The Progressive Corporation 2009 Annual Report

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.

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:

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.

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

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:

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.

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:

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.

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

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

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:

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.

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.