III. Results of Operations – UnderwritingA. Growth

Net premiums written represent the premiums generated from policies written during the period less any premiums ceded to reinsurers. Net premiums earned, which are a function of the premiums written in the current and prior periods, are earned as revenue over the life of the policy using a daily earnings convention.

Progressive experienced an increase in total written and earned premiums during 2009, as compared to declines in both 2008 and 2007. The increase in premiums, which we started to see during the latter part of 2008 and in 2009, reflects the increase in new applications and our efforts to increase retention, as well as other initiatives we have underway to help provide distinctive new auto business options (discussed below). The Commercial Auto business continues to be negatively affected by the economy, as many customers are insuring fewer vehicles and selecting less coverage, which is reflected in lower premiums in the last two years.

Policies in force, our preferred measure of growth, represents all policies under which coverage is in effect as of the end of the period specified. As of December 31, our policies in force were:

To analyze growth, we review new policies, rate levels, and the retention characteristics of our books of business. During the last three years, we experienced the following growth in new and renewal applications:

The increase in new applications for our Personal Lines business during 2009, as compared to 2008, reflects significant growth in our personal auto business applications, slightly offset by declines in our special lines products. Our Direct auto business saw a double-digit increase in new applications during 2009. Our Agency auto business also experienced an increase, albeit to a lesser extent than Direct. We have seen a surge in quoting activity in both our Agency and Direct businesses, but most notably in Direct business quotes obtained through the Internet. Although we are unable to definitively identify what is driving this increase, we believe that our advertising campaign, which incents customers to shop online, and our brand-building efforts, along with customers evaluating their choices in response to the current economy, may be contributors. The decrease in our new applications in our special lines products partially resulted from the significant decline in year-over-year motorcycle and scooter sales, which reflected more sales in 2008, when gas prices were higher, as compared to 2009. The decline in new applications for our Commercial Auto business reflects the economic downturn, particularly in the housing and construction sectors.

We have several initiatives underway aimed at providing consumers with distinctive new auto insurance options. During 2009, we continued the countrywide rollout of a program, which was introduced in 2008, called Name Your Price®, that allows Direct auto consumers to design a quote based on the price they would like to pay for their auto insurance; we then will tell them the level of coverage that price provides. As of year-end 2009, Name Your Price is available in 40 jurisdictions, including 32 states and the District of Columbia that rolled-out during the year. We plan to expand this program to the rest of the country during 2010.

We also rolled out a redesigned product model in our Agency auto business, which was designed to help improve competetiveness through further price segmentation, to an additional 22 states since the end of 2008, bringing the total number of states with this product to 35. We do not plan any additional rollout of this model since we have already begun shifting our focus to newer product models, which further refine our segmentation and incorporate the best design elements of the Agency and Direct auto products. During 2009, we introduced the latest product model in 3 states and we plan to continue the rollout to about 20-30 states in 2010.

In addition, during 2009, we expanded MyRate®, our usage-based insurance product, into 10 additional states. This product is now available to Direct auto customers in a total of 19 states and Agency auto customers in 10 of the 19 states. During 2010, we plan to continue expansion of MyRate into about 15 additional states depending on regulatory approval and business results.

We are also continuing with our efforts to further penetrate customer households through cross-selling products. Progressive Home Advantage®, our program in which we “bundle” our auto product with property insurance provided by one of three unaffiliated insurance carriers, is becoming an integral part of our consumer offerings and is currently available to Agency customers in 41 states and Direct customers in 48 states and the District of Columbia; this program is not available to Direct customers in Florida and Alaska. In addition, we are focused on selling auto policies to our special lines customers and vice versa. These multi-product customers are an important part of our strategic agenda, since they tend to stay with us longer, have better loss experience, and represent a sizable segment of the market.

During 2009, total personal auto written premium per policy decreased 2%, despite a modest increase in rates for the year, primarily reflecting shifts in the mix of business. On a year-over-year basis, our Agency auto business experienced a 1% increase in premium per policy on new business and was relatively flat on renewal business. Our Direct auto premium per policy was down about 7% on new business and 3% on renewals, as compared to last year. The decrease in our Direct auto premium per policy primarily reflects mix shifts (e.g., age of drivers, existence of prior insurance, and driving records). We believe our pricing levels are aligned with our profitability targets, but we remain ready to react quickly, and as often as necessary, should trends change. In 2008 and 2007, our total auto written premium per policy was down 2% and 5%, respectively, compared to the prior year, due to rate reductions taken in mid-2006 and into 2007. Our Commercial Auto written premium per policy decreased in each of the last three years. This business is continuing to be affected by the economic downturn as our Commercial Auto customers are selecting less coverage and insuring fewer vehicles.

Another important element affecting growth is customer retention. One measure of retention is policy life expectancy, which is our actuarial estimate of the average length of time that a policy will remain in force before cancellation or lapse in coverage. Our policy life expectancy measures for our Agency and Direct personal auto products are now higher than the same measures a year ago by approximately 2% and 3%, respectively, while the special lines products policy life expectancy was down 3%. Our policy life expectancy in our Commercial Auto business remained flat, compared to the end of 2008. Our policy life expectancy for both Agency and Direct personal auto products increased in both 2008 and 2007, while Commercial Auto was down in 2008 and was relatively flat for 2007, compared to 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.

B. ProfitabilityProfitability for our underwriting operations is defined by pretax underwriting profit, which is calculated as net premiums earned less losses and loss adjustment expenses, policy acquisition costs, and other underwriting expenses. We also use underwriting profit margin, which is underwriting profit expressed as a percentage of net premiums earned, to analyze our results. For the three years ended December 31, our underwriting profitability measures were as follows:

Our underwriting margins in 2009 reflect favorable prior accident year development, compared to unfavorable development in both 2008 and 2007. In addition, in 2009, we experienced fewer losses from catastrophes as compared to 2008 when we incurred losses from hurricanes Ike and Gustav, and hail storms and floods in the Midwest and Great Plains.

Further underwriting results for our Personal Lines business, including its channel components, the Commercial Auto business, and other indemnity businesses, as defined in Note 10 – Segment Information, were as follows:

Losses and Loss Adjustment Expenses (LAE)

Claims costs, our most significant expense, represent payments made, and estimated future payments to be made, to or on behalf of our policyholders, including expenses needed to adjust or settle claims. These costs include an estimate for costs related to assignments, based on current business, under state-mandated automobile insurance programs for risks that cannot obtain insurance in the voluntary market; these assignments represent a very small portion of our total reserves. Claims costs are a function of loss severity and frequency and are influenced by inflation and driving patterns, among other factors. Accordingly, anticipated changes in these factors are taken into account when we establish premium rates and loss reserves. Our reserves would differ if the underlying assumptions were changed. See the Critical Accounting Policies for a discussion of the effect of changing estimates.

In 2009, the loss and LAE ratio decreased 2.8 points over last year, which includes favorable prior year accident year development, compared to unfavorable development in 2008 (discussed below) and lower catastrophe losses. Catastrophe losses from 2009 storms contributed 0.7 points to our loss/LAE ratio, compared to 1.2 points in 2008, and 0.3 points in 2007. The large amount of catastrophe losses in 2008 primarily related to hurricanes Ike and Gustav, and hail storms and floods in the Midwest and Great Plains.

The following discussion on our severity and frequency trends excludes the impact from comprehensive coverage due to the volatility related to certain types of losses, such as catastrophe losses and glass claims.

During 2009, total personal auto incurred severity (i.e., average cost per claim, including both paid losses and the change in reserves), excluding comprehensive coverage, was relatively flat compared to 2008, but increased about 3% in 2008 and 4% in 2007, over the prior year periods. The decrease in severity we experienced in the property coverages in 2009 was offset by an increase in personal injury protection (PIP) severity; bodily injury severity remained relatively flat. The overall increase in severity in both 2008 and 2007 was primarily from increases in both bodily injury and PIP coverages, while the severity for the property coverages in total was relatively flat. It is difficult to estimate future severity, especially for bodily injury and PIP claims, but we continue to monitor changes in the underlying costs, such as medical costs, jury verdicts, and regulatory changes, which may affect severity. The severity we experience will also vary relative to the change in our mix of business by policy limits and coverages.

Our incurred auto accident frequency on a calendar-year basis decreased less than 0.5% in 2009, over the prior year, with decreases in the property coverages offset by increases in our bodily injury and PIP coverages. We experienced a decline in year-over-prior year auto accident frequency in 2008, while frequency was relatively flat in 2007, compared to the prior year. We cannot predict with any certainty the degree or direction of frequency change that we will experience in the future. We continue to analyze trends to distinguish changes in our experience from external factors, such as changes in the number of vehicles per household, miles driven, gasoline prices, greater vehicle safety, and unemployment rates, versus those resulting from shifts in the mix of our business.

The table below presents the actuarial adjustments implemented and the loss reserve development experienced in the years ended December 31:

Total development consists both of actuarial adjustments and “all other development.” The actuarial adjustments represent the net changes made by our actuarial department to both current and prior accident year reserves based on regularly scheduled reviews. Through these reviews, the actuaries have the ability to identify and measure variances in frequency and severity trends and adjust the reserves to reflect the current costs. We report these actuarial adjustments separately for the current and prior accident years to show the impact of these changes on the prior accident years development.

“All other development” represents claims settling for more or less than reserved, emergence of unrecorded claims at rates different than reserved, and changes in reserve estimates on specific claims. Although we believe that the development from both the actuarial adjustments and “all other development” generally results from the same factors, as discussed below, we are unable to quantify the portion of the reserve development that might be applicable to any one or more of those underlying factors.

As reflected in the table above, we experienced favorable reserve development in 2009, compared to unfavorable total development in 2008 and 2007. The favorable development in 2009 is primarily attributable to favorable development for accident year 2008 and accident years 2006 and prior. For 2008, the unfavorable development is heavily weighted towards claims from the 2006 accident year with favorable development for periods older than that. The prior year loss reserve development for 2007 primarily also reflected unfavorable development from accident years greater than one year old (i.e., accident year 2005 and prior).

In 2009, approximately 90% of the favorable reserve development was attributable to our personal auto and Commercial Auto products, with each contributing nearly equal amounts. The balance of the favorable development was primarily from our special lines products. The total prior year loss reserve development in 2008 and 2007 principally arose in our Commercial Auto business for both years, while our Personal Lines business, in the aggregate, experienced little or no development for these years.

Changes in our estimate of severity from what we originally expected when establishing the loss and LAE reserves is the principal cause of prior accident year development. These changes in estimates are the result of what we observed in the underlying data as it developed. The Personal Lines case loss reserves saw minimal development during the year, which is a change from the unfavorable development of the prior two years. The favorable development we experienced in our total Personal Lines business in 2009 was primarily related to lower than expected defense and cost containment costs, which reflects less use of outside defense attorneys, due to new procedures implemented in our claims organization, as well as increased utilization of our in-house counsel. The favorable development in our Commercial Auto business was primarily due to favorable settlements on larger losses. During 2008 and 2007, we experienced unfavorable reserve development after several years of recognizing favorable development. The majority of the development in 2008 was driven by bodily injury severity on the late reported Commercial Auto claims in both the business auto and specialty truck markets, as well as personal auto PIP losses, with primarily two states experiencing the majority of the unfavorable PIP development for the year. The development in 2007 was driven by the unfavorable settlement of several outstanding lawsuits and the emergence of more than expected large losses from prior years, along with the reviews of larger bodily injury and uninsured motorist claims.

We continue to focus on our loss reserve analysis, attempting to enhance accuracy and to further our understanding of our loss costs. A detailed discussion of our loss reserving practices can be found in our Report on Loss Reserving Practices, which was filed in a Form 8-K on June 25, 2009.

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

Underwriting ExpensesProgressive’s other underwriting expenses and policy acquisition costs as a percentage of premiums earned have been fairly consistent over the last three years. On a year-over-year basis, we saw an increase in our advertising expenditures in each of the last three years. Despite an increase in advertising expenditures, in 2009 and 2008 we saw a decrease in our average costs per policy on a year-over-year basis, reflecting improved customer retention and a solid increase in companywide policies in force per employee, as well as a focus on process improvements to help reduce expenses (e.g., moving customers to a paperless environment). In accordance with GAAP, policy acquisition costs are amortized over the policy period in which the related premiums are earned (See Note 1 – Reporting and Accounting Policies). We do not defer any direct-response advertising costs.

C. Personal Lines

Progressive’s Personal Lines business writes insurance for personal autos and recreational vehicles, and represented 89% of our total net premiums written in 2009, compared to 87% for both 2008 and 2007. We currently write our Personal Lines products in all 50 states and our personal auto product in the District of Columbia. In December 2009, we began offering our personal auto product on an Internet-only basis in Australia. In mid-2008, we began offering our personal auto product and boat insurance to Direct Internet customers in Massachusetts. In April 2009, we expanded our offerings in Massachusetts to include motorcycle and RV insurance; these products are available online, over the phone, and through a small number of independent agents. Over time, we expect more products and buying options will be introduced in Massachusetts as we continue to grow in the market.

Personal auto represented 90% of our total Personal Lines net premiums written in each of the past three years. These auto policies are primarily written for 6-month terms. The remaining Personal Lines business is comprised of special lines products (e.g., motorcycles, watercraft, and RVs), which are written for 12-month terms. Personal auto policies in force increased 5% for 2009 and 2% for both 2008 and 2007; policies in force for the special lines products increased 3% in 2009, 7% in 2008, and 8% in 2007. Net premiums written for personal auto increased 5% in 2009 and declined 1% and 3% in 2008 and 2007, respectively; special lines net premiums written grew 4% in both 2009 and 2008 and 5% in 2007.

Our total Personal Lines business generated combined ratios of 92.4, 94.6, and 93.0 in 2009, 2008, and 2007, respectively. The strong underwriting results in 2009 were widely distributed by product and state. In 2009, 45 states, and the District of Columbia, were profitable for our personal auto business, including 9 of our 10 largest auto business states. The special lines products had a favorable effect on the total Personal Lines combined ratio of approximately one point in both 2009 and 2007, compared to about 0.5 points in 2008, which reflects the higher catastrophe losses affecting these products in 2008.

Even though our Agency and Direct businesses are managed under one Personal Lines organization, we will continue to report our Agency and Direct business results separately as components of our Personal Lines segment to provide further understanding of our products by channel.

The Agency Business

The Agency business includes business written by the more than 30,000 independent insurance agencies that represent Progressive, as well as brokerages in New York and California. During 2009, we saw new Agency auto application growth in 29 states; however, some of our big states did not see this growth during the year. Beginning in 2007 and throughout 2008, we restricted business in New York and California. In New York, we introduced a new product design in January 2009 and were able to lift the remaining restrictions on writing some classes of new business. In California, during the third quarter 2009, we introduced a new product, which includes lower auto rate levels and enhanced segmentation; the new plan is attracting a favorable mix of customers.

On a year-over-year basis, written premium per policy on total Agency auto business was flat in 2009, compared to decreases of 2% in 2008 and 4% in 2007. The declines in 2008 and 2007 were primarily attributable to declines in written premium per policy on renewal auto business, and reflected rate reductions taken in 2006 and 2007. For both 2009 and 2008, we saw a slight increase, on a year-over-year basis, in our Agency auto written premium per policy on new business.

Within the Agency business, we are continuing to see a shift from traditional agent quoting to quotes generated through third-party comparative rating systems, where our rates are quoted more often, but the conversion rate (i.e., converting a quote to a sale) is significantly lower. Year-over-year, the rate of conversion (i.e., converting a quote to a sale) was down in each of the past three years, on an increase each year in the number of Agency auto quotes. Although the rate of conversion was down in 2009, the rate of decline was significantly less than in 2008, primarily reflecting our increased competitiveness as some competitors are raising rates and the rollout of our new product models. In addition, we believe the increase in quoting activity reflects increased consumer shopping and our efforts with agents to make our competitive alternatives more visible.

The underwriting expense ratio in our Agency business has remained relatively consistent over the last three years. Improved customer retention and cost saving efforts helped keep expenses in line.

The Direct Business

The Direct business includes business written directly by Progressive online and over the phone. In 2009, as compared to 2008, 48 states, including 9 of our top 10 states, and the District of Columbia, experienced an increase in new Direct auto applications. Internet sales continue to be the most significant source of new business that is initiated in the Direct channel.

Written premium per policy for total Direct auto was down about 4% for both 2009 and 2008 and 6% in 2007, compared to the prior year, reflecting decreases in written premium per policy on new auto business and more modest decreases on renewal auto business. In 2009 and 2008, a shift in the mix of business (e.g., age of drivers, proof of prior insurance) offset the rate increases taken in both years. In 2007, the decline reflected rate decreases taken at that time.

On a year-over-year basis, the total number of quotes in the Direct business increased in both 2009 and 2008, reflecting an increase in Internet quotes due to more effective advertising, an increase in consumer shopping in 2009, and our entry into Massachusetts in 2008. In 2007, the total number of quotes decreased with less quotes from both the phone and Internet.

We are continuing to see the Internet becoming a greater portion of our Direct business mix, which historically has had a lower conversion rate than phone. Nonetheless, the conversion rate for Internet-initiated quotes has improved in each of the last three years, while the conversion rate for phone-initiated business increased in 2009 and 2007, but was down in 2008.

We saw our total advertising expenditures increase on a year-over-year basis in each of the last three years. We continue to work toward achieving our key objective of having our efforts in marketing and other brand-building activities match our competency in other technical skills, such as pricing and claims handling. In 2008, we launched a new advertising campaign, which provides a consistent identity and serves as a foundation for delivery of our many messages. Despite the higher advertising spend, we saw lower average total costs per policy in each of the last three years, due to greater efficiency.

D. Commercial Auto

Progressive’s Commercial Auto business writes primary liability and physical damage insurance for automobiles and trucks owned by small businesses, with the majority of our customers insuring three or fewer vehicles. Our Commercial Auto business represented 11% of our total net premiums written in 2009, compared to 13% for both 2008 and 2007. This business is primarily distributed through independent agents and operates in the business auto and specialty truck markets. The business auto market, which accounts for slightly more than half of our total Commercial Auto premiums and approximately 60% of the vehicles we insure, includes autos, vans, and pick-up trucks used by artisans, such as contractors, landscapers, and plumbers, and a variety of other small businesses. The remainder is in the specialty truck commercial auto market, which includes dump trucks, logging trucks, tow trucks, local cartage, and other short-haul commercial vehicles.Both of these markets have been significantly affected by the downturn in the economy, as well as increased competition in the commercial auto business.

We currently write our Commercial Auto business in 49 states; we do not write Commercial Auto in Hawaii or the District of Columbia. The majority of our policies in this business are written for 12-month terms.

As compared to the prior year, total written premium per policy decreased about 7%, 4%, and 6% in 2009, 2008, and 2007, respectively. Although we have been increasing rates in our Commercial Auto business, written premium per policy is decreasing due to customers selecting less coverage and insuring fewer vehicles. The economic downturn during the last two years has had a significant effect on our Commercial Auto business growth.

Commercial Auto’s expense ratio decreased slightly during 2009, but increased in 2008 and 2007. The lower amount of premiums earned contributed to higher expense and combined ratios in 2008 and 2007. Also, in 2007, we made significant investments in agency distribution and direct marketing capabilities in this business.

Although Commercial Auto differs from Personal Lines auto in its customer base and products written, both businesses require the same fundamental skills, including disciplined underwriting and pricing, as well as excellent claims service. Since the Commercial Auto policies have higher limits (up to $1 million) than Personal Lines auto, we analyze the large loss trends and reserving in more detail to allow us to react quickly to changes in this exposure.

E. Other Indemnity Our other indemnity businesses, which represented less than 1% of our net premiums written in each of the last three years, primarily include writing professional liability insurance for community banks, principally directors and officers liability insurance. The program, sponsored by the American Bankers Association (ABA), insures over 1,600 banks, representing every state. In addition, our other indemnity businesses include managing our run-off businesses.

We have entered into an agreement to sell our community bank program to an ABA affiliate. The transaction is expected to close during the first half of 2010. As an interim measure, effective August 1, 2009, we began reinsuring 100% of this risk with another carrier. Prior to August 1, 2009, we reinsured the majority of the risk on the professional liability insurance coverages with a small mutual reinsurer controlled by its bank customers and various other reinsurance entities. The sale of this business will not have a material effect on our financial condition, results of operations, or cash flows.

F. Service Businesses Our service businesses provide insurance-related services and represented less than 1% of our total revenues for each of the last three years and do not have a material effect on our overall operations.

Our principal service business is providing policy issuance and claims adjusting services for the Commercial Auto Insurance Procedures/Plans (CAIP), which are state-supervised plans serving the involuntary market in 43 states. We have previously competed with two other carriers for the majority of the CAIP market. However, both of these other carriers withdrew, leaving us as the largest CAIP provider countrywide. Although our market share increased, we did not realize an increase to revenues as the downturn in the CAIP market continues. As a service provider, we collect fee revenue that is earned on a pro rata basis over the term of the related policies. We cede 100% of the premiums and losses to the plans. Reimbursements to us from the CAIP plans are required by state laws and regulations. Material violations of contractual service standards can result in ceding restrictions for the affected business. We have maintained, and plan to continue to maintain, compliance with these standards. Any changes in our participation as a CAIP service provider would not materially affect our financial condition, results of operations, or cash flows.

Our service businesses also include our alliance with three unaffiliated homeowner insurance companies. Through Progressive Home Advantage®, we act as an agent to offer new and existing Progressive customers home, condo, and renters insurance underwritten by these homeowner’s insurance companies. Commissions received from this business are used to mitigate the underwriting expenses associated with maintaining this program. This program is available to our Personal Lines customers in 48 states and the District of Columbia; it is not currently available in Alaska or Florida.

Our service businesses generated an operating loss in 2009 and 2008 and a slight profit in 2007, reflecting the continuing downturn in the involuntary commercial auto market.

G. 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, various Progressive entities are named as defendants in a number of class action or individual lawsuits arising out of the operations of the insurance subsidiaries. These cases include those alleging damages as a result of our use of credit in underwriting and related requirements under the federal Fair Credit Reporting Act; practices in evaluating or paying medical or injury claims or benefits, including, but not limited to, personal injury protection, medical payments, uninsured motorist/underinsured motorist (UM/UIM), and bodily injury benefits; rating practices at policy renewal; the utilization, content, or appearance of UM/UIM rejection forms; the practice of taking betterment on boat repairs; labor rates paid to auto body repair shops; and cases challenging other aspects of our claims or marketing practices or other business operations. Other insurance companies face many of these same issues. During the last three years, we have settled several nationwide or statewide class action lawsuits. These settlements did not have a material effect on our financial condition, cash flows, or results of operations. See Note 12 – Litigation for a more detailed discussion.

H. Income Taxes As reported in the balance sheets, income taxes are comprised of net current income taxes recoverable and net deferred tax assets and liabilities. A deferred tax asset/liability is a tax benefit/expense that is expected to be realized in a future tax return. At both December 31, 2009 and 2008, our income taxes were in a net asset position.

Our net deferred tax asset was $420.0 million at December 31, 2009, compared to $793.3 million at December 31, 2008. The decrease in the deferred tax asset since December 31, 2008 is primarily due to the net unrealized gains generated in our investment portfolio since that date. Management believes that it is more likely than not that the entire amount of the deferred tax asset will ultimately be realized; therefore, we have not recorded any valuation allowance against the deferred tax asset at December 31, 2009 and 2008. For a complete discussion of our deferred tax assets, see the Critical Accounting Policies – Deferred Tax Assets section.

There have been no material changes in our uncertain tax positions during 2009.

See Note 5 – Income Taxes for further information.