common equities

  1.7    1.7    NA   
   

Total

  $80.9    $40.8    $40.1   
       

NA = Not Applicable

 

1

Reflects the non-credit related OTTI recorded as a component of accumulated other comprehensive income at the time the credit impairment was determined. The valuation on these positions improved by $16.0 million subsequent to the write-downs, resulting in a remaining balance of $24.1 million in accumulated other comprehensive income at December 31, 2009.

 

2

Represents securities where our total OTTI losses were credit related; no unrealized losses are recorded as a component of accumulated other comprehensive income.

 

App.-A-13

 


 

The following table provides a rollforward of the amounts related to credit losses recognized in earnings for which a portion of the OTTI loss was recognized in accumulated other comprehensive income at the time the credit impairment was determined and recognized:

 

(millions)   Commercial
Mortgage-
Backed
   Corporate
Debt
   Residential
Mortgage-
Backed
   Total  

Beginning balance at April 1, 2009

  $    $ 6.5    $ 24.2    $ 30.7   

Credit losses for which an OTTI was previously recognized

              1.4      1.4   

Credit losses for which an OTTI was not previously recognized

    .9           15.5      16.4   
   

Ending balance at December 31, 2009

  $ .9    $ 6.5    $ 41.1    $ 48.5   
         

Since it was determined that it is more likely than not that we will not be required to sell the securities prior to the recovery (which could be maturity) of their respective cost bases, in order to measure the amount of credit losses on the securities that were determined to be other-than-temporarily impaired during the year, 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 asset-backed portfolio included: current performance indicators on the underlying assets (i.e., delinquency rates, foreclosure rates, and default rates), credit support (via current levels of subordination), and historical credit ratings. Updated cash flow expectations were also generated by our portfolio managers 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 implied 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 was deemed to exist, and the security was written-down.

Gross Unrealized Losses  As of December 31, 2009, we had $326.6 million of gross unrealized losses in our fixed-income portfolio (i.e., fixed-maturity securities, nonredeemable preferred stocks, and short-term investments) and $2.3 million in our common equities. We currently do not intend to sell the fixed-income securities and determined that it is more likely than not that we will not be required to sell these securities for the period of time necessary to recover their cost bases. In addition, we may retain the common stocks to maintain correlation to the Russell 1000 Index, as long as the portfolio and index correlation remain similar. If our strategy was to change and these securities were determined to be other-than-temporarily impaired, we would recognize a write-down in accordance with our stated policy.

The following tables show the composition of gross unrealized losses by major security type by the length of time that individual securities have been in a continuous unrealized loss position:

 

(millions)

 

Total
Fair
Value

  

Total
Unrealized
Losses

    Less than 12 Months     12 Months or Greater  
       Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 
December 31, 2009               

Fixed maturities:

              

U.S. government obligations

  $ 4,595.3    $ (128.5   $ 2,408.1    $ (6.4   $ 2,187.2    $ (122.1

State and local government obligations

    448.6      (5.3     41.3      (.2     407.3      (5.1

Corporate debt securities

    344.2      (6.9     264.6      (1.8     79.6      (5.1

Residential mortgage-backed securities

    367.4      (79.9     27.9      (2.5     339.5      (77.4

Commercial mortgage-backed securities

    386.1      (18.9     32.6      (.9     353.5      (18.0

Other asset-backed securities

    81.6      (1.8     71.6      (.3     10.0      (1.5

Redeemable preferred stocks

    507.5      (85.3                 507.5      (85.3
   

Total fixed maturities

    6,730.7      (326.6     2,846.1      (12.1     3,884.6      (314.5

Equity securities - common equities

    30.7      (2.3     20.9      (1.7     9.8      (.6
   

Total portfolio

  $ 6,761.4    $ (328.9   $ 2,867.0    $ (13.8   $ 3,894.4    $ (315.1
         

App.-A-14

 


 

(millions)

 

Total
Fair
Value

  

Total
Unrealized
Losses

    Less than 12 Months     12 Months or Greater  
       Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 
December 31, 2008               

Fixed maturities:

              

U.S. government obligations

  $ 232.5    $ (1.1   $ 232.5    $ (1.1   $    $   

State and local government obligations

    1,100.6      (90.1     274.8      (17.9     825.8      (72.2

Corporate debt securities

    493.1      (54.4     278.3      (27.4     214.8      (27.0

Residential mortgage-backed securities

    592.8      (137.1     219.1      (41.4     373.7      (95.7

Commercial mortgage-backed securities

    1,422.1      (243.7     842.9      (116.7     579.2      (127.0

Other asset-backed securities

    128.8      (10.1     117.7      (7.4     11.1      (2.7

Redeemable preferred stocks

    60.6      (8.0     60.6      (8.0            
   

Total fixed maturities

    4,030.5      (544.5     2,025.9      (219.9     2,004.6      (324.6

Equity securities:

              

Nonredeemable preferred stocks

    437.6      (17.3     305.4      (13.2     132.2      (4.1

Common equities

    123.2      (29.3     110.5      (26.5     12.7      (2.8
   

Total equity securities

    560.8      (46.6     415.9      (39.7     144.9      (6.9
   

Total portfolio

  $ 4,591.3    $ (591.1   $ 2,441.8    $ (259.6   $ 2,149.5    $ (331.5
         

The $85.3 million gross unrealized losses in our redeemable preferred stock portfolio reflects the effect of our $266.7 million reclassification, on a pretax basis, of prior other-than-temporary impairment losses under the accounting guidance for impairments that was adopted during 2009, partially offset by the subsequent recovery in value recorded during the remainder of 2009.

Included in gross unrealized losses at December 31, 2009, was $24.1 million related to securities for which a portion of the OTTI loss was recorded in earnings as a credit loss. The fair value and gross unrealized losses for these securities were comprised of the following:

 

(millions)

 

Total
Fair
Value

  

Total
Unrealized
Losses

    Less than 12 Months     12 Months or Greater  
       Fair
Value
   Unrealized
Losses
    Fair
Value
   Unrealized
Losses
 

Fixed maturities:

              

Residential mortgage-backed securities

  $ 77.4    $ (23.6   $ 15.6    $ (1.9   $ 61.8    $ (21.7

Commercial mortgage-backed securities

    1.8      (.5     .5      (.2     1.3      (.3
   

Total fixed maturities

  $ 79.2    $ (24.1   $ 16.1    $ (2.1   $ 63.1    $ (22.0
         

Trading Securities  At December 31, 2009 and 2008, 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, 2009, 2008, and 2007.

Derivative Instruments  We have invested in the following derivative exposures at various times: interest rate swaps, asset-backed credit default swaps, U.S. corporate debt credit default swaps, and cash flow hedges. In addition, during 2009, we invested in equity options as an economic, forecasted forward sale.

For all derivative positions discussed below, realized holding period gains and losses are netted with any upfront cash that may be exchanged under the contract to determine if the net position should be classified either as an asset or liability. To be reported as a component of the available-for-sale portfolio, the inception-to-date realized gain on the derivative position at period end would have to exceed any upfront cash received (net derivative asset). On the other hand, a net derivative liability would include any inception-to-date realized loss plus the amount of upfront cash received (or netted, if upfront cash was paid) and would be reported as a component of other liabilities. These net derivative assets/liabilities are not separately disclosed on the balance sheet due to their immaterial effect on our financial condition, cash flows, and results of operations.

 

App.-A-15

 


 

The following table shows the status of our derivative instruments at December 31, 2009 and 2008, and for the years ended December 31, 2009, 2008, and 2007; amounts are on a pretax basis:

 

(millions)              Balance Sheet     Income Statement  
    Notional Value1               Fair Value    

Net Realized

Gains (Losses) on Securities

 
    December 31,               December 31,     Years ended December 31,  

Derivatives

designated as:

  2009    2008    2007    Purpose    Classification    2009     2008     2009     2008     2007  

Hedging

instruments

                          

Foreign currency cash flow hedge2

  $    $ 8    $    Forecasted
transaction
   Accumulated
other
comprehensive
income
   $      $ .2      $      $      $   
   

Non-hedging

instruments

                          

Assets:

                          

Interest rate swaps3

    713      1,800      1,325    Manage
portfolio
duration
   Investments -
fixed maturities
     .1        96.3        .1        104.3        53.1   
   

Liabilities:

                          

Corporate credit default swaps

    25      25         Manage
credit risk
   Other liabilities      (.8     (.5     (.6     (.7       
   

Asset-backed credit default swaps

              140    General
portfolio
investing
   NA                                  (45.9
   

Closed:

                          

Interest rate swaps

    4,186      1,550         Manage
portfolio
duration
                      10.4        57.1          
   

Corporate credit default swaps

    7      545      250    Manage
credit risk
                      (.4     20.8        10.0   
   

Asset-backed credit default swaps

         140      50    General
portfolio
investing
                             (19.7     2.5   
   

Equity options4 (177,190 contracts)

    NA      NA      NA    Manage
price risk
                      (9.1              
   

Foreign currency trade2

    8              Manage
currency
risk
                      .9                 
   

Total

    NA      NA      NA            $ (.7   $ 96.0      $ 1.3      $ 161.8      $ 19.7   
          

 

1

The amounts represent the value held at year-end for open positions and the maximum amount held during the year for closed positions.

 

2

During the fourth quarter 2009, we reclassified our cash flow hedge and closed the position; see Cash Flow Hedges below for further discussion.

 

3

The $713 million notional value swap was entered into as a short position (i.e., receive variable and pay fixed coupon) while the swaps held at December 31, 2008 and 2007 were long positions (i.e., receive fixed and pay variable coupon).

 

4

Each contract is equivalent to 100 shares of common stock of the issuer; we had no option activity in 2008 or 2007.

NA = Not Applicable

App.-A-16

 


 

CASH FLOW HEDGES

In the fourth quarter 2009, we recognized a realized gain of $0.9 million reflecting the previously deferred gain on our foreign currency cash flow hedge.

During the second quarter 2007, we entered into a forecasted debt issuance hedge against a possible rise in interest rates in anticipation of issuing $1 billion of our 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (the “Debentures”). The hedge was designated as, and qualified for, cash flow hedge accounting treatment. Upon issuance of the Debentures, the hedge was closed, and we recognized a pretax gain of $34.4 million, which is recorded as part of accumulated other comprehensive income. The $34.4 million gain is deferred and is being recognized as an adjustment to interest expense over the 10-year fixed interest rate term of the Debentures. During 2009, 2008, and 2007, we recognized $2.8 million, $2.6 million, and $1.3 million, respectively, as an adjustment to interest expense.

INTEREST RATE SWAPS

During the years ended December 31, 2009, 2008, and 2007, we invested in interest rate swap positions primarily to manage the fixed-income portfolio duration. As of December 31, 2009, no cash collateral was delivered or received on our open interest rate swap position. As of December 31, 2008 and 2007, we had received $79.6 million and $44.4 million, respectively, in cash collateral from the counterparties on our then open interest rate swap positions, which amounts were invested in short-term securities.

CORPORATE CREDIT DEFAULT SWAPS

During the years ended December 31, 2009 and 2008, we held a position, which was opened during the third quarter 2008, on one corporate issuer within the financial services sector where we bought credit default protection in the form of a credit default swap for a 5-year time horizon. We hold this protection to reduce our exposure to potential additional valuation declines on our preferred stock due to credit impairment of the issuer. As of December 31, 2009, we delivered $0.6 million in cash collateral to the counterparty on our open corporate credit default swap position. Additionally, during the third quarter 2009, we closed a position where we bought credit default protection in the form of credit default swaps for a 2-year time horizon on one corporate issuer within the industrial sector. We paid $0.6 million in upfront cash when we entered the 2-year exposure position, which was offset against our then open exposure. During the fourth quarter 2008, we closed positions where we bought credit default protection in the form of credit default swaps for 3-year and 5-year time horizons on debt issuances of nine different corporate issuers within the financial services sector that we opened during the third quarter 2008. We originally purchased the protection to reduce our overall financial sector exposure given the heightened risk in the financial markets at the time and our exposure to financial firms. No cash collateral was delivered or received on these positions during the year ended December 31, 2008.

During the year ended December 31, 2007, we opened and closed positions where we bought credit default protection in the form of credit default swaps on a corporate non-investment-grade index, and we closed positions where we bought credit default swaps on an investment-grade index. No cash collateral was delivered or received on these positions during the year ended December 31, 2007.

EQUITY OPTIONS

During the year ended December 31, 2009, we opened and closed positions where we simultaneously sold and purchased a substantially equivalent amount of call and put options, respectively, on Citigroup common stock, which related to our preferred stock holding. The purpose of this transaction was to effect a forward sale of a portion of the common stock we expected to receive from Citigroup resulting from the conversion of our preferred stock holding into common stock pursuant to Citigroup’s exchange that occurred during the third quarter 2009. This was achieved through matching the strike price and term of the option contracts and was meant to offset the downside price risk of the common stock during the time period pending the exchange. All of the common stock we received from the preferred stock conversion was sold by the end of the third quarter. As of December 31, 2009, we did not have any unsettled collateral deliveries related to this position. We had no equity option positions during the years ended December 31, 2008 and 2007.

ASSET-BACKED CREDIT DEFAULT SWAPS

We held no asset-backed credit default swap positions during the year ended December 31, 2009. During the fourth quarter 2008, we closed a position for which we sold credit protection in the form of a credit default swap comprised of a basket of 20 asset-backed bonds supported by sub-prime mortgage loans. We covered the credit default swap’s notional exposure by acquiring U.S. Treasury Notes of equal maturity and principal amount and reducing our overall exposure with any upfront cash received. As of December 31, 2009 and 2008, we did not have any collateral deliveries related to this position outstanding. As of December 31, 2007, we delivered $44.8 million ($34.1 million of U.S. Treasury Notes and $10.7 million of cash) in collateral to the counterparties on the asset-backed credit default swap position.

 

App.-A-17

 


 

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 and active exchange-traded equity 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 the reporting entity’s subjective evaluation about the assumptions market participants would use in pricing the financial instrument (e.g., certain structured securities and privately held investments).

During 2009, we adopted the recently issued fair value guidance, pursuant to generally accepted accounting principles, that requires us to evaluate whether a market is distressed or inactive in determining the fair value for our portfolio. Based on this new guidance, we added to our review certain additional market level inputs to evaluate whether sufficient activity, volume, and new issuances existed 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.

The composition of the investment portfolio by major security type was:

 

    Fair Value     
(millions)   Level 1    Level 2    Level 3   Total    Cost

December 31, 2009

            

Fixed maturities:

            

U.S. government obligations

  $ 4,817.5    $    $   $ 4,817.5    $ 4,939.6

State and local government obligations

         2,024.0          2,024.0      1,974.2

Corporate and other debt securities

         1,253.2      29.3     1,282.5      1,246.0
 

Subtotal

    4,817.5      3,277.2      29.3     8,124.0      8,159.8
 

Asset-backed securities:

            

Residential mortgage-backed

         470.3      46.1     516.4      592.0

Commercial mortgage-backed

         1,568.5      21.6     1,590.1      1,572.0

Other asset-backed

         718.4      7.8     726.2      721.9
 

Subtotal asset-backed securities

         2,757.2      75.5     2,832.7      2,885.9
 

Redeemable preferred stocks:

            

Financials

    17.8      231.9          249.7      277.2

Utilities

         66.9          66.9      69.4

Industrials

         237.0      53.1     290.1      324.7
 

Subtotal redeemable preferred stocks

    17.8      535.8      53.1     606.7      671.3
 

Total fixed maturities

    4,835.3      6,570.2      157.9     11,563.4      11,717.0
 

Equity securities:

            

Nonredeemable preferred stocks:

            

Financials

    604.2      534.2          1,138.4      561.6

Utilities

         65.8          65.8      50.8

Industrials

         51.6          51.6      53.0
 

Subtotal nonredeemable preferred stocks

    604.2      651.6          1,255.8      665.4
 

Common equities:

            

Common stocks1  

    803.3               803.3      593.2

Other risk investments

              12.9     12.9      5.2
 

Subtotal common equities

    803.3           12.9     816.2      598.4
 
  $ 6,242.8    $ 7,221.8    $ 170.8     13,635.4      12,980.8
          

Other short-term investments2 

            1,078.0      1,078.0
 

Total portfolio

          $ 14,713.4    $ 14,058.8
       

Debt3 

          $ 2,154.2    $ 2,177.2
       

App.-A-18

 


 

    Fair Value     
(millions)   Level 1    Level 2    Level 3   Total    Cost

December 31, 2008

            

Fixed maturities:

            

U.S. government obligations

  $ 3,693.6    $    $   $ 3,693.6    $ 3,565.7

State and local government obligations

         3,004.4          3,004.4      3,041.4

Foreign government obligations

         16.4          16.4      16.2

Corporate and other debt securities

         615.1      27.2     642.3      694.2
 

Subtotal

    3,693.6      3,635.9      27.2     7,356.7      7,317.5
 

Asset-backed securities:

            

Residential mortgage-backed

         622.7      .3     623.0      758.7

Commercial mortgage-backed

         1,423.6      26.4     1,450.0      1,692.7

Other asset-backed

         118.1      11.0     129.1      139.2
 

Subtotal asset-backed securities

         2,164.4      37.7     2,202.1      2,590.6
 

Redeemable preferred stocks:

            

Financials

    12.1      155.7          167.8      166.1

Utilities

         37.0          37.0      37.0

Industrials

         138.4      44.7     183.1      184.1
 

Subtotal redeemable preferred stocks

    12.1      331.1      44.7     387.9      387.2
 

Total fixed maturities

    3,705.7      6,131.4      109.6     9,946.7      10,295.3
 

Equity securities:

            

Nonredeemable preferred stocks:

            

Agencies

         1.0          1.0      1.0

Financials

    477.2      505.9          983.1      960.3

Utilities

         53.6          53.6      54.5

Industrials

              112.3     112.3      115.5
 

Subtotal nonredeemable preferred stocks

    477.2      560.5      112.3     1,150.0      1,131.3
 

Common equities:

            

Common stocks1  

    714.3               714.3      547.8

Other risk investments

              13.5     13.5      5.8
 

Subtotal common equities

    714.3           13.5     727.8      553.6
 
  $ 4,897.2    $ 6,691.9    $ 235.4     11,824.5      11,980.2
          

Other short-term investments2 

            1,153.6      1,153.6
 

Total portfolio

          $ 12,978.1    $ 13,133.8
       

Debt3 

          $ 1,581.6    $ 2,175.5
       

 

1

Common stocks are managed externally to track the Russell 1000 Index. Therefore, a break-out by major sector type is not provided.

 

2

Due to the underlying nature of these securities, cost approximates fair value.

 

3

Debt is not subject to measurement at fair value in the Consolidated Balance Sheets. Therefore, it is not broken out by hierarchy level; fair values are obtained from publicly quoted sources.

Our portfolio valuations classified as either Level 1 or Level 2 in the above table are priced exclusively by external sources, including: pricing vendors, dealers/market makers, and exchange-quoted prices. With limited exceptions, our Level 3 securities are also priced externally; however, due to several factors (e.g., nature of the securities, level of activity, 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.

At December 31, 2009, vendor-quoted prices represented approximately 77% of our Level 1 classifications, compared to 74% at December 31, 2008. The securities quoted by vendors in Level 1 represent holdings in our U.S. Treasury Notes, which are frequently traded and the quotes are considered similar to exchange trade quotes. The balance of our Level 1 pricing comes from quotes obtained directly from trades made on an active exchange. At December 31, 2009, vendor-quoted prices comprised 92% of our Level 2 classifications, compared to 97% at December 31, 2008. We reviewed

 

App.-A-19

 


 

independent documentation detailing the pricing techniques, models, and methodologies used by these pricing vendors and believe that their policies adequately consider market activity, either based on specific transactions for the issue valued or based on modeling of securities with similar credit quality, duration, yield, and structure that were recently transacted. We continue to monitor any changes or modifications to their processes. During 2009 and 2008, we reviewed each sector for transaction volumes and determined that sufficient activity and liquidity existed to provide a credible source for market level valuations.

At December 31, 2009, broker-quoted prices represented the remaining 8% of our Level 2 classifications, compared to 3% at December 31, 2008. In these instances, we typically use broker/dealers because the security we hold is not widely held or frequently traded and thus is not serviced by the pricing vendors. We reviewed independent documentation detailing the pricing techniques, models, and methodologies used by broker/dealers and determined that they used the same pricing techniques as the external vendor pricing sources discussed above. The broker/dealers contain back office pricing desks, separate from the day-to-day traders that buy and sell the securities. This process creates uniformity in pricing when they quote externally to their various customers. The broker/dealer valuations are quoted in terms of spreads to various indices and the spreads are based off recent transactions adjusted for movements since the last trade or based off similar characteristic securities currently trading in the market. These quotes are not considered binding offers to transact. From time to time, we will obtain more than one broker quote for a security, when we feel it is necessary. In addition, from time to time, we will receive a broker/dealer quote for those securities priced by vendors as further evaluation of market price. We believe this additional step helps to ensure that we are reporting the most representative price and validates our pricing methodology.

To the extent the inputs used by external pricers are determined to not contain sufficient observable market information, we will reclassify the affected security valuations to Level 3. At December 31, 2009 and 2008, securities in our fixed-maturity portfolio listed as Level 3 were comprised substantially of securities that were either: (i) private placement deals, (ii) thinly held and/or traded securities, or (iii) lower rated non-investment-grade securities, where little liquidity exists. Based on these factors, it was difficult to independently verify observable market inputs that were used to generate the external valuations we received. At December 31, 2009 and 2008, one private common equity security with an aggregate value of $10.2 million was priced internally.

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 received externally and research material valuation differences to identify the appropriate fair value to report for these securities.

Based on the criteria described above, we believe that the current level classifications are appropriate based on the valuation techniques used and that our fair values accurately reflect current market assumptions in the aggregate.

App.-A-20

 


 

The following tables provide a summary of changes in fair value associated with Level 3 assets for the years ended December 31, 2009 and 2008:

 

     Level 3 Fair Value  

(millions)

  Fair Value
at Dec. 31,
2008
   Calls/
Maturities/
Paydowns
    Purchases    Sales     Realized
(gain)/loss
    Change in
Valuation
    Transfers
in (out)
   

Fair value

at Dec. 31,

2009

 

Fixed maturities:

                 

Asset-backed securities:

                 

Residential mortgage-backed

  $ .3    $ (3.9   $ 49.4    $      $      $ .3     $      $ 46.1  

Commercial mortgage-backed

    26.4      (.8          (23.3     6.3       20.2       (7.2 )       21.6  

Other asset-backed

    11.0      (3.5     11.0                    .3       (11.0     7.8  
   

Total asset-backed securities

    37.7      (8.2     60.4      (23.3     6.3       20.8      
 
(18.2
 

  
    75.5  

Corporate debt securities

    27.2                  (1.1     (1.8     5.0              29.3  

Redeemable preferred stocks - industrials

    44.7                                8.4              53.1  
   

Total fixed maturities

    109.6      (8.2     60.4      (24.4     4.5       34.2       (18.2     157.9  
   

Nonredeemable preferred stocks - industrials

    112.3      (15.2          (99.8     (.6     3.3                

Common equities - other risk investments

    13.5      (.1                        (.5            12.9  
   

Total Level 3 securities

  $ 235.4    $ (23.5   $ 60.4    $ (124.2   $ 3.9     $ 37.0     $ (18.2   $ 170.8  
         

 

1

Of the $18.2 million of transfers out of Level 3, $11.0 million was due to a privately placed other asset-backed security that was priced internally at acquisition. The security was transferred into the Level 2 category once pricing was provided by a vendor. The remaining $7.2 million transferred out of Level 3 and placed into the Level 2 category reflects changes in the inputs used to measure fair value during the period.

 

    Level 3 Fair Value  
(millions)   Fair value
at Dec. 31,
2007
   Calls/
Maturities/
Paydowns
    Purchases    Sales     Realized
(gain)/loss
   Change in
Valuation
    Transfers
in (out)
    Fair value
at Dec. 31,
2008
 

Fixed maturities:

                  

Asset-backed securities:

                  

Residential mortgage-backed

  $ .5    $ (.1   $    $      $    $ (.1   $      $ .3  

Commercial mortgage-backed

    58.4      (3.1                      (30.5     1.6        26.4  

Other asset-backed

    30.6      (3.9          (14.3     .5      (1.9            11.0  
   

Total asset-backed securities

    89.5      (7.1          (14.3     .5      (32.5     1.6        37.7  

Corporate debt securities

    29.9                              (2.7            27.2  

Redeemable preferred stocks - industrials

                                        44.7        44.7  
   

Total fixed maturities

    119.4      (7.1          (14.3     .5      (35.2     46.3        109.6  
   

Nonredeemable preferred stocks - industrials

    115.6                              (3.3            112.3  

Common equities - other risk investments

    13.7      (.9                      .7              13.5  
   

Total Level 3 securities

  $ 248.7    $ (8.0   $    $ (14.3   $ .5    $ (37.8   $ 46.3      $ 235.4  
         

 

1

Represents securities transferred into Level 3 during 2008 due to infrequent trading and illiquidity.

 

App.-A-21

 


 

4.  DEBT

Debt at December 31 consisted of:

 

     2009    2008
(millions)   Carrying
Value
   Fair
Value
   Carrying
Value
   Fair
Value

6.375% Senior Notes due 2012 (issued: $350.0, December 2001)

  $ 349.2    $ 375.1    $ 348.9    $ 355.3

7% Notes due 2013 (issued: $150.0, October 1993)

    149.5      166.9      149.3      154.3

6 5/8% Senior Notes due 2029 (issued: $300.0, March 1999)

    294.7      317.9      294.6      272.0

6.25% Senior Notes due 2032 (issued: $400.0, November 2002)

    394.1      409.4      394.0      350.0

6.70% Fixed-to-Floating Rate Junior Subordinated

          

Debentures due 2067 (issued: $1,000.0, June 2007)

    989.7      884.9      988.7      450.0
 

Total

  $ 2,177.2    $ 2,154.2    $ 2,175.5    $ 1,581.6
       

All of the outstanding debt was issued by The Progressive Corporation. Debt includes amounts we have borrowed and contributed to the capital of our insurance subsidiaries or used, or have available for use, for other business purposes. Fair values are obtained from publicly quoted sources. There are no restrictive financial covenants or credit rating triggers on our debt.

Interest on all debt is payable semiannually at the stated rates. However, the 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (the “Debentures”) will only bear interest at this fixed annual rate through, but excluding, June 15, 2017. Thereafter, the Debentures will bear interest at an annual rate equal to the three-month LIBOR plus 2.0175%, and the interest will be payable quarterly. In addition, subject to certain conditions, we have the right to defer the payment of interest on the Debentures for one or more periods not exceeding ten consecutive years each. During any such deferral period, among other conditions, interest would continue to accrue, including interest on the deferred interest, and we generally would not be able to declare or pay any dividends on, or repurchase any of, our common shares.

Except for the Debentures, all principal is due at the maturity stated in the table above. The Debentures will become due on June 15, 2037, the scheduled maturity date, but only to the extent that we have received sufficient net proceeds from the sale of certain qualifying capital securities. We must use our commercially reasonable efforts, subject to certain market disruption events, to sell enough qualifying capital securities to permit repayment of the Debentures in full on the scheduled maturity date or, if sufficient proceeds are not realized from the sale of such qualifying capital securities by such date, on each interest payment date thereafter. Any remaining outstanding principal will be due on June 15, 2067, the final maturity date.

The 7% Notes are noncallable. The 6.375% Senior Notes, the 6 5/8% Senior Notes, and the 6.25% Senior Notes (collectively, “Senior Notes”) may be redeemed in whole or in part at any time, at our option, subject to a “make-whole” provision. Subject to the Replacement Capital Covenant discussed below, the Debentures may be redeemed, in whole or in part, at any time: (a) prior to June 15, 2017, at a redemption price equal to the greater of (i) 100% of the principal amount of the Debentures being redeemed, or (ii) a “make-whole” amount, in each case plus any accrued and unpaid interest; or (b) on or after June 15, 2017, at a redemption price equal to 100% of the principal amount of the Debentures being redeemed, plus any accrued and unpaid interest. In connection with the issuance of the Debentures, we entered into a Replacement Capital Covenant in which we agreed, for the benefit of the holders of one of our Senior Notes, that we will not repay, redeem, defease, or purchase all or part of the Debentures before June 15, 2047, unless, subject to certain limitations, we have received proceeds from the sale of certain replacement capital securities, as defined in the Replacement Capital Covenant.

Prior to issuance of the Senior Notes and Debentures, we entered into forecasted debt issuance hedges against possible rises in interest rates. Upon issuance of the applicable debt securities, the hedges were closed. At that time, we recognized, as part of accumulated other comprehensive income, unrealized gains (losses) of $18.4 million, $(4.2) million, $5.1 million, and $34.4 million associated with the 6.375% Senior Notes, the 6 5/8% Senior Notes, the 6.25% Senior Notes, and the Debentures, respectively. The gains (losses) on these hedges are deferred and are being recognized as adjustments to interest expense over the life of the related debt issuances for the Senior Notes, and over the 10-year fixed interest rate term for the Debentures.

App.-A-22

 


 

On December 31, 2009, we entered into an amendment to the 364-Day Secured Liquidity Credit Facility Agreement (“Credit Facility Agreement”) with PNC Bank, National Association (PNC), successor to National City Bank (NCB), which extended the expiration date of our outstanding credit facility agreement until December 31, 2010, unless earlier pursuant to the terms of the agreement. Under this agreement, we may borrow up to $125 million, which may be increased to $150 million at our request but subject to PNC’s discretion. The purpose of the credit facility is to provide liquidity in the event of disruptions in our cash management operations, such as disruptions in the financial markets that affect our ability to transfer or receive funds. We may borrow funds, on a revolving basis, either in the form of Eurodollar Loans or Base Rate Loans. Eurodollar Loans will bear interest at one-, two-, three-, or six-month LIBOR (as selected by us) plus 50 basis points for the selected period. Base Rate Loans will bear daily interest at the greater of (a) PNC’s prime rate for such day, (b) the federal funds effective rate for such day plus 1/2% per annum, or (c) one-month LIBOR plus 2% per annum. Any borrowings under this agreement will be secured by a lien on certain marketable securities held in our investment portfolio. A facility fee of $12,500 was paid as consideration for this revolving agreement in each of 2008 and 2009. In addition, in January 2009, we deposited $125 million into an FDIC-insured deposit account (as part of the FDIC Temporary Liquidity Guarantee program) at NCB to provide us with additional cash availability in the event of such a disruption to our cash management operations; as of January 1, 2010, this deposit is no longer covered by FDIC insurance. Our access to these funds is unrestricted. However, if we withdraw funds from this account for any reason other than in connection with a disruption in our cash management operations, the availability of borrowings under the PNC credit facility will be reduced on a dollar-for-dollar basis until such time as we replenish the funds to the deposit account. There are no rating triggers under the credit agreement. We had no borrowings under this arrangement in 2009 or 2008.

The Credit Facility Agreement entered into on December 31, 2008, replaced an uncommitted line of credit with NCB in the principal amount of $125 million. Under the uncommitted line of credit, no commitment fees were required to be paid and there were no rating triggers. Interest on amounts borrowed would have generally accrued at the one-month LIBOR plus 0.375%. We had no borrowings under this arrangement during 2008.

Aggregate principal payments on debt outstanding at December 31, 2009, are $0 for 2010 and 2011, $350.0 million for 2012, $150.0 million for 2013, $0 for 2014, and $1.7 billion thereafter.

5.  INCOME TAXES

The components of our income tax provision (benefit) were as follows:

 

(millions)   2009    2008     2007

Current tax provision

  $ 491.0    $ 255.4     $ 503.7

Deferred tax expense (benefit)

    8.4      (407.7     6.8
 

Total income tax provision (benefit)

  $ 499.4    $ (152.3   $ 510.5
       

The provision (benefit) for income taxes in the accompanying consolidated statements of income differed from the statutory rate as follows:

 

($ in millions)   2009     2008     2007  

Income (loss) before income taxes

  $ 1,556.9       $ (222.3     $ 1,693.0    
                             

Tax at statutory rate

  $ 544.9     35   $ (77.8   35   $ 592.6     35

Tax effect of:

           

Exempt interest income

    (26.7   (2     (38.7   17       (40.3   (3

Dividends received deduction

    (17.9   (1     (35.0   16       (35.4   (2

Other items, net

    (.9          (.8          (6.4     
   

Total income tax provision (benefit)

  $ 499.4     32   $ (152.3   68   $ 510.5     30
         

 

App.-A-23

 


 

Deferred income taxes reflect the effect for financial statement reporting purposes of temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities. At December 31, 2009 and 2008, the components of the net deferred tax assets were as follows:

 

(millions)   2009     2008  

Deferred tax assets:

   

Write-downs on securities

  $ 353.8     $ 478.4  

Unearned premiums reserve

    290.5       291.4  

Non-deductible accruals

    158.5       150.0  

Loss reserves

    118.9       117.9  

Derivative instruments

    2.8         

Net unrealized losses on securities

           41.4  

Other

    1.4       10.0  

Deferred tax liabilities:

   

Net unrealized gains on securities

    (231.6       

Hedges on forecasted transactions

    (11.6     (13.4

Deferred acquisition costs

    (140.8     (144.9

Depreciable assets

    (97.9     (96.1

Derivative instruments

           (23.8

Other

    (24.0     (17.6
   

Net deferred tax assets

    420.0       793.3  

Net income taxes recoverable (payable)

    (3.3     28.3  
   

Income taxes

  $ 416.7     $ 821.6  
         

The decrease in our net deferred tax asset during the year is primarily due to the net unrealized gains that occurred in the investment portfolio. Although realization of the deferred tax asset is not assured, management believes that it is more likely than not that the deferred tax asset will be realized based on our expectation that we will be able to fully utilize the deductions that are ultimately recognized for tax purposes.

Our IRS exams for 2004-2007 have been completed. Technically the statute of limitations for all of these years remains open (for 2004 and 2005 until June 30, 2010 due to a statute extension, and for 2006 and 2007 until three years from the date the returns were filed). However, since the audits of these years have been completed, we consider these years to be effectively settled.

We are currently under IRS examination for the 2008 and 2009 tax years under the Compliance Assurance Program (CAP). Under CAP, the IRS begins its examination process for the tax year before the tax return is filed, by examining significant transactions and events as they occur. The goal of the CAP program is to expedite the exam process and to reduce the level of uncertainty regarding a taxpayer’s tax filing positions.

We recognize interest and penalties, if any, related to unrecognized tax benefits as a component of income tax expense. We have not recorded any unrecognized tax benefits, or any related interest and penalties, as of December 31, 2009 or December 31, 2008. The 2009 tax provision includes an interest benefit (net of tax) of $0.3 million related to the settlement of the 2004-2007 IRS exams.

App.-A-24

 


 

6.   LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

Activity in the loss and loss adjustment expense reserves is summarized as follows:

 

(millions)   2009     2008    2007

Balance at January 1

  $ 6,177.4     $ 5,942.7    $ 5,725.0

Less reinsurance recoverables on unpaid losses

    244.5       287.5      361.4
 

Net balance at January 1

    5,932.9       5,655.2      5,363.6
 

Incurred related to:

      

Current year

    10,040.9       9,981.8      9,845.9

Prior years

    (136.0     33.2      80.3
 

Total incurred

    9,904.9       10,015.0      9,926.2
 

Paid related to:

      

Current year

    6,542.2       6,700.4      6,737.2

Prior years

    3,172.0       3,036.9      2,897.4
 

Total paid

    9,714.2       9,737.3      9,634.6
 

Net balance at December 31

    6,123.6       5,932.9      5,655.2

Plus reinsurance recoverables on unpaid losses

    529.4       244.5      287.5
 

Balance at December 31

  $ 6,653.0     $ 6,177.4    $ 5,942.7
       

Our objective is to establish case and IBNR reserves that are adequate to cover all loss costs, while sustaining minimal variation from the date that the reserves are initially established until losses are fully developed. Our reserves developed favorably in 2009, compared to unfavorable development in both 2008 and 2007. Total development consists of net changes made by our actuarial department on prior accident year reserves, based on regularly scheduled reviews, claims settling for more or less than reserved, emergence of unrecorded claims at rates different than reserved, and changes in reserve estimates by claim representatives. In 2009, the favorable development was primarily related to lower than expected defense and cost containment reserves and favorable settlements on larger losses in our Commercial Auto business. In 2008, an increase in the number of late reported Commercial Auto claims, and an increase in the estimated severity on these claims, was a primary contributor to the unfavorable development. The unfavorable development in 2007 was due to the settlement of some large outstanding litigation, the number of large losses emerging from prior accident years being more than anticipated, plus the result of reviews of large bodily injury and uninsured motorist claims.

Because we are primarily an insurer of motor vehicles, we have limited exposure to environmental, asbestos, and general liability claims. We have established reserves for such exposures, in amounts that we believe to be adequate based on information currently known. These claims are not expected to have a material effect on our liquidity, financial condition, cash flows, or results of operations.

We write personal and commercial auto insurance in the coastal states, which could be exposed to hurricanes or other natural catastrophes. Although the occurrence of a major catastrophe could have a significant effect on our monthly or quarterly results, we believe that, based on historical performance, such an event would not be so material as to disrupt the overall normal operations of Progressive. We are unable to predict the frequency or severity of any such events that may occur in the near term or thereafter.

7.  REINSURANCE

The effect of reinsurance on premiums written and earned for the years ended December 31 was as follows:

 

    2009     2008     2007  
(millions)   Written     Earned     Written     Earned     Written     Earned  

Direct premiums

  $ 14,196.3     $ 14,199.4     $ 13,775.6     $ 13,810.1     $ 13,982.4     $ 14,107.0  

Ceded

    (193.4     (186.6     (171.3     (178.7     (209.9     (229.6
   

Net premiums

  $ 14,002.9     $ 14,012.8     $ 13,604.3     $ 13,631.4     $ 13,772.5     $ 13,877.4  
         

 

App.-A-25

 


 

Our ceded premiums are attributable to premiums written under state-mandated involuntary Commercial Auto Insurance Procedures/Plans and premiums ceded to state-provided reinsurance facilities (together referred to as “State Plans”), for which we retain no loss indemnity risk, and premiums ceded related to our non-auto programs.

Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to Progressive. Since the majority of our reinsurance is through State Plans, our exposure to losses from their failure is minimal, since the plans are funded by mechanisms supported by the insurance companies in the state. We evaluate the financial condition of our other reinsurers and monitor concentrations of credit risk to minimize our exposure to significant losses from reinsurer insolvencies. We also require unauthorized reinsurers to secure reinsurance through collateral, such as lines of credit or trust accounts.

At December 31, 2009, approximately 50% of the “prepaid reinsurance premiums” was comprised of State Plans, compared to about 55% at December 31, 2008. As of December 31, 2009 and 2008, approximately 90% and 80%, respectively, of the “reinsurance recoverables” were attributable to State Plans. The remainder of the “prepaid reinsurance premiums” and “reinsurance recoverables” was primarily related to non-auto programs.

Losses and loss adjustment expenses were net of reinsurance ceded of $417.6 million in 2009, $109.2 million in 2008, and $109.6 million in 2007. During 2009, we changed our loss reserving process regarding lifetime estimates for claims ceded to a state-provided reinsurance program, which increased both the amount of ceded loss reserves and the corresponding reinsurance recoverables on unpaid losses and, therefore, had no impact on our results of operations.

8.  STATUTORY FINANCIAL INFORMATION

Consolidated statutory policyholders’ surplus was $4,953.6 million and $4,470.6 million at December 31, 2009 and 2008, respectively. Statutory net income was $1,300.8 million, $368.4 million, and $1,105.2 million for the years ended December 31, 2009, 2008, and 2007, respectively.

At December 31, 2009, $477.7 million of consolidated statutory policyholders’ surplus represented net admitted assets of our insurance subsidiaries and affiliate that are required to meet minimum statutory surplus requirements in such entities’ states of domicile. The companies may be licensed in states other than their states of domicile, which may have higher minimum statutory surplus requirements. Generally, the net admitted assets of insurance companies that, subject to other applicable insurance laws and regulations, are available for transfer to the parent company cannot include the net admitted assets required to meet the minimum statutory surplus requirements of the states where the companies are licensed.

During 2009, the insurance subsidiaries paid aggregate cash dividends of $1,208.7 million to the parent company. Based on the dividend laws currently in effect, the insurance subsidiaries could pay aggregate dividends of $1,008.5 million in 2010 without prior approval from regulatory authorities, provided the dividend payments are not within 12 months of previous dividends paid by the applicable subsidiary.

9.  EMPLOYEE BENEFIT PLANS

Retirement Plans  Beginning January 1, 2009, Progressive has a defined contribution pension plan which covers all United States employees who are 18 years or older and have been employed with the company for at least 30 days. Progressive will match up to a maximum of 6% of the employee’s eligible compensation contributed to the plan. Company matching contributions could be invested by a participant in any of the investments available under the plan. Company matching contributions were $60.7 million in 2009.

Prior to January 1, 2009, Progressive had a two-tiered Retirement Security Program. The first tier was a defined contribution pension plan covering all employees who met requirements as to age and length of service. Company contributions varied from 1% to 5% of annual eligible compensation up to the Social Security wage base, based on years of eligible service and could be invested by a participant in any of the investments available under the plan. Company contributions were $25.5 million in 2008 and $22.5 million in 2007.

The second tier was a long-term savings plan under which Progressive matched, up to a maximum of 3%, of the employee’s eligible compensation, amounts contributed to the plan by an employee. Company matching contributions could be invested by a participant in any of the investments available under the plan. Company matching contributions were $30.9 million in 2008 and $29.3 million in 2007.

App.-A-26

 


 

Postemployment Benefits  Progressive provides various postemployment benefits to former or inactive employees who meet eligibility requirements, their beneficiaries, and covered dependents. Postemployment benefits include salary continuation and disability-related benefits, including workers’ compensation, and, if elected, continuation of health-care benefits for specified limited periods. The liability for these benefits was $23.9 million at December 31, 2009, compared to $25.9 million in 2008.

Postretirement Benefits  We provide postretirement health and life insurance benefits to all employees who met requirements as to age and length of service at December 31, 1988. There are approximately 100 people in this program. Our funding policy for the benefits is to fund these benefits by contributing annually to a 501(c)(4) trust the maximum amount that can be deducted for federal income tax purposes.

Incentive Compensation Plans – Employees  Our incentive compensation includes both non-equity incentive plans (cash) and equity incentive plans (stock-based). The cash incentive compensation includes a cash bonus program for a limited number of senior executives and Gainsharing programs for other employees; the bases of these programs are similar in nature. The stock-based incentive compensation plans provide for the granting of restricted stock awards to key members of management. Prior to 2003, we granted non-qualified stock options as stock-based incentive compensation (see below). The amounts charged to income for the incentive compensation plans for the years ended December 31 were:

 

(millions)    2009    2008    2007

Cash

   $ 120.4    $ 140.3    $ 126.2

Stock-based

     40.3      34.5      26.5

Our 2003 Incentive Plan, which provides for the granting of stock-based awards, including restricted stock awards, to key employees of Progressive, has 18.7 million shares currently authorized, net of restricted stock awards cancelled; 4.8 million shares remain available for future awards. Our 1995 Incentive Plan has expired; however, awards made under that plan prior to its expiration are still in effect.

In 2003, we began issuing restricted stock awards in lieu of stock options. The restricted stock awards are issued as either time-based or performance-based awards. The vesting period (i.e., requisite service period) must be a minimum of six months and one day. The time-based awards vest in equal installments upon the lapse of specified periods of time, typically three, four, and five years. The performance-based awards vest upon the achievement of predetermined performance goals. The performance-based awards are granted to approximately 40 executives and senior managers, in addition to their time-based awards, to provide additional compensation for achieving pre-established profitability and growth targets. Generally, the restricted stock awards are expensed pro rata over their respective vesting periods based on the market value of the awards at the time of grant. However, restricted stock awards granted in 2003 and 2004, that were deferred pursuant to our deferred compensation plan, are accounted for as liability awards, since distributions from the deferred compensation plan for these awards will be made in cash; accordingly, we record expense on a pro rata basis based on the current market value of common shares at the end of the reporting period.

Prior to 2003, we granted nonqualified stock options. These options became exercisable at various dates not earlier than six months after the date of grant, and remain exercisable for up to ten years from the date of the award. All remaining options outstanding vested on or before January 1, 2007 and will expire on or before December 31, 2011, if not exercised prior to that date. All options granted had an exercise price equal to the market value of the common shares on the date of grant. All option exercises are settled in Progressive common shares from either existing treasury shares or newly issued shares.

 

App.-A-27

 


 

A summary of all employee restricted stock activity during the years ended December 31 follows:

 

    2009    2008    2007
Restricted Shares   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value
   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value
   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value

Beginning of year

  8,260,696     $ 20.39    6,868,850     $ 22.33    6,232,522     $ 22.27

Add (deduct):

             

Granted

  4,072,152       12.08    3,038,793       15.98    2,318,637       21.01

Vested

  (1,239,281     23.14    (1,281,560     19.98    (1,005,680     18.80

Forfeited

  (479,551     16.98    (365,387     21.61    (676,629     22.44
 

End of year

  10,614,016     $ 17.04    8,260,696     $ 20.39    6,868,850     $ 22.33
     

Available, end of year

  4,753,038        8,424,255        11,287,225    
     

 

1

Represents shares available under the 2003 Incentive Plan. On January 1, 2010, 1,277,147 restricted stock awards vested with an aggregate fair value of $29.4 million.

Of the 1,239,281 restricted stock awards that vested during the year ended December 31, 2009, 1,001,051 shares were not deferred under our deferred compensation plan and 238,230 were deferred (see discussion of deferred compensation below). The aggregate fair value of the non-deferred awards, based on the respective grant date stock prices, was $23.2 million. Two types of deferred shares vested. First were 91,856 deferred liability awards. There was no intrinsic value attributed to these shares which were deferred, since, as previously discussed, these awards were granted in 2004 and, therefore, were expensed based on the current market value at the end of each reporting period. In addition, 146,374 deferred equity awards vested, which were granted after March 2005. The aggregate fair value of these deferred awards, based on the grant date stock price, was $3.5 million.

During the year ended December 31, 2009, we recognized $40.3 million, or $26.2 million after taxes, of compensation expense related to our outstanding unvested restricted stock. During the year ended December 31, 2008, we recognized $34.5 million, or $22.4 million after taxes, of compensation expense related to our outstanding unvested restricted stock. During the year ended December 31, 2007, we recognized $26.5 million, or $17.2 million after taxes, of compensation expense related to our outstanding unvested restricted stock and stock option awards. At December 31, 2009, the total unrecognized compensation cost related to unvested restricted stock awards was $79.6 million. This compensation expense will be recognized into the income statement over the weighted average vesting period of 2.25 years.

As discussed above, we stopped granting non-qualified stock options in 2002. All remaining stock option awards vested on January 1, 2007. Following is a summary of all employee stock option activity during the year ended December 31, 2007:

 

Nonvested stock options outstanding   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value

Beginning of year

  1,087,866     $ 5.82

Deduct:

   

Vested

  (1,087,866     5.82
 

End of year

       $
     

App.-A-28

 


 

In September 2007, we paid a $2.00 per common share special dividend to shareholders of record at the close of business on August 31, 2007. Since the holders of the outstanding stock option awards were not entitled to receive the cash dividend, we were required to increase the number of shares and reduce the exercise price of any of our then outstanding stock option awards in accordance with the antidilution provisions of our incentive plans. This adjustment is reflected in the appropriate tables below.

 

    2009    2008    2007
Options Outstanding   Number of
Shares
    Weighted
Average
Exercise
Price
   Number of
Shares
    Weighted
Average
Exercise
Price
   Number of
Shares
    Weighted
Average
Exercise
Price

Beginning of year

  8,503,273     $ 7.71    11,738,502     $ 7.75    13,747,221     $ 8.75

Add:

             

Antidilution adjustment

                      1,201,984       NM

Deduct:

             

Exercised

  (3,394,633     5.31    (3,235,229     7.86    (3,208,873     9.10

Forfeited

  (5,752     5.69              (1,830     11.78
 

End of year

  5,102,888     $ 9.31    8,503,273     $ 7.71    11,738,502     $ 7.75
     

Exercisable, end of year

  5,102,888     $ 9.31    8,503,273     $ 7.71    11,738,502     $ 7.75
     

NM = not meaningful

The total pretax intrinsic value of options exercised during the year ended December 31, 2009, was $36.1 million, based on the actual stock price at time of exercise.

The following employee stock options were outstanding and exercisable as of December 31, 2009:

 

Number of Shares   Weighted
Average
Exercise
Price
   Aggregate
Intrinsic
Value
   Weighted
Average
Remaining
Contractual
Life

5,102,888

  $ 9.31    $ 44.3 million    1.47 years

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the difference between our closing stock price of $17.99 on December 31, 2009, and the exercise price of the options, which is the amount that would have been received by the option holders, before taxes, had all option holders exercised their options as of that date. All of the exercisable options at December 31, 2009, were “in-the-money.”

Incentive Compensation Plans – Directors  Our 2003 Directors Equity Incentive Plan, which provides for the granting of stock-based awards, including restricted stock awards to non-employee directors of The Progressive Corporation, has 1.4 million shares currently authorized, net of restricted stock awards cancelled; 0.9 million shares remain available for future grants. Our 1998 Directors’ Stock Option Plan expired on April 24, 2008; however, stock option awards made under this plan prior to its expiration are still in effect.

In 2003, we began issuing restricted stock awards to non-employee directors as the equity component of their compensation. The restricted stock awards are issued as time-based awards. The vesting period (i.e., requisite service period) must be a minimum of six months and one day. The time-based awards granted to date have included vesting periods of 11 or 12 months from the date of each grant. The restricted stock awards are expensed pro rata over their respective vesting periods based on the market value of the awards at the time of grant.

Prior to 2003, we granted nonqualified stock options as the equity component of the directors compensation. These options were granted for periods up to ten years, became exercisable at various dates not earlier than six months after the date of grant, and remain exercisable for specified periods thereafter. All options granted had an exercise price equal to the market value of the common shares on the date of grant and, under the then applicable accounting guidance, no compensation expense was recorded. All option exercises are settled in Progressive common shares from either existing treasury shares or newly issued shares.

Restricted stock awards are granted to non-employee directors as their sole compensation for being a member of the Board of Directors.

 

App.-A-29

 


 

A summary of all directors restricted stock activity during the years ended December 31 follows:

 

    2009    2008    2007
Restricted Shares   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value
   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value
   Number of
Shares
    Weighted
Average
Grant
Date Fair
Value

Beginning of year

  105,420     $ 17.96    68,595     $ 23.52    66,031     $ 26.64

Add (deduct):

             

Granted

  129,467       15.78    105,420       17.96    76,074       23.52

Vested

  (105,420     17.96    (68,595     23.52    (66,031     26.64

Forfeited

  (10,483     15.74              (7,479     23.52
 

End of year

  118,984     $ 15.79    105,420     $ 17.96    68,595     $ 23.52
     

Available, end of year1 

  869,871        988,855        1,094,275    
     

 

1

Represents shares available under the 2003 Directors Equity Incentive Plan.

A summary of all stock option activity for both current and former directors during the years ended December 31 follows:

 

    2009    2008    2007
Options Outstanding   Number of
Shares
    Weighted
Average
Exercise
Price
   Number of
Shares
    Weighted
Average
Exercise
Price
   Number of
Shares
    Weighted
Average
Exercise
Price

Beginning of year

  401,357     $ 8.60    628,813     $ 7.97    772,664     $ 8.59

Add:

             

Antidilution adjustment1 

                      55,851       NM

Deduct:

             

Exercised

  (88,812     9.10    (227,456     6.86    (199,702     8.16
 

End of year

  312,545     $ 8.46    401,357     $ 8.60    628,813     $ 7.97
     

Exercisable, end of year2 

  312,545     $ 8.46    401,357     $ 8.60    628,813     $ 7.97
     

NM = not meaningful

 

1

See discussion above under Incentive Compensation Plans — Employees.

 

2

The 1998 Directors’ Stock Option Plan has expired.

The total pretax intrinsic value of options exercised during the year ended December 31, 2009, was $0.5 million, based on the actual stock price at time of exercise.

The following director stock options were outstanding and exercisable as of December 31, 2009:

 

Number of Shares   Weighted
Average
Exercise
Price
   Aggregate
Intrinsic
Value
   Weighted
Average
Remaining
Contractual
Life

312,545

  $ 8.46    $ 3.0 million    1.22 years

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the difference between our closing stock price of $17.99 on December 31, 2009, and the exercise price of the options, which is the amount that would have been received by the option holders, before taxes, had all option holders exercised their options as of that date. All of the exercisable options at December 31, 2009, were “in-the-money.”

Deferred Compensation  We maintain The Progressive Corporation Executive Deferred Compensation Plan (“Deferral Plan”) that permits eligible executives to defer receipt of some or all of their annual bonuses or all of their annual restricted stock awards. Deferred cash compensation is deemed invested in one or more investment funds, including common shares of Progressive, offered under the Deferral Plan and elected by the participant. All distributions from the Deferral Plan pursuant to deferred cash compensation will be paid in cash.

App.-A-30

 


 

For all restricted stock awards granted on or after March 17, 2005, and deferred pursuant to the Deferral Plan, the deferred amounts are deemed invested in our common shares and are ineligible for transfer to other investment funds in the Deferral Plan; all distributions will be made in common shares. For all awards granted prior to March 17, 2005, the deferred amounts are eligible to be transferred to any of the funds in the Deferral Plan; distributions of these deferred awards will be made in cash.

We reserved 3.6 million common shares for issuance under the Deferral Plan. An irrevocable grantor trust has been established to provide a source of funds to assist us in meeting our liabilities under the Deferral Plan. At December 31, 2009 and 2008, the trust held assets of $80.2 million and $66.7 million, respectively, of which $17.6 million and $13.5 million were held in Progressive’s common shares; these shares will be distributed in cash. In addition, at December 31, 2009 and 2008, the trust held 0.2 million and 0.1 million common shares, respectively, to be distributed in-kind.

10.  SEGMENT INFORMATION

We write personal auto and other specialty property-casualty insurance and provide related services throughout the United States. Our Personal Lines segment writes insurance for personal autos and recreational vehicles. The Personal Lines segment is comprised of both the Agency and Direct businesses. The Agency business includes business written by our network of more than 30,000 independent insurance agencies, including brokerages in New York and California, and strategic alliance business relationships (other insurance companies, financial institutions, and national agencies). The Direct business includes business written directly by us online and by phone.

Our Commercial Auto segment writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses in the specialty truck and business auto markets. This segment is distributed through both the independent agency and direct channels.

Our other indemnity businesses primarily include writing professional liability insurance for community banks and managing a small amount of run-off businesses.

Our service businesses provide insurance-related services, including processing CAIP business and serving as an agent for homeowners insurance through our program with three unaffiliated homeowner insurance companies.

All segment revenues are generated from external customers and we do not have a reliance on any major customer.

We evaluate segment profitability based on pretax underwriting profit (loss) for the Personal Lines and Commercial Auto businesses. In addition, we use underwriting profit (loss) for the other indemnity businesses and pretax profit (loss) for the service businesses. Pretax underwriting profit (loss) is calculated as follows:

 

Net premiums earned

Less: Losses and loss adjustment expenses

         Policy acquisition costs

         Other underwriting expenses

 

Pretax underwriting profit (loss)

 

Service business profit (loss) is the difference between service business revenues and service business expenses.

Expense allocations are based on certain assumptions and estimates primarily related to revenue and volume; stated segment operating results would change if different methods were applied. We do not allocate assets or income taxes to operating segments. In addition, we do not separately identify depreciation and amortization expense by segment and such disclosure would be impractical. Companywide depreciation expense was $87.3 million in 2009, $99.1 million in 2008, and $106.9 million in 2007. The accounting policies of the operating segments are the same as those described in Note 1 – Reporting and Accounting Policies.

 

App.-A-31

 


 

Following are the operating results for the years ended December 31:

 

    2009     2008     2007  
(millions)   Revenues    Pretax
Profit
(Loss)
    Revenues     Pretax
Profit
(Loss)
    Revenues    Pretax
Profit
(Loss)
 

Personal Lines

             

Agency

  $ 7,414.8    $ 579.2     $ 7,362.0     $ 360.7     $ 7,636.4    $ 500.2  

Direct

    4,951.1      357.9       4,485.8       274.8       4,372.6      339.9  
   

Total Personal Lines

    12,365.9      937.1       11,847.8       635.5       12,009.0      840.1  

Commercial Auto

    1,623.3      229.8       1,762.2       94.1       1,846.9      185.7  

Other indemnity

    23.6      8.7       21.4       5.3       21.5      (.7
   

Total underwriting operations

    14,012.8      1,175.6       13,631.4       734.9       13,877.4      1,025.1  
   

Service businesses

    16.7      (2.7     16.1       (4.3     22.3      1.8  

Investments

    534.1      523.0       (807.4     (816.2     787.1      774.7  

Interest expense

         (139.0            (136.7          (108.6
   

Consolidated total

  $ 14,563.6    $ 1,556.9     $ 12,840.1     $ (222.3   $ 14,686.8    $ 1,693.0  
         

 

1

Personal auto insurance accounted for 90% of the total Personal Lines segment net premiums earned in 2009 and 2008, and 91% in 2007; insurance for our special lines products (e.g., motorcycles, ATVs, RVs, mobile homes, watercraft, and snowmobiles) accounted for the balance of the Personal Lines net premiums earned.

 

2

Revenues represent recurring investment income and net realized gains (losses) on securities; pretax profit is net of investment expenses.

Progressive’s management uses underwriting margin and combined ratio as primary measures of underwriting profitability. The underwriting margin is the pretax underwriting profit (loss) expressed as a percentage of net premiums earned (i.e., revenues from insurance operations). Combined ratio is the complement of the underwriting margin. Following are the underwriting margins/combined ratios for our underwriting operations for the years ended December 31:

 

    2009    2008    2007
     Underwriting
Margin
    Combined
Ratio
   Underwriting
Margin
    Combined
Ratio
   Underwriting
Margin
    Combined
Ratio

Personal Lines

             

Agency

  7.8 %   92.2    4.9 %   95.1    6.5 %   93.5

Direct

  7.2     92.8    6.1     93.9    7.8     92.2

Total Personal Lines

  7.6     92.4    5.4     94.6    7.0     93.0

Commercial Auto

  14.2     85.8    5.3     94.7    10.1     89.9

Other indemnity

  NM      NM    NM      NM    NM      NM

Total underwriting operations

  8.4     91.6    5.4     94.6    7.4     92.6
             

 

1

Underwriting margins/combined ratios are not meaningful (NM) for our other indemnity businesses due to the low level of premiums earned by, and the variability of loss costs in, such businesses.

App.-A-32

 


 

11.   OTHER COMPREHENSIVE INCOME (LOSS)

The components of other comprehensive income (loss) for the years ended December 31 were as follows:

 

    2009     2008     2007  
(millions)   Pretax     Tax
(Provision)
Benefit
    After
Tax
    Pretax     Tax
(Provision)
Benefit
    After
Tax
    Pretax     Tax
(Provision)
Benefit
    After
Tax
 

Unrealized gains (losses) arising during period:

                 

Fixed maturities

  $ 535.4     $ (187.4   $ 348.0     $ (407.6   $ 142.7     $ (264.9   $ 52.1     $ (18.2   $ 33.9  

Non-credit related OTTI1

    (40.1     14.0       (26.1                                          

Equity securities

    671.7       (235.1     436.6       (238.6     83.5       (155.1     (189.2     66.2       (123.0

Reclassification adjustment for (gains) losses realized in net income:

                 

Fixed maturities

    (8.5     3.0       (5.5     9.7       (3.4     6.3       (2.3     .8       (1.5

Equity securities

    (86.7     30.3       (56.4     (197.1     69.0       (128.1     (63.4     22.2       (41.2
   

Change in unrealized
gains (losses)
2 

    1,071.8       (375.2     696.6       (833.6     291.8       (541.8     (202.8     71.0       (131.8

Net unrealized gains on forecasted transactions3 

    (5.1     1.8       (3.3     (4.4     1.5       (2.9     31.2       (10.9     20.3  

Foreign currency translation adjustment4 

    1.4              1.4                                            
   

Other comprehensive
income (loss)

  $ 1,068.1     $ (373.4   $ 694.7     $ (838.0   $ 293.3     $ (544.7   $ (171.6   $ 60.1     $ (111.5
         

 

1

Portion of other-than-temporary impairment losses that were non-credit related (see Note 2 – Investments for further discussion).

 

2

Excludes the $189.6 million ($291.8 million pretax) cumulative effect of change in accounting principle we recorded in June 2009 in accordance with the new accounting guidance for other-than-temporary impairments we adopted during the second quarter 2009 (see Note 2 – Investments for further discussion).

 

3

Entered into for the purpose of managing interest rate risk associated with our debt issuances (see Note 4 – Debt for further discussion), and managing foreign currency risk associated with our forecasted foreign currency transaction (see Note 2 – Investments for further discussion). We expect to reclassify $5.2 million into income within the next 12 months.

 

4

Foreign currency translation adjustments have no tax effect.

12.   LITIGATION

The Progressive Corporation and/or its insurance subsidiaries are named as defendants in various lawsuits arising out of claims made under insurance policies in the ordinary course of our business. All legal actions relating to such insurance claims are considered by us in establishing our loss and loss adjustment expense reserves.

In addition, The Progressive Corporation and/or its insurance subsidiaries are named as defendants in a number of class action or individual lawsuits arising out of the operation of the insurance subsidiaries. Other insurance companies face many of these same issues. The lawsuits discussed below are in various stages of development. We plan to contest these suits vigorously, but may pursue settlement negotiations in some cases, if appropriate. The outcomes of these cases are uncertain at this time.

Under current accounting guidance, we establish accruals for lawsuits when it is probable that a loss has been incurred and we can reasonably estimate its potential exposure (referred to as a loss that is both “probable and estimable” in the discussion below). Certain of the cases for which we have established accurals under this standard are mentioned in the discussion below. Based on currently available information, we believe that our accruals for these lawsuits are reasonable and that the amounts accrued did not have a material effect on our consolidated financial condition or results of operations. However, if any one or more of these cases results in a judgment against, or settlement by, our insurance subsidiaries for an amount that is significantly greater than the amount so accrued, the resulting liability could have a material effect on our consolidated financial condition, cash flows, and results of operations.

 

App.-A-33

 


 

As to lawsuits that do not satisfy both parts of this GAAP standard (i.e., the loss is not both probable and estimable), we have not established a liability at this time. In the event that any one or more of these cases results in a substantial judgment against, or settlement by, Progressive, the resulting liability could also have a material effect on our consolidated financial condition, cash flows, and results of operations.

The following is a discussion of potentially significant pending cases at December 31, 2009, and certain cases resolved during 2009, 2008, and 2007. Unless specifically noted: 1) we do not consider the losses from these cases to be probable and estimable, and we are unable to estimate a range of loss, if any, at this time; and 2) settlements were not material to our consolidated financial condition, cash flows, or results of operations. The outcomes of the unsettled cases are uncertain, but in each case we do not believe that the outcome will have a material impact on our consolidated financial condition, cash flows, and results of operations.

There is one putative class action lawsuit, and one lawsuit that was certified as a class action during 2009 that challenges our insurance subsidiaries’ use of certain automated database vendors or software to assist in the adjustment of bodily injury claims. The other lawsuits relating to this issue were either consolidated or dismissed. In each of these lawsuits, the plaintiffs allege that these databases or software systematically undervalue the claims. In 2007, we reached a settlement on a similar class action lawsuit and all payments for that settlement have been made and the file is closed.

There were eight class action lawsuits challenging certain aspects of our insurance subsidiaries use of credit information and compliance with notice requirements under the federal Fair Credit Reporting Act. The cases were consolidated and a tentative settlement agreement was negotiated in 2004. That settlement was amended in 2006, and all required payments were made by the end of 2009. We also had six similar individual cases that were resolved by a settlement in 2009. That resolution also included the claims of other class members who had opted out of the class action settlement. The administration of this settlement is expected to be completed in 2010.

During 2009, we settled one certified nationwide class action lawsuit challenging our insurance subsidiaries’ practice of taking betterment on boat repairs, one putative class action lawsuit alleging that Progressive’s insurance subsidiaries used non-conforming underinsured motorist rejection forms, one certified class action lawsuit alleging that Progressive’s insurance subsidiaries failed to offer certain enhanced personal injury protection (PIP) benefits, and three state class action lawsuits related to over-charging municipal tax to shareholders.

We currently have one certified class action lawsuit seeking interest on PIP payments that allegedly were late. We understand that there are a number of similar class actions against others in the insurance industry.

Progressive’s insurance subsidiaries are defending two putative class actions alleging that we violate the “make-whole” and “common-fund” doctrines. Specifically, it is alleged that we may obtain reimbursement of medical payments made on behalf of an insured only when the insured has been made whole by a third-party tortfeasor and that we further must deduct from the reimbursement amount a proportionate share of the insured’s legal fees for pursuing the third-party tortfeasor.

There are currently four putative class action lawsuits challenging the labor rates our insurance subsidiaries pay to auto body repair shops. One action was brought on behalf of insureds, while the other two were brought on behalf of repair facilities.

There are three putative class action lawsuits challenging Progressive’s insurance subsidiaries’ practice in Florida of paying PIP and first-party medical payments at 200% of the amount allowed by Medicare. One additional case was dismissed during 2009.

In 2008, we settled a putative class action lawsuit challenging the installment fee program used by our insurance subsidiaries.

During 2007, we settled various class action lawsuits and all payments for those settlements have been made and the cases are now closed. There was one lawsuit alleging that the insurance subsidiaries’ rating practices at renewal were improper, three lawsuits alleging that we failed to adjust MRI bills to a consumer price index in violation of a statute, and one lawsuit seeking refunds of all UIM premiums and certain UM premiums on grounds that the coverages were illusory. There were also three putative class action lawsuits related to the MRI billing issue that were either dismissed or settled for a nominal amount. There is one lawsuit pending relating to our rating practices at renewal, as to which class action status has been denied.

App.-A-34

 


 

Progressive’s subsidiaries are also named as a defendant in individual lawsuits related to employment issues. In 2009, we completed payments on the settlement reached in 2008 on one class action lawsuit challenging our classification of certain job titles under the Fair Labor Standards Act.

13.   COMMITMENTS AND CONTINGENCIES

We have certain noncancelable operating lease commitments with lease terms greater than one year for property and computer equipment. The minimum commitments under these agreements at December 31, 2009, were as follows:

 

(millions)

Year

  Commitment

2010

  $ 73.5

2011

    58.5

2012

    42.8

2013

    25.3

2014

    11.9

Thereafter

    16.2
 

Total

  $ 228.2
       

Some of the leases have options to renew at the end of the lease periods. The expense we incurred for the leases disclosed above, as well as other operating leases that may be cancelable or have terms less than one year, was:

 

(millions)

Year

   Expense

2009

   $ 109.0

2008

     124.8

2007

     139.5

We also have certain noncancelable purchase obligations. The minimum commitment under these agreements at December 31, 2009 was $132.3 million.

As of December 31, 2009, we had open investment funding commitments of $0.2 million; we had no uncollateralized lines or letters of credit as of December 31, 2009 or 2008.

 

App.-A-35

 


 

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of The Progressive Corporation:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in shareholders’ equity and cash flows present fairly, in all material respects, the financial position of The Progressive Corporation and its subsidiaries at December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 2 to the consolidated financial statements, the Company changed the manner in which it accounts for other-than-temporary impairment of debt securities in 2009.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

/s/ PricewaterhouseCoopers LLP

Cleveland, Ohio

March 1, 2010

App.-A-36

 


 

Management’s Report on Internal Control over Financial Reporting

Progressive’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. Our internal control structure was designed under the supervision of our Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect our transactions and dispositions of assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and our directors; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on our financial statements.

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the framework in Internal Control – Integrated Framework, management concluded that our internal control over financial reporting was effective as of December 31, 2009.

During the fourth quarter 2009, there were no changes in our internal control over financial reporting identified in the internal control review process that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PricewaterhouseCoopers LLP, an independent registered public accounting firm that audited the financial statements included in this Annual Report, has audited, and issued an attestation report on the effectiveness of, our internal control over financial reporting as of December 31, 2009; such report appears herein.

CEO and CFO Certifications

Glenn M. Renwick, President and Chief Executive Officer of The Progressive Corporation, and Brian C. Domeck, Vice President and Chief Financial Officer of The Progressive Corporation, have issued the certifications required by Sections 302 and 906 of The Sarbanes-Oxley Act of 2002 and applicable SEC regulations with respect to Progressive’s 2009 Annual Report on Form 10-K, including the financial statements provided in this Report. Among other matters required to be included in those certifications, Mr. Renwick and Mr. Domeck have each certified that, to the best of his knowledge, the financial statements, and other financial information included in the Annual Report on Form 10-K, fairly present in all material respects the financial condition, results of operations, and cash flows of Progressive as of, and for, the periods presented. See Exhibits 31 and 32 to Progressive’s Annual Report on Form 10-K for the complete Section 302 and 906 certifications, respectively.

 

App.-A-37

 


 

The Progressive Corporation and Subsidiaries

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The consolidated financial statements and the related notes, together with the supplemental information, should be read in conjunction with the following discussion and analysis of the consolidated financial condition and results of operations.

I.   OVERVIEW

The Progressive Corporation is a holding company that does not have any revenue producing operations, physical property, or employees of its own. The Progressive Group of Insurance Companies, together with our non-insurance subsidiaries, comprise what we refer to as Progressive. Progressive has been in business since 1937 and is estimated to be the country’s fourth largest private passenger auto insurer based on net premiums written during 2009. Our insurance companies offer personal automobile insurance and other specialty property-casualty insurance and related services throughout the United States. In December 2009, we began selling personal auto insurance in Australia. Our Personal Lines segment writes insurance for private passenger automobiles and recreational vehicles through more than 30,000 independent insurance agencies and directly to consumers online and over the phone. Our Commercial Auto segment, which writes through both the independent agency and direct channels, offers insurance for cars and trucks (e.g., pick-up or panel trucks) owned by small businesses and is estimated to be in the top four in its industry. These underwriting operations, combined with our service and investment operations, make up the consolidated group.

The Progressive Corporation receives cash through subsidiary dividends, borrowings, security sales, and other transactions, and uses these funds to contribute to its subsidiaries (e.g., to support growth), to make payments to shareholders and debt holders (e.g., dividends and interest, respectively), to repurchase its common shares, and for other business purposes that might arise. In 2009, the holding company received $1.1 billion from its subsidiaries, net of capital contributions. In December 2009, the Board declared a dividend of $.1613 per share, or $108.5 million, which was paid to shareholders in February 2010. This dividend was pursuant to our annual variable dividend policy and was based on 2009 underwriting results. No dividend was paid for 2008 reflecting the comprehensive loss we reported for that year, as discussed in Financial Condition below. During 2009, we used $180.6 million to repurchase 11.1 million Progressive common shares, at an average cost of $16.34 per share. We had no debt that matured in 2009. The holding company also has access to funds held in a non-insurance subsidiary; at year-end 2009, $2.2 billion of marketable securities were available in this company. On a consolidated basis, we generated positive operating cash flows of $1.5 billion in 2009.

For 2009, Progressive generated net income of $1.1 billion, or $1.57 per share, driven by strong underwriting profitability and solid investment returns. Our insurance operations generated 3% growth in written and earned premiums and 4% growth in policies in force, and produced an 8.4% underwriting profit margin. We continued to make progress on several initiatives intended to help spur our personal auto growth. Our Commercial Auto business continues to feel the effect of the weakened economy and competitive pressures on its ability to generate both premium and policy growth, but contributed to profitability with a 14.2% underwriting margin.

During 2009, our investment portfolio generated investment income of $507.0 million with net realized gains of $27.1 million. This was a significant change from the $1.4 billion of net realized losses we recognized in 2008, driven by significant other-than-temporary impairments, as a result of market declines, primarily in our preferred stock holdings. We ended 2009 with $7.9 billion of total capital (debt and equity), $1.5 billion more than at the start of the year. We continue to manage our investing and financing activities in order to maintain sufficient capital to support all the insurance we can profitably underwrite and service.

A. Operations

In 2009, our insurance subsidiaries generated underwriting profitability of 8.4%, which exceeded our targeted profitability objective of 4%. Both our Personal Lines and Commercial Auto businesses contributed to our strong profitability. In Personal Lines, only eight states did not meet or exceed their target profitability, with only three of those states actually recording an underwriting loss for the year. In Commercial Auto, only five states did not generate an underwriting profit.

We realized $136.0 million of favorable prior accident year development, which increased our profitability for 2009 by one percentage point. This development was primarily from the cost of claims settling at amounts lower than originally

App.-A-38

 


 

estimated. Just over half of this development was in our Personal Lines business, with almost all of the balance in Commercial Auto. For the year, our overall incurred auto accident frequency and severity remained relatively flat compared to the prior year, despite changes in the individual coverages. We saw a decrease in both frequency and severity in the property coverages, while both frequency and severity increased in our personal injury protection coverage. For bodily injury, we saw frequency increase in 2009 compared to 2008, and severity remain relatively flat year-over-year.

On a year-over-year basis, net premiums written and earned both increased 3%. Changes in net premiums written are a function of new business applications (i.e., issued policies), premium per policy, and retention.

During 2009, we saw total new auto applications increase 11%, primarily driven by a 20% increase in our Direct business. For the year, our Agency auto business generated a 3% increase in new applications, despite starting 2009 with significant declines. When evaluating new business application growth on a state-by-state basis, only 12 states did not see total auto applications increase in 2009. In Agency auto, 29 states saw new applications increase. For our Direct business, all but two states saw new auto applications increase on a year-over-year basis. Our Commercial Auto and special lines products both saw new applications decline about 9%. The weakened economy contributed to the decline in our Commercial Auto business, while the surge in new motorcycle and scooter business in 2008, when gas prices were at an all-time high in the United States, drove the 2009 decrease in special lines new applications on a year-over-year basis.

We are continuing with our efforts to spur personal auto growth through several initiatives underway aimed at providing consumers with distinctive new business options. These include the countrywide rollout of Name Your Price®, a program that provides Direct auto consumers the opportunity to select the price they would like to pay for auto insurance; the rollout of new product models, designed to improve competitiveness through further price segmentation; and the expansion of our usage-based insurance product, referred to as MyRate®. We are also continuing to increase our focus on the segment of customers who like to combine their auto and homeowners insurance policies, and we now have relationships with three homeowner carriers to pursue this sizeable market. In addition, in continuing to build options for the future that are in line with our strategic goals, we launched an Internet-only personal auto product in Australia during December 2009.

During 2009, on a year-over-year basis, our monthly average written premium per policy fluctuated from slightly negative to slightly positive in our Agency auto business, and ended the year relatively flat. The Direct auto business was a different story. We continued to see average written premium per policy lower than the prior year for a total decrease of 4% for the year, thus tempering the total written premium growth to 11%. The decrease in the Direct auto business written premium per policy primarily reflects the shifts in the mix of our business relating to the age of the drivers, the proof of prior insurance, and the driving records of our customers. Commercial Auto continued to see declines in premiums per policy, reflecting the continued impact of the economy on our commercial customers who are selecting less coverage and insuring fewer vehicles. The special lines products average written premiums were relatively flat year-over-year. Adjusting rates is a continuous process and we will continue to evaluate future rate needs and react quickly as we recognize changing trends.

Companywide policies in force have increased 4% on a year-over-year basis since December 31, 2008. This increase reflects about 476,000 additional Personal Lines policies and 27,000 fewer Commercial Auto policies. The biggest contributor to this growth was our Direct auto business where policies in force grew 13%, or 377,000 policies. Agency auto policies in force were relatively flat year-over-year, while our special lines products saw an increase of about 3%. The effects of the economy continued to negatively impact our Commercial Auto business as policies in force decreased 5%.

To continue to grow policies in force, it is critical that we retain our customers for longer periods, which is why increasing retention continues to be one of our most important priorities. In 2009, we continued to see an increase in customer retention. Total personal auto policy life expectancy increased 3% on a year-over-year basis, with our Agency and Direct auto policy life expectancies increasing 2% and 3%, respectively. Our Commercial Auto business policy life expectancy remained relatively flat, while our special lines products experienced a 3% decrease from the prior year. Realizing the importance that retention has on our ability to continue to grow profitably, we continue to emphasize competitive pricing, quality service, and other retention initiatives for our current customers.

 

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B. Investments and Capital Management

The fair value of our investment portfolio was $14.7 billion at December 31, 2009. During 2009, our asset allocation strategy was to maintain 0-25% of our portfolio in Group I securities (i.e., common equities, redeemable and nonredeemable preferred stocks (preferred stocks), and non-investment-grade and non-rated fixed-maturity securities), with the balance (75%-100%) of our portfolio in Group II securities (i.e., all other fixed-maturity securities, including U.S. Treasury Notes, municipal bonds, asset-backed securities, and corporate debt, as well as short-term investments). At December 31, 2009, our portfolio was allocated 20% to Group I and 80% to Group II.

Our investment portfolio produced a fully taxable equivalent (FTE) total return of 12.5% for 2009. We experienced positive FTE total returns in the fixed-income portfolio (i.e., fixed maturities, redeemable and nonredeemable preferred stocks, and short-term investments) of 12.2% and common stock portfolio of 29.5% in 2009. We continue to maintain our fixed-income portfolio strategy of investing in high-quality, shorter-duration securities given the current investment environment. We decreased the duration of our fixed-income portfolio during the year to end 2009 at 2.3 years, compared to 3.2 years at the end of 2008. The weighted average credit rating of our fixed-income portfolio ranged from AA+ early in 2009 to AA at the end of the year. Our common equity investment strategy remains an index replication approach using the Russell 1000 Index as the benchmark.

The first quarter 2009 marked the depths of the current financial crisis. A government administered bank stress test, the results of which were released in May, served as an effective tool to restore investor confidence in the solvency of the financial system. Many banks used the stress test results to raise equity capital to restore their balance sheet strength and improve their ability to weather a severe economic downturn. The recapitalization of the banking system, combined with significant liquidity injections and asset purchases by the Federal Reserve and a meaningful fiscal stimulus program, sparked a virtuous cycle of asset and economic recovery during the balance of 2009. Valuations improved for nearly all risk assets. The market values of common and preferred stock improved dramatically, credit spreads returned to within sight of their pre-crisis levels for corporate bonds, and liquidity improved markedly across all markets. Access to the capital markets returned for most issuers, alleviating fears of liquidity driven defaults. Housing markets arrested their rapid declines and, by late in the year, showed signs of improving in some regions. Although these were positive developments, significant risks remain in the financial markets and U.S. economy. Employment markets weakened sharply early in the year and remained soft at year end. Inflation readings were subdued, as low levels of resource utilization and high unemployment provided no pressure for higher wages or prices. The Federal Reserve maintained their target of 0-0.25% for the overnight funds rate and stated that it was likely to remain at an exceptionally low level for an extended period. At year-end 2009, two-year and ten-year U.S. Treasury Notes were yielding 1.11% and 3.88%, respectively, compared to 0.74% and 2.21% at the end of 2008.

Approximately 75% of our preferred stock holdings are obligations of financial sector issuers. During 2009, we recorded $213.2 million of other-than-temporary impairment losses on our redeemable and nonredeemable preferred stocks. The write-downs were due to a combination of issuer fundamentals and severe market declines where we were unable to objectively determine that the securities would substantially recover in the near term. At year-end, we had a net unrealized gain of $555.0 million in our redeemable and nonredeemable financial sector preferred stock portfolio.

At December 31, 2009, we held approximately $164.4 million of sub-prime mortgage bonds, classified as home-equity bonds. In addition, we held $28.7 million of non-prime collateralized mortgage obligations (Alt-A securities). Together, these securities had net unrealized losses of $54.8 million at year-end 2009. During 2009, we recorded other-than-temporary impairment losses of $23.7 million on home-equity securities and $4.0 million on our Alt-A securities.

Our investment results provided a substantial contribution to the increase in our capital position. We ended 2009 with $7.9 billion of total capital (debt plus equity). We continue to manage our investing and financing activities in order to maintain sufficient capital to support all the insurance we can profitably underwrite and service.

II.   FINANCIAL CONDITION

A. Holding Company

In 2009, The Progressive Corporation, the holding company, received $1.1 billion of dividends, net of capital contributions made to subsidiaries. For the three-year period ended December 31, 2009, The Progressive Corporation received $2.6 billion of dividends from its subsidiaries, net of capital contributions. Regulatory restrictions on subsidiary dividends are described in Note 8 – Statutory Financial Information.

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Progressive’s debt-to-total capital (debt plus equity) ratios at December 31, 2009, 2008, and 2007 were 27.5%, 34.0%, and 30.6%, respectively. During the last three years, The Progressive Corporation did not retire any debt securities. In June 2007, we took actions to restructure our capital position, which included issuing $1 billion of 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067. See Note 4 – Debt for further discussion of our current outstanding debt. The plan also consisted of returning capital to shareholders through share repurchases and a special dividend of $2.00 per common share. The 2007 recapitalization plan is discussed in further detail in the Liquidity and Capital Resources section below.

During 2009, we repurchased 11,053,953 of our common shares. The total cost to repurchase these shares was $180.6 million, with an average cost of $16.34 per share. During the three-year period ended December 31, 2009, we repurchased 93,858,986 of our common shares at a total cost of $1.9 billion (average cost of $20.33 per share), including shares repurchased as part of our 2007 recapitalization plan.

Progressive maintains a policy of paying an annual variable dividend that, if declared, would be payable shortly after the close of the year. The annual variable dividend is based on a target percentage of after-tax underwriting income multiplied by a companywide performance factor (“Gainshare factor”), subject to the limitations discussed below. The target percentage is determined by our Board of Directors on an annual basis and announced to shareholders and the public. For 2007, 2008, and 2009, the Board determined the target percentage to be 20% of annual after-tax underwriting income. For 2010, the Board has determined the target percentage to be 25% of annual after-tax underwriting income.

The Gainshare factor can range from zero to two and is determined by comparing our operating performance for the year to certain predetermined profitability and growth objectives approved by the Board. This Gainshare factor is also used in the variable cash incentive program currently in place for our employees (referred to as our “Gainsharing program”). Although recalibrated every year, the structure of the Gainsharing program generally remains the same. For 2009, the Gainshare factor was .71, compared to .80 in 2008 and .74 in 2007.

Our annual variable dividend program is subject to certain limitations. If the Gainshare factor is zero or if our after-tax comprehensive income (net income plus the after-tax change in net unrealized gains (losses), among other factors) is less than after-tax underwriting income, no dividend will be paid.

During the last three years, we paid $1.5 billion in shareholder dividends. The annual variable dividends are intended to be paid at the beginning of the year subsequent to the date the Board of Directors declared the dividend. The dividend calculated based on 2009 underwriting results was declared by the Board in December 2009 and paid to shareholders in February 2010; the total amount of dividends was $108.5 million, or $.1613 per common share. No dividend was paid in 2009, based on 2008 results, reflecting the fact that we had an after-tax comprehensive loss of $614.7 million, despite reporting $477.7 million of after-tax underwriting income for the same period. In January 2008, we paid shareholder dividends of $98.3 million, or $.145 per common share, pursuant to a December 2007 declaration by our Board of Directors. In addition, in 2007, we returned $1.4 billion to shareholders via an extraordinary cash dividend of $2.00 per share as part of a recapitalization plan that took place during the year.

B. Liquidity and Capital Resources

Progressive’s insurance operations create liquidity by collecting and investing premiums from new and renewal business in advance of paying claims. As an auto insurer, our claims liabilities are generally short in duration. At any point in time, approximately 50% of our outstanding reserves are paid within the following twelve months and less than 15% are still outstanding after three years. See Claims Payment Patterns, a supplemental disclosure provided in this Annual Report, for further discussion on the timing of claims payments.

As of December 31, 2009, our consolidated statutory policyholders’ surplus was $5.0 billion, compared to $4.5 billion at December 31, 2008. Our net premiums written-to-surplus ratio was 2.8 to 1 at year-end 2009, compared to 3.0 at both year-end 2008 and 2007. We also have access to $2.2 billion in a non-insurance subsidiary, portions of which could be contributed to the capital of our insurance subsidiaries to support growth as needed. In addition, our risk-based capital ratios, which are a series of dynamic surplus-related formulas that contain a variety of factors that are applied to financial balances based on the degree of certain risks (e.g., asset, credit, and underwriting), are well in excess of minimum requirements. See Note 8 – Statutory Financial Information for any regulatory restrictions on subsidiary dividends.

 

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For the three years ended December 31, 2009, operations generated positive cash flow of $4.8 billion, and cash flows are expected to remain positive in both the short-term and reasonably foreseeable future. As of December 31, 2009, 80% of our portfolio was invested in U.S. Treasury Notes, municipal bonds, asset-backed securities, corporate debt, and short-term investments (Group II securities). In addition, our fixed-income portfolio duration was 2.3 years, with a weighted average credit quality of AA. At year end, we held $5.9 billion in short-term investments and U.S. Treasury securities. We believe that we have sufficient readily marketable securities to cover our claims payments without having a negative effect on our cash flows from operations.

Based upon our capital planning and forecasting efforts, we believe that we have sufficient capital resources, cash flows from operations, and borrowing capacity to support our current and anticipated business, scheduled principal and interest payments on our debt, and expected capital requirements. The covenants on our existing debt securities do not include any rating or credit triggers that would require an adjustment of the interest rate or an acceleration of principal payments in the event our securities are downgraded by a rating agency. We have no scheduled debt maturities until January 2012.

Progressive seeks to deploy capital in a prudent manner and uses multiple data sources and modeling tools to estimate the frequency, severity, and correlation of identified exposures, including, but not limited to, catastrophic losses and the business interruptions discussed below, to estimate our potential capital needs.

Management views our capital position as consisting of three layers, each with a specific size and purpose. The first layer of capital, which we refer to as “regulatory capital,” is the amount of capital we need to satisfy state insurance regulatory requirements and support our objective of writing all the business we can write and service, consistent with our underwriting discipline of achieving a 96 combined ratio. This capital is held within our various insurance entities.

The second layer of capital we call “extreme contingency.” While our regulatory capital is, by definition, a cushion for absorbing financial consequences of adverse events, such as loss reserve development, litigation, weather catastrophes, or investment market corrections, we view that as a base and hold additional capital for even more extreme conditions. The modeling used to quantify capital needs for these conditions is quite extensive, including tens of thousands of simulations, representing our best estimates of such contingencies based on historical experience. This capital is held either at the holding company or in our insurance entities, where it is potentially eligible for a dividend up to the holding company.

The third layer of capital is capital in excess of the sum of the first two layers and provides maximum flexibility to repurchase stock, consider acquisitions, and pay dividends to shareholders, among other purposes. This capital is largely held at the holding company.

At all times during the last two years, our total capital exceeded the sum of our regulatory capital layer plus our self-constructed extreme contingency load. However, in 2008, and through the first quarter 2009, the amount of capital in our third layer was diminished, principally due to decreased valuations for securities held in our investment portfolio. During this time, our capital management practices allowed us to manage our business without having to sell securities at values that we believed were below our long-term assessment of the value of the investments. At December 31, 2009, we held total capital (debt plus equity) of $7.9 billion at book value, compared to $6.4 billion at book value at December 31, 2008.

The speed by which the market valuations of the assets held in our portfolio can change is the basis for our ongoing review of portfolio risk. To help manage these risks and preserve our capital base, as of December 31, 2009, we held approximately $5.9 billion in short-term investments and U.S. Treasury securities. See Item 1A, “Risk Factors,” in our Form 10-K filed with the SEC for a discussion of certain matters that may affect our portfolio and capital position.

In order to provide liquidity in the event of disruptions in our cash management operations, such as disruptions in the financial markets, that could affect our ability to transfer or receive funds, we currently have a 364-Day Secured Liquidity Credit Facility Agreement with PNC Bank, National Association (PNC), successor to National City Bank. Under this agreement, we may borrow up to $125 million, which may be increased to $150 million at our request but subject to PNC’s discretion. Any borrowings under this agreement will be secured by a lien on certain marketable securities held in our investment portfolio. In addition, we deposited $125 million into an account at PNC in January 2009, to provide us with additional cash availability in the event of such a disruption to our cash management operations. Our access to these funds is unrestricted. However, if we withdraw funds from this account for any reason other than in connection with such a disruption in our cash management operations, the availability of borrowings under the PNC credit facility will be reduced on a dollar-for-dollar basis until such time as we replenish the funds to the deposit account. See Note 4 – Debt for further

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discussion of our credit facility and previous line of credit; there were no borrowings under these agreements during the last three years.

In 2007, we took efforts to restructure our capital position, which included the following components:

 

 

The payment of an extraordinary cash dividend of $2.00 per common share, or $1.4 billion.

 

 

A Board authorization for us to repurchase up to 100 million of our common shares prior to June 30, 2009. Prior to expiration, we only purchased 52.8 million shares; therefore, effective July 1, 2009, the Board of Directors authorized the repurchase of up to 50.0 million common shares. This new authorization does not have an expiration date.

 

 

The issuance of $1 billion of 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (the “Debentures”) on June 18, 2007. The proceeds of the offering were $987.3 million, before $1.5 million of expenses related to the issuance. In addition, upon issuance of the Debentures, we closed a forecasted debt issuance hedge, which was entered into to hedge against a possible rise in interest rates, and recognized a $34.4 million pretax gain as part of shareholders’ equity; this gain is being recognized as an adjustment to interest expense and amortized over 10 years, which represents the fixed interest rate period of the Debentures. See Note 4 – Debt for further discussion of the terms of the Debentures.

In connection with the issuance of the Debentures, we also entered into a Replacement Capital Covenant for the benefit of the holders of our 6.25% Senior Notes due 2032 (the “Covered Debt”). Under the Replacement Capital Covenant, we may not repay, redeem, or repurchase any of the Debentures prior to June 15, 2047 (or, if earlier, prior to the occurrence of certain events specified in the Replacement Capital Covenant), except to the extent that (subject to certain limitations) the amount to be repaid, redeemed, or purchased does not exceed a specified percentage of net cash proceeds from the sale to third parties of certain replacement capital securities (as defined in the Replacement Capital Covenant) plus the proceeds from the sale or issuance of common shares or certain qualifying warrants. The identity of the Covered Debt may be changed from time to time by the company upon the occurrence of certain events specified in, and in accordance with the requirements of, the provisions of the Replacement Capital Covenant. See our Current Report on Form 8-K, filed on June 22, 2007, for additional information and a copy of the Replacement Capital Covenant.

C. Commitments and Contingencies

Contractual Obligations

A summary of our noncancelable contractual obligations as of December 31, 2009, follows:

 

    Payments due by period
(millions)   Total    Less than
1 year
   1-3 years    3-5 years    More than
5 years

Debt

  $ 2,200.0    $    $ 350.0    $ 150.0    $ 1,700.0

Interest payments on debt

    1,562.8      144.7      278.2      234.2      905.7

Operating leases

    228.2      73.5      101.3      37.2      16.2

Purchase obligations

    132.3      61.2      59.1      4.9      7.1

Loss and loss adjustment expense reserves

    6,653.0      3,612.0      2,256.4      556.9      227.7
 

Total

  $ 10,776.3    $ 3,891.4    $ 3,045.0    $ 983.2    $ 2,856.7
       

Purchase obligations represent our noncancelable commitments for goods and services. Unlike many other forms of contractual obligations, loss and loss adjustment expense (LAE) reserves do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total loss and LAE reserve payments to be made by period, as shown above, are estimates based on our recent payment patterns. To further understand our claims payments, see Claims Payment Patterns, a supplemental disclosure provided in this Annual Report. In addition, we annually publish a comprehensive Report on Loss Reserving Practices, which was most recently filed with the SEC on a Form 8-K on June 25, 2009, that further discusses our claims payment development patterns.

We did not enter into any significant new contractual commitments outside the ordinary course of business during 2009. In 2008, we entered into two contracts to expand our brand building efforts. In January 2008, we entered into a 16-year contract for the ballpark naming rights and a sponsorship deal with the Cleveland Indians Major League Baseball team;

 

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portions of these contracts are cancelable. Over the contract term, Progressive will pay an average of approximately $3.6 million per year. In addition, in March 2008, we announced our title sponsorship of the Progressive Insurance Automotive X PRIZE competition. The Automotive X PRIZE is a two and one-half year international competition designed to inspire a new generation of safe, low emissions vehicles capable of achieving the equivalent of at least 100 miles per gallon in fuel efficiency. The total cost of the sponsorship is expected to be approximately $12.5 million, which includes both the prize for the winning teams and the funding of some operational expenses over the course of the competition. These expenditures are a reallocation of a small percentage of our annual media spend and are intended to generate greater exposure for our brand.

As discussed in the Liquidity and Capital Resources section above, we believe that we have sufficient borrowing capacity, cash flows, and other capital resources to satisfy these contractual obligations.

Off-Balance-Sheet Arrangements

Our off-balance-sheet leverage includes derivative positions and open investment funding commitments (as disclosed in Note 2 – Investments, Note 13 – Commitments and Contingencies and the Derivative Instruments section of this Management’s Discussion and Analysis). It also includes operating leases and purchase obligations (disclosed in the table above).

Other

We currently have no significant construction underway.

We completed construction of one new claims service center in 2009, two in 2008, and four in 2007; these projects were funded internally through operating cash flows. At December 31, 2009, we have a total of 54 centers that are available to provide concierge level claims service. The service centers are located in 41 metropolitan areas across the United States and serve as our primary approach to damage assessment and coordination of vehicle repairs at authorized auto repair facilities in these markets.

We maintain insurance on our real property and other physical assets, including coverage for losses due to business interruptions caused by covered property damage. However, the insurance will not compensate us for losses that may occur due to disruptions in service as a result of a computer, data processing, or telecommunications systems failure that is unrelated to covered property damage, nor will the insurance necessarily compensate us for all losses resulting from covered events. To help maintain functionality and reduce the risk of significant interruptions of our operations, we maintain back-up systems or facilities for certain of our principal systems and services. We still may be exposed, however, should these measures prove to be unsuccessful or inadequate against severe, multiple, or prolonged service interruptions or against interruptions of systems where no back-up currently exists. In addition, we have established emergency management teams, which are responsible for responding to business disruptions and other risk events. The teams’ ability to respond successfully may be limited depending on the nature of the event, the completeness and effectiveness of our plans to maintain business continuity upon the occurrence of such an event, and other factors beyond our control.

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III.  RESULTS OF OPERATIONS — UNDERWRITING

A. Growth

 

(millions)   2009      2008      2007  

NET PREMIUMS WRITTEN

       

Personal Lines

       

Agency

  $ 7,391.2      $ 7,322.3      $ 7,549.4  

Direct

    5,061.9        4,556.5        4,371.8  
   

Total Personal Lines

    12,453.1        11,878.8        11,921.2  

Commercial Auto

    1,533.9        1,704.8        1,828.9  

Other indemnity

    15.9        20.7        22.4  
   

Total underwriting operations

  $ 14,002.9      $ 13,604.3      $ 13,772.5  
         

Growth over prior year

    3      (1 )%       (3 )% 
         

NET PREMIUMS EARNED

       

Personal Lines