The Progressive Corporation 2009 Annual Report

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.

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.

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 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:

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; 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.