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PROGRESSIVE CORP/OH/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) I. OVERVIEW During the third quarter 2014, The Progressive Corporation's insurance subsidiaries generated net premiums written and policies in force growth of 6% and 2%, respectively, on a year-over-year basis. Net income for the third quarter was $296.1 million, or $.50 per share, up from $232.4 million, or $.39 per share, in the third quarter 2013. The 27% increase in net income reflects underwriting profitability of 7.5%, or $339.8 million, for the quarter, 1.7 points better than last year. The improved results were attributable primarily to higher profitability in Commercial Lines, and to a lesser extent in our Personal Lines business. Net realized gains on our investment portfolio were $38.2 million for the third quarter 2014, compared to $27.9 million in the third quarter last year. Our pretax investment income, excluding realized gains and losses and net of investment expenses, was down 4% on a quarter-over-prior-year quarter basis, due to lower yields year over year. Comprehensive income, which includes the impact of both realized and unrealized gains and losses, was down 20% over the third quarter last year, primarily due to much lower equity market returns in the third quarter 2014, compared to the high returns in the same period last year. At September 30, 2014, our total capital position (debt plus equity) was $9.1 billion, compared to $9.0 billion at June 30, 2014. A. Operations During the third quarter 2014, we realized an increase in net premiums written of 6% on a companywide basis, compared to the prior year period, reflecting growth in all of our businesses. Our Agency and Direct Personal Lines businesses grew 3% and 11%, respectively, and our Commercial Lines business increased 6%. To analyze growth, we review written premium per policy (e.g., rates), new business applications (i.e., issued policies), and customer retention. For the third quarter, on a year-over-year basis, written premium per policy increased 5% in our Agency auto business, 4% in our Direct auto business, 4% in our Commercial Lines business, and 1% for our special lines products. The increases resulted from both rate changes and shifts in our mix of business. Overall, our rates are up slightly year over year, with most of the rate increases taken in the first half of 2014. Adjusting rates is an ongoing process. We will continue to evaluate future rate needs and react quickly as we recognize loss cost trends at the state level. Personal Lines new applications for the third quarter decreased 3%, compared with the same period last year, reflecting a 14% decrease for our Agency auto business, partially offset by increases of 7% and 1% for our Direct auto business and special lines products, respectively. The decline in new business in Agency auto was due in part to rate and underwriting actions we took early in 2014 in several states to meet margin targets, as well as actions by our competitors to increase their competitiveness in the marketplace. Our Commercial Lines new applications increased 3%, driven by slight rate decreases taken during the quarter, as well as the lifting of some of the underwriting restrictions we had previously implemented. During the third quarter 2014, our renewal applications increased 4% in Personal Lines and declined 1% in Commercial Lines. The primary contributor to the Personal Lines increase was our Direct auto business renewal applications, which grew 7%, while Agency auto and special lines renewal applications were up 1% and 3%, respectively. We have several initiatives in place to help stimulate growth and provide consumers with distinctive insurance options, including: • Snapshot®, our usage-based insurance program - we continued with our marketing campaign to communicate the benefits of Snapshot in a way we believe will help demonstrate the advantages to consumers, such as the ability to better manage their insurance costs byexhibiting safe driving habits. • Expansion of our mobile acquisition capabilities - now that our technology is able to provide the capability for almost all combinations of cars and drivers to be quoted on a mobiledevice, we are continuing with our efforts to provide people theopportunity to transact all their business with us on any device they choose (e.g., smartphone, tablet). • Multi-product penetration - our relationships withnon-affiliated homeowner insurance carriers continue to grow, as many of our customers now bundle auto and property coverages. To further develop our bundling strategy, we are now writing our own renters insurance product through our Agency channel in two states. • Refinement of our core product design - we continually look for ways to provide consumers with distinctive auto insurance options. We expect to begin the roll out of the next generation of our auto program in December, which will include, among other features, modifying our approach to pricing preferred customers and to our Snapshot offering. 31-------------------------------------------------------------------------------- On a companywide basis, year-over-year, policies in force grew 2%, with Personal Lines growing 2% and Commercial Lines down 1%. Our Direct auto business grew 7%, our Agency auto business declined 1%, and our special lines policies grew 1% over last year. We ended the third quarter with 13.3 million Personal Lines policies in force, up about 264,400 policies in force from the third quarter 2013, but down 41,100 policies in force from the end of the second quarter 2014. To further grow policies in force, it is critical that we retain our customers for longer periods. Consequently, increasing retention is one of our most important priorities, and our efforts to increase the number of multi-product households continues to be a key initiative to support that goal. 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, is one measure of customer retention. We have historically disclosed our changes in policy life expectancy using a trailing 12-month period since we believe this measure is indicative of recent experience, mitigates the effects of month-to-month variability, and addresses seasonality. Using a trailing 12-month measure, policy life expectancy was flat for our Agency auto business and increased 6% for our Direct auto business, on a year-over-year basis. Our policy life expectancy for our special lines products decreased 1% and decreased 3% for our Commercial Lines business compared to last year. Last quarter we began to disclose policy life expectancy for our personal auto products using a trailing 3-month measure. Although using a trailing 3-month measure does not address seasonality and can create more volatility, this measure is more responsive to current experience and can be an indicator in how our retention rates are moving. Our trailing 3-month policy life expectancy, on a year-over-year basis, was up 1% in Direct auto and down 6% in Agency auto resulting from increased rate competitiveness in the Agency channel along with various actions we took to restrict writing unprofitable business. B. Investments and Capital Management The fair value of our investment portfolio was $19.1 billion at September 30, 2014. Our asset allocation strategy is to maintain 0%-25% of our portfolio in Group I securities, with the balance (75%-100%) of our portfolio in Group II securities. We define Group I securities to include: • common equities • nonredeemable preferred stocks • redeemable preferred stocks, except for 50% of investment-grade redeemable preferred stocks with cumulative dividends, which are included in Group II, and • all other non-investment-grade fixed-maturity securities Group II securities include: • short-term securities, and • all other fixed-maturity securities, including 50% of the investment-grade redeemable preferred stocks with cumulative dividends We use the credit ratings from models provided by the National Association of Insurance Commissioners (NAIC) for classifying our residential and commercial mortgage-backed securities (excluding interest-only securities), and credit ratings from nationally recognized statistical rating organizations (NRSRO) for all other debt securities, in determining whether securities should be classified as Group I or Group II. At September 30, 2014, 21% of our portfolio was allocated to Group I securities and 79% to Group II securities, compared to 22% and 78%, respectively, at December 31, 2013. Our investment portfolio produced a fully taxable equivalent (FTE) total return of 0.3% for the third quarter 2014, compared to 1.3% for the third quarter 2013. Our common stock and fixed-income portfolios both contributed to these total returns with FTE returns of 0.2% and 0.3%, respectively, for the third quarter 2014, and 6.3% and 0.6%, respectively, for the third quarter 2013. The overall decrease is primarily the result of the decline in the equity market. At both September 30, 2014 and 2013, the fixed-income portfolio had a weighted average credit quality of AA-. We maintain our fixed-income portfolio strategy of investing in high-quality, liquid securities. Our recurring investment income generated a pretax book yield of 2.3% during the third quarter 2014, compared to 2.6% during the third quarter 2013. The decrease in yield from third quarter 2013 to 2014 was the result of investing new money, including reinvestment of cash, in short duration paper with lower yields, a slight decrease in our portfolio duration, which included an increase in the amount of short-term paper we hold, and some sales of higher book yield securities at realized gains. At September 30, 2014, our duration was 1.6 years, compared to 2.0 years at September 30, 2013. We remain confident in our preference for shorter duration positioning during times of low interest rates as a means to limit any decline in portfolio value from an increase in rates, and we expect long-term benefits from any return to more substantial yields. At September 30, 2014, we held $20.2 million in Australian government obligations to support our Australian operations, as well as $150.0 million in commercial paper issued by two Canadian provinces, included as part of our short-term investments; we held no other foreign sovereign debt. As of that date, we also held $505.2 million of U.S. dollar-denominated corporate bonds and nonredeemable preferred stocks issued by companies that are domiciled, or whose parent companies are domiciled, 32 -------------------------------------------------------------------------------- in European countries. Of these securities, $78.8 million are U.K.-domiciled financial institution nonredeemable preferred stocks and $426.4 million are corporate bonds from U.K. and other European companies primarily in the consumer, industrial, energy, and communications industries. In total, our European-domiciled fixed-income securities represented approximately 3% of our portfolio at September 30, 2014. We manage our investing and financing activities in order to maintain sufficient capital to support all of the insurance we can profitably write and service. Our total capital position was $9.1 billion at September 30, 2014, compared to $8.1 billion at December 31, 2013. II. FINANCIAL CONDITION A. 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. Operations generated positive cash flows of about $1.7 billion for the first nine months of both 2014 and 2013. We held total capital (debt plus equity) of $9.1 billion, at book value, at September 30, 2014, compared to $8.8 billion and $8.1 billion at September 30, 2013 and December 31, 2013, respectively. Our debt-to-total capital ratio was 23.8%, 22.8%, and 23.1% at September 30, 2014 and 2013, and December 31, 2013, respectively, reflecting the impact of a debt issuance and debt extinguishments during the last 12 months. As discussed below, during the third quarter 2014, we repurchased $44.3 million of our outstanding debt in the open market, compared to $54.1 million during the third quarter 2013. In addition, during the fourth quarter 2013, we retired all $150 million of our 7% Notes at maturity. We financed these transactions through available cash. During the second quarter 2014, we issued $350 million of our 4.35% Senior Notes due 2044 in an underwritten public offering. We received net proceeds, after deducting underwriter's discounts and commissions and other expenses related to the issuance, of approximately $345.6 million, which were added to our investment portfolios. We issued this debt to take advantage of attractive terms in the market. We plan to use these funds for general corporate purposes, which may include the repurchase of our outstanding securities and repayment or redemption of outstanding indebtedness, among other uses. Year-over-year, interest expense was relatively flat for the third quarter 2014, and down 5% for the first nine months of 2014, reflecting lower average interest rates on our outstanding debt. 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, any declared dividends, and other 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 seek to deploy capital in a prudent manner and use multiple data sources and modeling tools to estimate the frequency, severity, and correlation of identified exposures, including, but not limited to, catastrophic and other insured losses, natural disasters, and other significant business interruptions, 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 combined ratio of 96 or better. This capital is held by 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, and 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 a non-insurance subsidiary of the holding company or in our insurance entities, where it is potentially eligible for a dividend up to the holding company. Regulatory restrictions on subsidiary dividends are discussed in Note 8 - Statutory Financial Information in our Annual Report to Shareholders for the year ended December 31, 2013, which is included as Exhibit 13 to our Annual Report on Form 10-K. 33-------------------------------------------------------------------------------- • The third layer of capital is capital in excess of the sum of the first two layers and provides maximum flexibility to repurchase stock or other securities, consider acquisitions, and pay dividends to shareholders, among other purposes. This capital is largely held at a non-insurance subsidiary of the holding company. During the first nine months of 2014 and at all times during 2013, our total capital exceeded the sum of our regulatory capital layer plus our self-constructed extreme contingency layer. The amount of capital in our third layer allowed us to take several actions to deploy underleveraged capital, including: • Repurchases of our outstanding debt securities. From time to time, we may elect to repurchase our outstanding debt securities in the open market or in privately negotiated transactions, reducing our future interest expense, when management believes that such securities are attractively priced and capital is available for such a purpose. During the third quarter 2014 and 2013, werepurchased, in the open market, $44.3 million and $54.1 million, respectively, in principal amount of our 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (the "6.70% Debentures"). Since the amounts paid exceeded the carrying value of the debt werepurchased, we recognized losses on these extinguishments of $4.8 million in 2014 and $4.3 million last year. • Repurchases of our common shares. In accordance with our financial policies, we continued our practice of repurchasing our common shares. As of September 30, 2014, we had 21.5 million shares remaining under our 2011 Board repurchase authorization. The following table shows our share repurchase activity during the respective periods: Three Months Ended September 30, Nine Months Ended September 30, (millions, except per share amounts) 2014 2013 2014 2013 Total number of shares purchased 3.9 1.5 9.6 6.8 Total cost $ 94.7 $ 38.1 $ 234.7 $ 164.8 Average price paid per share $ 24.60 $ 25.32 $ 24.48 $ 24.35 • Dividends. As part of our capital management activities, in February 2014 and 2013, we paid annual variable dividends of $.4929 per share and $.2845 per share, respectively, which were each declared in December of the prior year. In addition to the annual variable dividend, the Board of Directors declared a $1.00 per common share special dividend in December 2013, which was paid in February 2014. Short-Term Borrowings We did not engage in short-term borrowings to fund our operations or for liquidity purposes during the nine months ended September 30, 2014 or at any point in 2013. As discussed above, our insurance operations create liquidity by collecting and investing insurance premiums in advance of paying claims. Information concerning our insurance operations can be found below under Results of Operations-Underwriting, and details about our investment portfolio can be found below under Results of Operations-Investments. During the first quarter 2014, we renewed the unsecured, discretionary line of credit with PNC Bank, National Association ("PNC") in the maximum principal amount of $100 million. The prior line of credit, which was entered into during the first quarter 2013, has expired. The Line of Credit is on substantially the same terms and conditions as the prior line of credit. All advances under this agreement are subject to PNC's discretion, would bear interest at a variable, daily rate, and must be repaid on the earlier of the 30th day after the advance or the expiration date of the facility, March 25, 2015. We had no borrowings under either line of credit during the first nine months of 2014 or throughout 2013. We had no open repurchase commitments at September 30, 2014 or 2013 or December 31, 2013. We did not enter into any repurchase commitment transactions during the first nine months of 2014. During the first nine months of 2013, we entered into repurchase commitment transactions for 48 days, including 34 days during the third quarter 2013. In these transactions, we loaned U.S. Treasury securities to internally approved counterparties in exchange for cash equal to the fair value of the securities, as described in more detail below under Results of Operations - Investments; Repurchase and Reverse Repurchase Transactions. These investment transactions were entered into to enhance the yield from our fixed-income portfolio and not as a source of liquidity or funding for our operations. 34 -------------------------------------------------------------------------------- B. Commitments and Contingencies Contractual Obligations During the first nine months of 2014, our contractual obligations have not changed materially from those discussed in our Annual Report on Form 10-K for the year ended December 31, 2013. Off-Balance-Sheet Arrangements Our off-balance-sheet leverage includes derivative positions, operating leases, and purchase obligations. See the "Derivative Instruments" section of Note 2 - Investments and of this Management's Discussion and Analysis for a summary of our derivative activity since year-end 2013. There have been no material changes in the other off-balance-sheet items since the discussion in the notes to the financial statements in Progressive's Annual Report on Form 10-K for the year ended December 31, 2013. Other As of September 30, 2014, we have in operation 65 Service Centers in 50 metropolitan areas across the country, that are designed to provide end-to-end resolution for auto physical damage losses. Currently, we own approximately 85% of our Service Centers and lease the remaining sites. In 40 of these centers, we have combined a claims office with a Service Center to improve our efficiency and manage costs. In an effort to provide the Service Center experience to more of our expanding customer population, we plan to open two new Service Centers during the fourth quarter 2014 and one to two more Service Centers over the next two years, each co-located with a full service claims office. Based on our historical experience, the cost of these facilities, excluding land, is estimated to average $4 to $6 million per center, depending on a number of variables, including the size and location of the center, and is expected to be funded through operating cash flows. III. RESULTS OF OPERATIONS - UNDERWRITING A. Growth Three Months Ended September 30, Nine Months Ended September 30, % % ($ in millions) 2014 2013 Change 2014 2013 Change NET PREMIUMS WRITTEN Personal Lines Agency $ 2,284.5 $ 2,227.3 3 $ 6,868.1 $ 6,653.2 3 Direct 1,984.4 1,789.7 11 5,739.9 5,257.1 9 Total Personal Lines 4,268.9 4,017.0 6 12,608.0 11,910.3 6 Commercial Lines 463.4 437.6 6 1,433.0 1,380.8 4 Other indemnity 0 0 NM 0 0 NMTotal underwriting operations $ 4,732.3 $ 4,454.6 6 $ 14,041.0 $ 13,291.1 6 NET PREMIUMS EARNED Personal Lines Agency $ 2,235.2 $ 2,162.7 3 $ 6,680.7 $ 6,421.4 4 Direct 1,848.9 1,693.4 9 5,435.1 5,020.4 8 Total Personal Lines 4,084.1 3,856.1 6 12,115.8 11,441.8 6 Commercial Lines 456.0 446.8 2 1,340.1 1,317.3 2 Other indemnity 0 .1 (100) 0 .2 (100)Total underwriting operations $ 4,540.1 $ 4,303.0 6 $ 13,455.9 $ 12,759.3 5 NM = Not Meaningful Net premiums written represent the premiums 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. 35 --------------------------------------------------------------------------------Policies in force, our preferred measure of growth, represents all policies under which coverage was in effect as of the end of the period specified. As of September 30, our policies in force were: % (thousands) 2014 2013 Change POLICIES IN FORCE Agency auto 4,784.6 4,842.4 (1) Direct auto 4,453.4 4,172.3 7 Total auto 9,238.0 9,014.7 2 Special lines1 4,081.8 4,040.7 1 Total Personal Lines 13,319.8 13,055.4 2 Commercial Lines 517.8 524.7 (1) 1Includes insurance for motorcycles, ATVs, RVs, mobile homes, watercraft, snowmobiles, and similar items, as well as personal umbrella and renters products. To analyze growth, we also review new policies, rate levels, and the retention characteristics of our books of business. The following table shows our year-over-year changes in new and renewal applications (i.e., issued policies): Growth Over Prior Year Quarter Year-to-date 2014 2013 2014 2013 APPLICATIONS Personal Lines: New (3)% 6% 0% (4)% Renewal 4% 2% 3% 3% Commercial Lines: New 3% (6)% (3)% (6)% Renewal (1)% (1)% (1)% 1% In our Personal Lines business for both the third quarter and first nine months of 2014, new applications increased in our Direct auto business, while our Agency auto new applications decreased year-over-year and our special lines new applications were relatively flat. Our auto and special lines renewal applications increased in both distribution channels, with the Direct auto channel experiencing more significant increases. We remain focused on providing consumers with distinctive auto insurance options and are continually refining our core product design. We are continuing to roll-out our newest personal auto product model, which incorporates our latest underwriting features. In our Commercial Lines business, rate increases taken throughout the last two years, as well as new business underwriting restrictions, primarily in our for-hire specialty and for-hire transportation business market targets, contributed to the year-over-year decreases in both new and renewal applications year-to-date. During the third quarter 2014, we lowered rates slightly and lifted some of our new business underwriting restrictions, both of which contributed to the year-over-year new application growth for the quarter. Snapshot®, our usage-based insurance program, provides customers the opportunity to improve their auto insurance rates based on their personal driving behavior. Snapshot is currently available to our Agency and Direct auto customers in 45 states plus the District of Columbia. Through our marketing campaigns and other initiatives we continue to expose consumers to the benefits of Snapshot. We are also continuing with our efforts to further penetrate customer households through cross-selling auto policies with our special lines products and vice versa, as well as through Progressive Home Advantage® (PHA). PHA is the program in which we "bundle" our auto product with property insurance provided by eleven unaffiliated insurance carriers. Bundled products are an integral part of our consumer offerings and an important part of our strategic agenda. These customers represent a sizable segment of the market, and our experience is that they tend to stay with us longer and generally have a better loss experience. More and more of our auto customers, especially Direct auto customers, are now multi-product customers with combinations of special lines, homeowners, or renters, as well as auto coverage. As of September 30, 2014, PHA was available to Direct customers in 49 states, Agency customers in 25 states, including one state added during the third quarter 2014, and to both 36 -------------------------------------------------------------------------------- Direct and Agency customers in the District of Columbia. PHA was available to Agency customers in Florida and, in the second quarter 2014, was made available to Direct customers in that state. PHA is not yet available to customers in Alaska. We plan to expand coverage with our key provider for PHA in the Agency channel, American Strategic Insurance, next year. In the second quarter 2014, we introduced our own renters insurance product in our Agency channel. We are currently offering this product in two states, including one state added during the third quarter 2014. We will roll-out this product to additional states as part of our bundling strategy. Expanding our capabilities in the mobile space also remains an important initiative. Consumers want the ability to transact all forms of business when and where they want and on whatever device best suits their needs (e.g., smartphone, tablet). We provide consumers with the ability to obtain a quote for and buy an auto insurance policy on our mobile website in all states and the District of Columbia. Our mobile quoting feature allows consumers nationwide to obtain a quote for at least five drivers and four vehicles. In many states, consumers can quote up to twelve drivers and twelve vehicles. We believe this multi-driver, multi-vehicle feature capability meets 99% of consumer needs. We also provide the comparison rate experience on a mobile device in most of the country. During the third quarter 2014, we enhanced our mobile application for iPhone® and Android smartphones to allow policyholders to easily access their policy documents, make payments directly from their checking account, and view both their payment schedule and billing history. Policyholders can also add endorsements and make account changes from their mobile device, as well as receive text alerts for billing and severe weather. In addition, much of our agency-dedicated website, which includes quote/buy, servicing, and reporting capabilities, is accessible to agents through many brands of tablet computers. Our application allows policyholders to view, store, and share their digital insurance ID card, which can be used as legal proof of insurance in most of the country. In addition, policyholders can report their claims and submit related photos using the application, as well as use their phone's GPS capabilities to specify the location of the claim. We also allow consumers to use their phone's camera to photograph their driver license and/or current insurance card to provide easy data fill for quotes started from our mobile application in 36 states and the District of Columbia. Our Commercial Lines customers can also now view their identification cards and certificates of insurance through this application. Quotes, sales, payments, and document requests from mobile devices represent low double-digit percentages of all such transactions with Progressive. We recognize the importance of the mobile space and look for opportunities to add new functionality to our mobile websites and applications. We are also expanding our Commercial Auto coverage offerings through our latest product model, which simplifies the quoting and claims experience, and provides incentives for customers to stay with us longer. In addition, through our Progressive Commercial AdvantageSM program, we offer general liability and business owners policies and workers' compensation coverage, all of which are written by unaffiliated insurance companies or agencies. The workers' compensation coverage is offered in 44 states, while the other products are offered throughout the continental United States. We experienced the following changes in written premium per policy: Growth Over Prior Year Quarter Year-to-date 2014 2013 2014 2013 WRITTEN PREMIUM PER POLICY Personal Lines-auto 4% 3% 3% 5% Commercial Lines 4% 4% 4% 6% The increased written premium per policy in our personal auto business for both the third quarter and first nine months of 2014 reflects increases in written premium per policy in both our Agency and Direct auto businesses. We selectively raised rates during the first half of 2014, compared to relatively stable rates during 2013, in both our Agency and Direct auto businesses to meet their margin targets. For our Commercial Lines business, the increase in written premium per policy primarily reflects rate increases taken throughout 2013 and continuing into 2014, principally on new business in our for-hire transportation and for-hire specialty business market targets. Adjusting rates is an ongoing process and we will continue to evaluate future rate needs and react quickly as we recognize changing loss cost trends at the state level. 37 -------------------------------------------------------------------------------- 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 (including any renewals) will remain in force before cancellation or lapse in coverage. The following table shows our year-over-year changes in policy life expectancy using both 3-month and 12-month measures. In addition, we are disclosing our quarterly year-over-year change in our renewal ratio. The renewal ratio is the percent of policies that have come up for renewal during the quarter that have actually renewed. Growth Over Prior Year 2014 2013 RETENTION MEASURES Personal Lines - auto Policy life expectancy Trailing 3-months (3)% (4)% Trailing 12-months 2% (7)% Renewal ratio (0.2)% 0.3%Commercial Lines - policy life expectancy (trailing 12-months) (3)% 1% The decline in our trailing 3-month policy life expectancy, which reflects more recent experience, is due in part to rate increases in both our Agency and Direct channels, relative to generally flat rate changes in 2013, as well as rate competitiveness in our Agency channel in 2014. Our Commercial Lines business policy life expectancy has decreased primarily reflecting rate increases taken throughout 2013 and continuing into the first nine months of 2014, mainly in our for-hire specialty, for-hire transportation, and contractor business market targets. Recognizing the importance that retention has on our ability to grow profitably, we emphasize competitive pricing for a given risk, quality service, and having the products and services available for our customers as their needs change during their insurable life. B. Profitability Profitability for our underwriting operations is defined by pretax underwriting profit, which is calculated as net premiums earned plus "fees and other revenues" 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 respective periods, our underwriting profitability results were as follows: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Underwriting Underwriting Underwriting Underwriting Profit (Loss) Profit (Loss) Profit (Loss) Profit (Loss) ($ in millions) $ Margin $ Margin $ Margin $ Margin Personal Lines Agency $ 147.0 6.6 % $ 122.0 5.6 % $ 468.5 7.0 % $ 428.4 6.7 % Direct 107.6 5.8 107.3 6.3 294.3 5.4 360.5 7.2 Total Personal Lines 254.6 6.2 229.3 5.9 762.8 6.3 788.9 6.9 Commercial Lines 85.1 18.6 26.3 5.9 204.4 15.2 73.7 5.6 Other indemnity1 .1 NM (6.2 ) NM (5.3 ) NM (9.7 ) NM Total underwriting operations $ 339.8 7.5 % $ 249.4 5.8 % $ 961.9 7.1 % $ 852.9 6.7 % 1Underwriting margins for our other indemnity businesses are not meaningful (NM) due to the low level of premiums earned by, and the variability of loss costs in, such businesses. Our underwriting margins for both the three and nine months ended September 30, 2014 were better than our long-term profitability target of at least 4%. Pricing and market conditions are always significant drivers of underwriting margins over any defined period. Our Personal Lines profitability was lower on a year-over-year basis for the first nine months of 2014, primarily reflecting decreased underwriting profitability in our Direct channel. The Direct channel results through September include unfavorable loss reserve development, primarily in our adjusting and other loss adjustment expense reserves, compared to favorable case loss reserve development last year. The improvement in Commercial Lines profitability is due to a lower loss 38 -------------------------------------------------------------------------------- ratio, mainly resulting from rate increases taken during the last two years, lower frequency, mainly in our truck business, and favorable case reserve development in both the third quarter and first nine months of 2014, compared to unfavorable reserve development in both the third quarter and first nine months of 2013. Further underwriting results for our Personal Lines business, including results by distribution channel, the Commercial Lines business, and our underwriting operations in total, were as follows: Three Months Ended September 30, Nine Months Ended September 30, Underwriting Performance1 2014 2013 Change 2014 2013 Change Personal Lines-Agency Loss & loss adjustment expense ratio 73.6 74.2 (.6) pts. 73.2 73.0 .2 pts. Underwriting expense ratio 19.8 20.2 (.4) pts. 19.8 20.3 (.5) pts. Combined ratio 93.4 94.4 (1.0) pts. 93.0 93.3 (.3) pts. Personal Lines-Direct Loss & loss adjustment expense ratio 74.3 72.5 1.8 pts. 74.1 71.9 2.2 pts. Underwriting expense ratio 19.9 21.2 (1.3) pts. 20.5 20.9 (.4) pts. Combined ratio 94.2 93.7 .5 pts. 94.6 92.8 1.8 pts. Total Personal Lines Loss & loss adjustment expense ratio 73.9 73.5 .4 pts. 73.6 72.5 1.1 pts. Underwriting expense ratio 19.9 20.6 (.7) pts. 20.1 20.6 (.5) pts. Combined ratio 93.8 94.1 (.3) pts. 93.7 93.1 .6 pts. Commercial Lines Loss & loss adjustment expense ratio 60.0 73.1 (13.1) pts. 63.2 72.6 (9.4) pts. Underwriting expense ratio 21.4 21.0 .4 pts. 21.6 21.8 (.2) pts. Combined ratio 81.4 94.1 (12.7) pts. 84.8 94.4 (9.6) pts. Total Underwriting Operations2 Loss & loss adjustment expense ratio 72.5 73.5 (1.0) pts. 72.6 72.6 0 pts. Underwriting expense ratio 20.0 20.7 (.7) pts. 20.3 20.7 (.4) pts. Combined ratio 92.5 94.2 (1.7) pts. 92.9 93.3 (.4) pts. Accident year loss & loss adjustment expense ratio3 73.0 73.6 (.6) pts. 72.4 72.0 .4 pts. 1Ratios are expressed as a percentage of net premiums earned; "fees and other revenues" are netted with underwriting expenses in the ratio calculations. 2Combined ratios for the other indemnity businesses are not presented separately due to the low level of premiums earned by, and the variability of loss costs in, such businesses. These businesses generated an underwriting profit (loss) of $0.1 million and $(6.2) million for the three months ended September 30, 2014 and 2013, respectively, and $(5.3) million and $(9.7) million for the nine months ended September 30, 2014 and 2013, respectively. 3The accident year ratio includes only the losses that occurred during the period noted. As a result, accident period results will change over time, either favorably or unfavorably, as we revise our estimates of loss costs when payments are made or reserves for that accident period are reviewed. 39 --------------------------------------------------------------------------------Losses and Loss Adjustment Expenses (LAE) Three Months Ended September 30, Nine Months Ended September 30, (millions) 2014 2013 2014 2013Change in net loss and LAE reserves $ 60.8 $ 155.7 $ 168.1 $ 338.5 Paid losses and LAE 3,231.0 3,008.5 9,598.7 8,928.2 Total incurred losses and LAE $ 3,291.8 $ 3,164.2 $ 9,766.8 $ 9,266.7 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. 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 estimated needed reserves are adjusted as these underlying assumptions change. Our total loss and loss adjustment expense ratio decreased 1.0 point for the third quarter 2014 and was flat for the first nine months of 2014, compared to the same periods in 2013. During the third quarter 2014, we experienced increased loss severity, relatively flat loss frequency, and an increase in average premium per exposure across most coverages, compared to the third quarter 2013. During the third quarter 2014, we also experienced a greater amount of favorable reserve development, compared to the third quarter 2013. On a year-to-date basis, we saw a slight increase in loss severity, relatively flat loss frequency, slightly higher catastrophe losses, and less unfavorable reserve development, compared to the first nine months of 2013. The loss and LAE ratio for our Commercial Lines business saw significant improvement for both the third quarter and first nine months of 2014, with decreases of 13.1 points and 9.4 points, respectively, on a year-over-year basis. The improvement is primarily due to rate increases taken during the last two years, lower frequency, mainly in our truck business, and favorable case reserve development in both the third quarter and first nine months of 2014, compared to unfavorable reserve development in both the third quarter and first nine months of 2013. The following discussion of our severity and frequency trends excludes comprehensive coverage because of its inherent volatility, as it is typically linked to catastrophic losses generally resulting from adverse weather. Comprehensive coverage insures against damage to a customer's vehicle due to various causes other than collision, such as windstorm, hail, theft, falling objects, and glass breakage. Total personal auto incurred severity (i.e., average cost per claim, including both paid losses and the change in case reserves) increased about 4%-6% for both the three and nine months ended September 30, 2014, compared to the prior year periods. Following are the changes we experienced in severity in our auto coverages on a year-over-year basis for the periods indicated: • Bodily injury increased about 5%-6% for both the third quarter and first nine months of 2014. • Property coverages increased with property damage up about 5%-6% and collision up about 2%-3% for both periods. • Personal injury protection (PIP) increased about 17% for the third quarter and about 7% year to date. The quarter-over-prior-year quarter increase was primarily concentrated in New York,Florida, and New Jersey. Approximately half of the increase is due to loss cost increases, with the remainder due to geographic mix shifts, as well as the fact that we had unusually low severity in the third quarter 2013. It is a challenge 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, health care reform, and jury verdicts, along with regulatory changes and other factors that may affect severity. Our incurred frequency of auto accidents, on a calendar-year basis, decreased about 1% for the third quarter 2014 and increased about 2% for the first nine months of 2014, compared to the same periods last year. Following are our frequency changes by coverage on a year-over-year basis for the periods indicated: • Bodily injury decreased about 2%-3% for both periods. • For the third quarter 2014, collision and property damage both decreased about 2%. Year to date, property damage was relatively flat, while collision increased about 3%. • PIP decreased approximately 3% for the third quarter and was relatively flat year to date. 40-------------------------------------------------------------------------------- We closely monitor the changes in frequency, but the degree or direction of near-term frequency change is not something that we are able to predict with any certainty. We 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, as we attempt to reserve more accurately for our loss exposure. The following table shows catastrophe losses incurred during the periods: Three Months Ended September 30, Nine Months Ended September 30, ($ in millions) 2014 2013 2014 2013 Catastrophe losses incurred $ 32.4 $ 34.9 $ 171.4 $ 164.5 Increase to combined ratio .7 pts. .8 pts. 1.3 pts. 1.3 pts. We respond promptly to catastrophic storms when they occur in order to provide exemplary claims service to our customers. The table below presents the actuarial adjustments implemented and the loss reserve development experienced in the following periods: Three Months Ended September 30, Nine Months Ended September 30, (millions) 2014 2013 2014 2013 ACTUARIAL ADJUSTMENTS Reserve decrease/(increase) Prior accident years $ 3.1 $ (.9 ) $ 53.9 $ 28.1 Current accident year (16.2 ) 18.3 (41.0 ) 14.1 Calendar year actuarial adjustment $ (13.1 ) $ 17.4 $ 12.9 $ 42.2 PRIOR ACCIDENT YEARS DEVELOPMENT Favorable/(Unfavorable) Actuarial adjustment $ 3.1 $ (.9 ) $ 53.9 $ 28.1 All other development 19.7 4.0 (86.5 ) (107.0 ) Total development $ 22.8 $ 3.1 $ (32.6 ) $ (78.9 ) (Increase) decrease to calendar year combined ratio .5 pts. .1 pts. (.2 ) pts. (.6 ) pts. Total development consists of both 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, our actuaries identify and measure variances in the projected frequency and severity trends, which allows them to adjust the reserves to reflect the current costs. We report these actuarial adjustments separately for the current and prior accident years to reflect these adjustments as part of the total prior accident years' development. "All other development" represents claims settling for more or less than reserved, emergence of unrecorded claims at rates different than anticipated in our incurred but not recorded (IBNR) reserves, 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. Our objective is to establish case and IBNR reserves that are adequate to cover all loss costs, while incurring minimal variation from the date that the reserves are initially established until losses are fully developed. As reflected in the table above, we experienced total unfavorable development for the first nine months of both 2014 and 2013. 41 -------------------------------------------------------------------------------- Year-to-date 2014 • The unfavorable prior year reserve development was attributable to accident year 2013. • Unfavorable reserve development in our personal auto product was partially offset by favorable development in our Commercial Lines business. • Of the unfavorable reserve development in our personal auto product, our Agency auto business accounted for approximately 60% and our Direct auto business accounted for about 40%. • In our personal auto product, we incurred unfavorable loss development in our PIP coverage. In addition, we hadunfavorable loss adjustment expense reserve development primarilyaffecting the 2013 accident year. • The favorable reserve development in our Commercial Lines business was primarily related to favorable case reserve development on our high limit policies. Year-to-date 2013 • Approximately half of the unfavorable prior year reserve development was attributable to accident year 2011 and about 35% was related to accident year 2012. The aggregate reserve development for accident years 2010 and prior accounted for about 15% of the total prior year reserve development. • About 50% of our unfavorable reserve development was in our Personal Lines business, primarily our personal auto product.Unfavorable development in our Agency channel was partially offset by favorable development in our Direct channel. An additional 40% of our unfavorable reserve development was in our Commercial Lines business, with the remainder in our run-off businesses. • The unfavorable reserve development in our Agency autobusiness was in our IBNR reserves due to higher frequency and severity on late emerging claims primarily in our bodily injury and property damage coverages, as primarily reflected in the "all other development." • Lower than anticipated severity costs on case reserves was the primary contributor to the favorable development in our Direct auto business. • In our Commercial Lines business, we experienced unfavorable development due to higher frequency and severity on late emerging claims primarily in our bodily injury coverage for our truck business. • In our other businesses, we experienced unfavorabledevelopment primarily due to reserve increases in our run-off professional liability group business based on an actuarial review of our claims history. In our loss reserve analysis, we work 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 August 8, 2014. Underwriting Expenses Progressive's policy acquisition costs and other underwriting expenses, net of "fees and other revenues," expressed as a percentage of net premiums earned decreased 0.7 points and 0.4 points for the three and nine months ended September 30, 2014, compared to the same periods last year. 42 -------------------------------------------------------------------------------- C. Personal Lines Growth over prior year Quarter Year-to-date Net premiums written 6 % 6 % Net premiums earned 6 % 6 % Policies in force (at September 30) 2 % Progressive's Personal Lines business writes insurance for personal autos and recreational vehicles and represented 90% of our total net premiums written in the third quarter and first nine months of both 2014 and 2013. We currently write our Personal Lines products in all 50 states. We also offer our personal auto product (not special lines products) in the District of Columbia and on an Internet-only basis in Australia. Personal auto represented 91% and 90% of our total Personal Lines net premiums written in the third quarter and first nine months of both 2014 and 2013, respectively. 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, primarily in our Agency channel. The special lines products are typically used more during the warmer weather months and, therefore, would have a negative impact on our total Personal Lines results during those periods and a favorable impact on underwriting profitability during the off season. Compared to September 30, 2013, policies in force grew 2% for auto and 1% for special lines products. In addition, on a year-over-year basis, for the third quarter and first nine months of 2014, net premiums written for personal auto increased 6% in both periods; special lines net premiums written grew 4% for the third quarter and 3% for the first nine months of 2014. Our total Personal Lines business generated combined ratios of 93.8 and 93.7 for the third quarter and first nine months of 2014, respectively, compared to 94.1 and 93.1, respectively, last year. In the third quarter 2014, 44 states and the District of Columbia were profitable, including 8 of our 10 largest states; 45 states were profitable year-to-date 2014, including all of our 10 largest states. The special lines products had an unfavorable impact on the total Personal Lines combined ratio for the third quarters of 2014 and 2013 of 0.4 points and 0.9 points, respectively, compared to a favorable impact of 0.9 points and 0.6 points for the first nine months of 2014 and 2013, respectively. The Personal Lines business is comprised of the Agency business and the Direct business. The Agency Business Growth over prior year Quarter Year-to-date Net premiums written 3 % 3 % Net premiums earned 3 % 4 % Auto: policies in force (at September 30) (1 )% new applications (14 )% (7 )% renewal applications 1 % 1 % written premium per policy 5 % 4 % Retention measures (at September 30): policy life expectancy - trailing 3-months (6 )% trailing 12-months 0 % renewal ratio (0.4 )% The Agency business includes business written by more than 35,000 independent insurance agencies that represent Progressive, as well as brokerages in New York and California. On a year-over-year basis, for the third quarter and first nine months of 2014, we generated new Agency auto application growth in only 9 states and 19 states, respectively, as well as in the District of Columbia for both periods. None of our top ten Agency auto states, based on volume, generated new application growth for the third quarter and only four states experienced an increase year to date. The decrease in new application growth in both the third quarter and first nine months of 2014 was due in part to rate increases we took in selected states in early 2014 to meet our margin targets and various actions taken to restrict writing unprofitable business, as well as actions by our competitors to increase their competitiveness in the marketplace. 43 -------------------------------------------------------------------------------- The selective rate increases taken in our Agency auto business during both 2014 and 2013 contributed to the increase we experienced in written premium per policy. Written premium per policy for Agency auto increased 4% for new business for the third quarter and first nine months of 2014 and 4%-5% for renewal business for the same periods, compared to the corresponding periods last year. Our trailing 12-month policy life expectancy was essentially unchanged from a year ago, but the trailing 3-month measure was down 6% reflecting slightly lower renewal ratios, as well as a decline in our mix of preferred auto new business applications. On a year-over-year basis, Agency auto quotes experienced a slight decrease for both the third quarter and first nine months of 2014. Compared to last year, our Agency auto rate of conversion (i.e., converting a quote to a sale) decreased in both the third quarter and first nine months of 2014, although to a larger extent during the quarter. The decrease in the conversion rate was primarily due to rate increases taken in early 2014, as well as actions by our competitors to increase their competitiveness in the marketplace. The Direct Business Growth over prior year Quarter Year-to-date Net premiums written 11 % 9 % Net premiums earned 9 % 8 % Auto: policies in force (at September 30) 7 % new applications 7 % 8 % renewal applications 7 % 6 % written premium per policy 4 % 2 % Retention measures (at September 30): policy life expectancy - trailing 3-months 1 % trailing 12-months 6 % renewal ratio (0.1 )% The Direct business includes business written directly by Progressive on the Internet, through mobile devices, and over the phone. We experienced new application growth for both the third quarter and first nine months of 2014 due to an increase in demand, as well as improvement in conversion. For the third quarter 2014, we experienced a year-over-year increase in new Direct auto applications in 36 states and the District of Columbia; seven of our top 10 Direct auto states experienced an increase. On a year-to-date basis, the Direct auto business had new application growth in 40 states and the District of Columbia, including eight of our top 10 states. Written premium per policy for new Direct auto business increased 4%-5% for both the third quarter and first nine months of 2014 and written premium per policy on renewal business increased 2%-3% in both periods, compared to the same periods last year, reflecting the selective rate increases we took in the first half of 2014. Our Direct auto business experienced an increase in policy life expectancy of 6% based on our trailing 12-month measure and 1% based on the trailing 3-month measure, in part reflecting the increase in the number of bundled policies. On a year-over-year basis, the total number of quotes in the Direct business increased 6% for both the third quarter and first nine months of 2014, compared to the same periods last year, driven by an increase in advertising, as well as increased quoting from our mobile application. The overall Direct business conversion rate saw a slight increase in both the third quarter and first nine months of 2014, reflecting solid increases in our phone business conversion rate and a slight increase in conversion of our Internet-initiated business. The underwriting expense ratio for our Direct business decreased 1.3 points and 0.4 points for the third quarter and first nine months of 2014, respectively, compared to the same periods last year. On a year-over-year basis, advertising costs increased in both periods, although to a lesser extent in the third quarter. We remain focused on maintaining a well-respected brand and will continue to spend on advertising as long as we achieve our profitability targets. We continue to use "Flo" both in and out of the "Superstore" to provide fresh and engaging messages. In addition, we continued with our branding efforts utilizing the apron, which Progressive people metaphorically tie on as they work to improve the customer experience. 44 -------------------------------------------------------------------------------- D. Commercial Lines Growth over prior year Quarter Year-to-date Net premiums written 6 % 4 % Net premiums earned 2 % 2 % Policies in force (at September 30) (1 )% New applications 3 % (3 )% Renewal applications (1 )% (1 )% Written premium per policy 4 % 4 % Policy life expectancy - trailing 12-months (at September 30) (3 )% Progressive's Commercial Lines business writes primary liability, physical damage, and other auto-related insurance for automobiles and trucks owned and/or operated predominately by small businesses, with the majority of our customers insuring approximately two vehicles. Our Commercial Lines business represented 10% of our total net premiums written for the third quarter and first nine months of both 2014 and 2013. This business is primarily distributed through independent agents and operates in the following business market targets: • Business auto - autos, vans, and pick-up trucks used by small businesses, such as retailing, farming, services, and private trucking • For-hire transportation - tractors, trailers, and straight trucks primarily used by regional general freight and expeditor-type businesses and non-fleet long-haul operators • Contractor - vans, pick-up trucks, and dump trucks used by small businesses, such as artisans, heavy construction, and landscapers/snowplowers • For-hire specialty - dump trucks, log trucks, and garbage trucks used by dirt, sand and gravel, logging, and coal-typebusinesses, and • Tow - tow trucks and wreckers used in towing services and gas/service station businesses. Business auto is the largest business market target, measured by premium volume, and accounts for approximately one third of our total Commercial Lines premiums, while the for-hire transportation and contractor business market targets each accounts for another 25%. Business auto and contractor together account for approximately 75% of the vehicles we insure in this business, while for-hire transportation accounts for about 10%. We currently write our Commercial Lines business in 49 states; we do not write Commercial Lines in Hawaii or the District of Columbia. The majority of our policies in this business are written for 12-month terms. Our Commercial Lines business experienced a decrease in new applications for the first nine months of 2014, compared to last year, driven by significant declines in our contractor business market target, due to rate increases taken throughout the last two years, as well as some underwriting restrictions on new business. During the third quarter 2014, new applications increased as we lowered rates slightly and lifted some of the new business underwriting restrictions. The increase in written premium per policy, for both the third quarter and first nine months of 2014, primarily reflects rate increases taken throughout 2013 and continuing into 2014, principally on new business in our for-hire transportation and for-hire specialty business market targets. Rate increases also contributed to the decrease in policy life expectancy. E. Other Indemnity Our other indemnity businesses consist of managing our run-off businesses, including the run-off of our professional liability businesses. Our other indemnity businesses generated an operating profit of $0.1 million for the third quarter 2014 and an operating loss of $5.3 million for the first nine months of 2014, primarily reflecting reserve increases. These businesses generated operating losses of $6.2 million and $9.7 million, respectively, for the three and nine month periods ended September 30, 2013. 45 -------------------------------------------------------------------------------- F. Service Businesses Our service businesses, which represent less than 1% of our total revenues and do not have a material effect on our overall operations, primarily include: • Commercial Auto Insurance Procedures/Plans (CAIP) - We are the only servicing carrier on a nationwide basis for CAIP, which are state-supervised plans servicing the involuntary market. As a service provider, we provide policy issuance and claims adjusting services and collect fee revenue that is earned on a pro rata basis over the terms of the related policies. • Commission-Based Businesses - We have two commission-based service businesses. Through Progressive Home Advantage® , we offer, either directly or through our network of independent agents, home, condominium, and renters insurance written by eleven unaffiliated homeowner's insurance companies. For the policies written under this program in our Direct business, we receive commissions, all of which are used to offset the expenses associated with maintaining this program. Through Progressive Commercial AdvantageSM, we offer our customers the ability to package their auto coverage with other commercial coverages that are written by unaffiliated insurance companies or agencies. This program offers general liability and business owners policies throughout the continental United States and workers' compensation coverage in 44 states as of September 30, 2014. We receive commissions for the policies written under this program, all of which are used to offset the expenses associated with maintaining this program. G. Income Taxes Income taxes are comprised of net deferred tax assets and liabilities, as well as net current income taxes payable/recoverable. Net deferred income tax assets/liabilities are disclosed on the balance sheets. At September 30, 2014 and December 31, 2013, we reported net deferred tax liabilities, compared to net deferred tax assets at September 30, 2013. The movement to a liability position at both September 30, 2014 and December 31, 2013 from an asset position at September 30, 2013 is primarily due to unrealized gains in the investment portfolio and recognition of losses on sales of securities on which we had previously recorded other-than-temporary impairments. A deferred tax asset/liability is a tax benefit/expense that is expected to be realized in a future tax return. At September 30, 2014 and 2013 and at December 31, 2013, we determined that we did not need a valuation allowance on our gross deferred tax assets. Although realization of the gross deferred tax assets is not assured, management believes it is more likely than not that the gross deferred tax assets will be realized based on our expectation that we will be able to fully utilize the deductions that are ultimately recognized for tax purposes. At September 30, 2014 and 2013, we had net current income taxes payable of $47.6 million and $14.3 million, respectively, which were reported as part of "other liabilities," while at December 30, 2013, we had net current income taxes recoverable of $17.1 million, which were reported as part of "other assets." There were no material changes in our uncertain tax positions or effective tax rate during the quarter ended September 30, 2014. 46 --------------------------------------------------------------------------------IV. RESULTS OF OPERATIONS - INVESTMENTS A. Portfolio Allocation The composition of the investment portfolio was: % of Fair Total Duration ($ in millions) Value Portfolio (years) Rating1 September 30, 2014 Fixed maturities $ 13,269.4 69.5 % 1.8 AA- Nonredeemable preferred stocks 763.3 4.0 2.4 BB+ Short-term investments - other 2,671.1 14.0 <.1 AA Total fixed-income securities 16,703.8 87.5 1.6 AA- Common equities 2,379.4 12.5 na na Total portfolio2,3 $ 19,083.2 100.0 % 1.6 AA- September 30, 2013 Fixed maturities $ 13,797.7 76.7 % 2.2 AA- Nonredeemable preferred stocks 726.0 4.0 1.4 BB+ Short-term investments - other 1,146.1 6.4 <.1 AA+ Total fixed-income securities 15,669.8 87.1 2.0 AA- Common equities 2,326.1 12.9 na na Total portfolio2,3 $ 17,995.9 100.0 % 2.0 AA- December 31, 2013 Fixed maturities $ 13,540.4 75.0 % 2.1 AA- Nonredeemable preferred stocks 711.2 3.9 1.3 BB+ Short-term investments - other 1,272.6 7.1 <.1 AA+ Total fixed-income securities 15,524.2 86.0 2.0 AA- Common equities 2,530.5 14.0 na na Total portfolio2,3 $ 18,054.7 100.0 % 2.0 AA- na = not applicable 1Represents ratings at period end. Credit quality ratings are assigned by nationally recognized statistical rating organizations (NRSRO). To calculate the weighted average credit quality ratings, we weight individual securities based on fair value and assign a numeric score of 0-5, with non-investment-grade and non-rated securities assigned a score of 0-1. To the extent the weighted average of the ratings falls between AAA and AA+, we assign an internal rating of AAA-. 2Our portfolio reflects the effect of unsettled security transactions and collateral on open derivative positions; at September 30, 2014, $158.0 million was included in "other liabilities," compared to $63.7 million and $61.3 million at September 30, 2013 and December 31, 2013, respectively. 3The total fair value of the portfolio at September 30, 2014 and 2013, and December 31, 2013 included $1.3 billion, $1.3 billion, and $1.8 billion, respectively, of securities held in a consolidated, non-insurance subsidiary of the holding company, net of any unsettled security transactions. Our asset allocation strategy is to maintain 0%-25% of our portfolio in Group I securities, with the balance (75%-100%) of our portfolio in Group II securities, as defined in the Overview - Investments and Capital Management section and as reflected in the following tables. We believe this asset allocation strategy allows us to appropriately assess the risks associated with these securities for capital purposes and is in line with the treatment by our regulators. 47 --------------------------------------------------------------------------------The following table shows the composition of our Group I and Group II securities at September 30, 2014 and 2013, and December 31, 2013: % of Fair Total ($ in millions) Value Portfolio September 30, 2014 Group I securities: Non-investment-grade fixed maturities $ 759.7 3.9 % Redeemable preferred stocks1,2 182.3 1.0 Nonredeemable preferred stocks 763.3 4.0 Common equities 2,379.4 12.5 Total Group I securities 4,084.7 21.4 Group II securities: Other fixed maturities2 12,327.4 64.6 Short-term investments - other 2,671.1 14.0 Total Group II securities 14,998.5 78.6 Total portfolio $ 19,083.2 100.0 % September 30, 2013 Group I securities: Non-investment-grade fixed maturities $ 617.5 3.4 % Redeemable preferred stocks1,2 225.1 1.3 Nonredeemable preferred stocks 726.0 4.0 Common equities 2,326.1 12.9 Total Group I securities 3,894.7 21.6 Group II securities: Other fixed maturities2 12,955.1 72.0 Short-term investments - other 1,146.1 6.4 Total Group II securities 14,101.2 78.4 Total portfolio $ 17,995.9 100.0 % December 31, 2013 Group I securities: Non-investment-grade fixed maturities $ 592.1 3.3 % Redeemable preferred stocks1,2 210.1 1.2 Nonredeemable preferred stocks 711.2 3.9 Common equities 2,530.5 14.0 Total Group I securities 4,043.9 22.4 Group II securities: Other fixed maturities2 12,738.2 70.5 Short-term investments - other 1,272.6 7.1 Total Group II securities 14,010.8 77.6 Total portfolio $ 18,054.7 100.0 % 1Includes non-investment-grade redeemable preferred stocks of $79.8 million, $105.1 million, and $106.3 million at September 30, 2014 and 2013, and December 31, 2013, respectively. 2Includes investment-grade redeemable preferred stocks, with cumulative dividends, of $102.5 million, $120.0 million, and $103.8 million at September 30, 2014 and 2013, and December 31, 2013, respectively. 48 -------------------------------------------------------------------------------- To determine the allocation between Group I and Group II, we use the credit ratings from models provided by the National Association of Insurance Commissioners (NAIC) for classifying our residential and commercial mortgage-backed securities, excluding interest-only securities, and the credit ratings from nationally recognized statistical rating organizations (NRSRO) for all other debt securities. NAIC ratings are based on a model that considers the book price of our securities when assessing the probability of future losses in assigning a credit rating. As a result, NAIC ratings can vary from credit ratings issued by NRSROs. Management believes NAIC ratings more accurately reflect our risk profile when determining the asset allocation between Group I and II securities. Unrealized Gains and Losses As of September 30, 2014, our portfolio had pretax net unrealized gains, recorded as part of accumulated other comprehensive income, of $1,492.6 million, compared to $1,331.4 million and $1,456.9 million at September 30, 2013 and December 31, 2013, respectively. The net unrealized gains in our fixed-income portfolio decreased $36.0 million since September 30, 2013 and increased $14.1 million since December 31, 2013. The decrease since September 30, 2013 was due to sales of securities with net realized gains in excess of the increase in the value of many non-treasury bonds. The increase since December 31, 2013 reflects valuation increases in most fixed-income sectors, partially offset by net realized gains on security sales. The contributions by individual sectors to the fixed-income portfolio change in net unrealized gains are discussed below. The net unrealized gains in our common stock portfolio increased $197.2 million and $21.6 million since September 30, 2013 and December 31, 2013, respectively, reflecting the returns in the broad equity market over these periods, adjusting for net gains recognized on security sales. See Note 2 - Investments for a further break-out of our gross unrealized gains and losses. Fixed-Income Securities The fixed-income portfolio is managed internally and includes fixed-maturity securities, short-term investments, and nonredeemable preferred stocks. The fixed-maturity securities and short-term investments, as reported on the balance sheets, were comprised of the following: September 30, 2014 September 30, 2013 December 31, 2013 Fair % of Fair % of Fair % of ($ in millions) Value Total Value Total Value Total Investment-grade fixed maturities:1 Short/intermediate term $ 14,430.2 90.5 % $ 13,717.2 91.8 % $ 13,571.5 91.6 % Long term 52.6 .3 60.8 .4 58.2 .4 Non-investment-grade fixed maturities:2 Short/intermediate term 1,432.9 9.0 1,107.3 7.4 1,132.5 7.7 Long term 24.8 .2 58.5 .4 50.8 .3 Total $ 15,940.5 100.0 % $ 14,943.8 100.0 % $ 14,813.0 100.0 % 1Long term includes securities with expected liquidation dates of 10 years or greater. Asset-backed securities are reported based upon their projected cash flows, with the cash flows expected in periods of 10 years or greater reported as part of the long-term category. All other securities that do not have a single expected maturity date are reported at average maturity. 2Non-investment-grade fixed-maturity securities are non-rated or have a credit quality rating of an equivalent BB+ or lower, classified by the lowest rating from a NRSRO. The non-investment-grade securities based upon our Group I modeling were $839.5 million, $722.6 million, and $698.4 million at September 30, 2014 and 2013, and December 31, 2013, respectively. A primary exposure for the fixed-income portfolio is interest rate risk, which is managed by maintaining the portfolio's duration (a measure of the portfolio's exposure to changes in interest rates) between 1.5 and 5 years. Interest rate risk includes the change in value resulting from movements in the underlying market rates of debt securities held. The duration of the fixed-income portfolio was 1.6 years at September 30, 2014, compared to 2.0 years at both September 30, 2013 and December 31, 2013. The distribution of duration and convexity (i.e., a measure that demonstrates how the duration of a security is expected to change based on a rise or fall in interest rates) is monitored on a regular basis. 49 -------------------------------------------------------------------------------- The duration distribution of our fixed-income portfolio, represented by the interest rate sensitivity of the comparable benchmark U.S. Treasury Notes, was: Duration Distribution September 30, 2014 September 30, 2013 December 31, 2013 1 year 32.7 % 18.8 % 26.9 % 2 years 23.3 23.0 24.9 3 years 16.1 29.1 23.4 5 years 22.1 25.9 22.2 10 years 5.8 3.2 2.6 Total fixed-income portfolio 100.0 % 100.0 % 100.0 % Another primary exposure related to the fixed-income portfolio is credit risk. This risk is managed by maintaining an A+ minimum average portfolio credit quality rating, as defined by NRSROs. The credit quality distribution of the fixed-income portfolio was: Rating September 30, 2014 September 30, 2013 December 31, 2013 AAA 46.9 % 50.6 % 50.8 % AA 14.8 12.4 12.7 A 9.7 7.9 8.2 BBB 17.3 19.4 18.2 Non-investment grade/non-rated1 11.3 9.7 10.1 Total fixed-income portfolio 100.0 % 100.0 % 100.0 % 1The non-investment-grade fixed-income securities based upon our Group I classification represented 7.6% of the total fixed-income portfolio at September 30, 2014, compared to 6.8% at September 30, 2013 and 7.1% at December 31, 2013. The changes in credit quality profile from December 31, 2013 were the result of a shift in the mix of the investment portfolio in the various credit categories and not due to downgrades in credit quality of the securities we held. Our portfolio is also exposed to concentration risk. Our investment constraints limit investment in a single issuer, other than U.S. Treasury Notes or a state's general obligation bonds, to 2.5% of shareholders' equity, while the single issuer guideline on preferred stocks and/or non-investment-grade debt is 1.25% of shareholders' equity. Additionally, the guideline applicable to any state's general obligation bonds is 6% of shareholders' equity. Our credit risk guidelines limit single issuer exposure; however, we also consider sector concentration a risk, and we frequently evaluate the portfolio's sector allocation with regard to internal parameters and external market factors. We consider concentration risk both overall and in the context of individual asset classes, including but not limited to common equities, residential and commercial mortgage-backed securities, municipal bonds, and high-yield bonds. At September 30, 2014, we were within all of the constraints described above. We monitor prepayment and extension risk, especially in our structured product and preferred stock portfolios. Prepayment risk includes the risk of early redemption of security principal that may need to be reinvested at less attractive rates. Extension risk includes the risk that a security will not be redeemed when anticipated, and that the security that is extended has a lower yield than a security we might be able to obtain by reinvesting the expected redemption principal. Our holdings of different types of structured debt and preferred securities, which are discussed in more detail below, help minimize this risk. During the first nine months of 2014, we did not experience significant prepayment or extension of principal relative to our cash flow expectations in the portfolio. Most of our preferred securities either convert from a fixed-rate coupon to a variable-rate coupon after the call date, or remain variable-rate coupon securities after the call date. The variable-rate coupon is determined by adding a benchmark interest rate, which is reset quarterly, to a credit risk premium that was fixed when the security was first issued. Extension risk on holding these securities is limited to the credit risk premium being below that of a new similar security, since the benchmark variable-rate portion of the security's coupon adjusts for movements in interest rates. Reinvestment risk is similarly limited to receiving a below market level coupon for the credit risk premium portion of a similar security as the benchmark variable interest rate adjusts for changes in short-term interest rate levels. Many of these securities have a minimum or floor coupon that is currently in effect. Since the beginning of 2011, eleven securities that converted from a fixed-rate coupon to a variable-rate coupon had 50 -------------------------------------------------------------------------------- their first call date; three of these securities were called. At September 30, 2014, we continued to hold six of the eight securities that were not called, with a fair value of $187.6 million. We also face the risk that dividend payments on our preferred stock holdings could be deferred for one or more periods. As of September 30, 2014, all of our preferred securities continued to pay their dividends in full and on time. Liquidity risk is another risk factor we monitor. Our overall portfolio remains very liquid and is sufficient to meet expected liquidity requirements. The short-to-intermediate duration of our portfolio provides an additional source of liquidity, as we expect approximately $0.5 billion, or 5%, and $2.5 billion, or 23%, of principal repayment from our fixed-income portfolio, excluding U.S. Treasury Notes and short-term investments, during the remainder of 2014 and all of 2015, respectively. Cash from interest and dividend payments provides an additional source of recurring liquidity. Included in the fixed-income portfolio are U.S. government obligations, which include U.S. Treasury Notes and interest rate swaps. Although the interest rate swaps are not obligations of the U.S. government, they are recorded in this portfolio as the change in fair value is correlated to movements in the U.S. Treasury market. The duration of these securities was comprised of the following at September 30, 2014: Fair Duration ($ in millions) Value (years) U.S. Treasury Notes Less than two years $ 2,194.6 1.4 Two to five years 563.7 3.1 Five to ten years 267.6 7.6 Total U.S. Treasury Notes 3,025.9 2.3 Interest Rate Swaps Five to ten years ($750 notional value) 37.0 (8.3 ) Total interest rate swaps ($750 notional value) 37.0 (8.3 ) Total U.S. government obligations $ 3,062.9 .2 The interest rate swap positions show a fair value of $37.0 million as they are in an overall asset position at quarter-end, which is fully collateralized by cash payments received from the counterparty. The liability associated with the cash collateral received is reported in the "other liabilities" section of the Consolidated Balance Sheets. The negative duration of the interest rate swaps is due to the positions being short interest-rate exposure (i.e., receiving a variable-rate coupon). In determining duration, we add the interest rate sensitivity of our interest rate swap positions to that of our Treasury holdings, but do not add the notional value of the swaps to our Treasury holdings in order to calculate an unlevered duration for the portfolio. 51 -------------------------------------------------------------------------------- ASSET-BACKED SECURITIES Included in the fixed-income portfolio are asset-backed securities, which were comprised of the following at the balance sheet dates listed: % of Asset- Fair Net Unrealized Backed Duration Rating ($ in millions) Value Gains (Losses) Securities (years) (at period end) September 30, 2014 Residential mortgage-backed securities: Prime collateralized mortgage obligations $ 519.6 $ 3.4 10.0 % .9 A- Alt-A collateralized mortgage obligations 195.4 3.3 3.8 1.3 BBB Collateralized mortgage obligations 715.0 6.7 13.8 1.0 A- Home equity (sub-prime bonds) 771.5 20.1 14.8 <.1 BBB- Residential mortgage-backed securities 1,486.5 26.8 28.6 .4 BBB Commercial mortgage-backed securities: Commercial mortgage-backed securities 2,000.2 22.7 38.4 3.0 AA- Commercial mortgage-backed securities: interest only 172.3 6.0 3.3 2.8 AAA- Commercial mortgage-backed securities 2,172.5 28.7 41.7 3.0 AA- Other asset-backed securities: Automobile 715.7 1.4 13.7 .9 AAA Credit card 296.7 .9 5.7 .8 AAA Other1 538.2 2.1 10.3 1.1 AAA- Other asset-backed securities 1,550.6 4.4 29.7 1.0 AAA- Total asset-backed securities $ 5,209.6 $ 59.9 100.0 % 1.6 AA- % of Asset- Fair Net Unrealized Backed Duration Rating ($ in millions) Value Gains (Losses) Securities (years) (at period end) September 30, 2013 Residential mortgage-backed securities: Prime collateralized mortgage obligations $ 266.9 $ 4.6 6.1 % .8 A- Alt-A collateralized mortgage obligations 109.0 2.9 2.5 1.6 BBB+ Collateralized mortgage obligations 375.9 7.5 8.6 1.0 A- Home equity (sub-prime bonds) 634.0 7.5 14.4 <.1 BBB- Residential mortgage-backed securities 1,009.9 15.0 23.0 .2 BBB Commercial mortgage-backed securities: Commercial mortgage-backed securities 2,095.7 9.1 47.6 3.2 AA Commercial mortgage-backed securities: interest only 144.3 6.8 3.3 2.5 AAA- Commercial mortgage-backed securities 2,240.0 15.9 50.9 3.1 AA Other asset-backed securities: Automobile 568.8 3.0 12.9 1.1 AAA Credit card 49.0 2.0 1.1 1.8 AAA Other1 531.1 .4 12.1 1.2 AA+ Other asset-backed securities 1,148.9 5.4 26.1 1.2 AAA- Total asset-backed securities $ 4,398.8 $ 36.3 100.0 % 2.0 AA- 52-------------------------------------------------------------------------------- % of Asset- Fair Net Unrealized Backed Duration Rating ($ in millions) Value Gains (Losses) Securities (years) (at period end) December 31, 2013 Residential mortgage-backed securities: Prime collateralized mortgage obligations $ 294.6 $ 4.4 6.7 % .8 A- Alt-A collateralized mortgage obligations 143.8 3.4 3.3 1.1 A- Collateralized mortgage obligations 438.4 7.8 10.0 .9 A- Home equity (sub-prime bonds) 689.5 10.0 15.8 <.1 BBB- Residential mortgage-backed securities 1,127.9 17.8 25.8 .2 BBB Commercial mortgage-backed securities: Commercial mortgage-backed securities 2,038.6 (.1 ) 46.7 3.2 AA Commercial mortgage-backed securities: interest only 121.9 6.2 2.8 2.4 AAA- Commercial mortgage-backed securities 2,160.5 6.1 49.5 3.1 AA+ Other asset-backed securities: Automobile 494.1 2.9 11.3 1.2 AAA Credit card 59.7 1.7 1.4 1.7 AAA Other1 523.9 (.1 ) 12.0 1.2 AAA- Other asset-backed securities 1,077.7 4.5 24.7 1.2 AAA- Total asset-backed securities $ 4,366.1 $ 28.4 100.0 % 1.9 AA- 1Includes equipment leases, manufactured housing, and other types of structured debt. Substantially all of the asset-backed securities have widely available market quotes. As of September 30, 2014, 18.6% of our asset-backed securities were exposed to non-prime mortgage loans (home equity and Alt-A). We reviewed all of our asset-backed securities for other-than-temporary impairment (OTTI) and yield or asset valuation adjustments under current accounting guidance, and we did not record any write-downs during the third quarter and first nine months of 2014, compared to $0.1 million and $0.5 million during the third quarter and first nine months of 2013, respectively. These write-downs occurred in the residential mortgage sectors of our asset-backed portfolio as detailed below. The increase in asset-backed securities since December 31, 2013, was predominately in our residential mortgage-backed securities and in our other asset-backed securities, where we acquired a combination of automobile and credit card receivable-backed securities. The securities acquired in the residential mortgage-backed sector were primarily short duration, less than one year, with sufficient collateral for the risk profile, while the securities in the other asset-backed category were AAA rated paper primarily with durations less than one year. These securities provided additional portfolio yield without significantly increasing our credit or duration risk over that of comparable short-term paper. 53-------------------------------------------------------------------------------- Collateralized Mortgage Obligations At September 30, 2014, 13.8% of our asset-backed securities were collateralized mortgage obligations (CMO), which are a component of our residential mortgage-backed securities. During the third quarter and first nine months of 2014, we did not record any write-downs in our CMO portfolio. During the first nine months of 2013, we recorded $0.1 million of credit loss write-downs on our CMO portfolio due to estimated principal losses in our most recent cash flow projections; we did not have any write-downs during the third quarter 2013. We did not have any write-downs on Alt-A securities during 2013. The following table details the credit quality rating and fair value of our CMOs, along with the loan classification and a comparison of the fair value at September 30, 2014, to our original investment value (adjusted for returns of principal, amortization, and write-downs): Collateralized Mortgage Obligations (at September 30, 2014) ($ in millions) Rating1 Non-Agency Prime Alt-A Government/GSE2 Total % of Total AAA $ 70.9 $ 0 $ 6.1 $ 77.0 10.8 % AA 14.7 17.5 1.6 33.8 4.7 A 281.2 117.6 0 398.8 55.8 BBB 54.6 1.4 0 56.0 7.8 Non-investment grade 90.5 58.9 0 149.4 20.9 Total $ 511.9 $ 195.4 $ 7.7 $ 715.0 100.0 % Increase (decrease) in value .3 % 1.7 % 13.0 % .8 % 1The credit quality ratings in the table above are assigned by NRSROs; when we assign the NAIC ratings, our non-investment-grade securities (i.e., Group I) represent $5.5 million, or 0.8% of the total. 2The securities in this category are insured by a Government Sponsored Entity (GSE) and/or collateralized by mortgage loans insured by the Federal Housing Administration (FHA) or the U.S. Department of Veteran Affairs (VA). Home-Equity Securities At September 30, 2014, 14.8% of our asset-backed securities were home-equity securities, which are a component of our residential mortgage-backed securities. We did not record any write-downs during the third quarter and first nine months of 2014, compared to $0.1 million and $0.4 million, respectively, for the same periods in 2013. The following table shows the credit quality rating of our home-equity securities, along with a comparison of the fair value at September 30, 2014, to our original investment value (adjusted for returns of principal, amortization, and write-downs): Home Equity Securities (at September 30, 2014) ($ in millions) Rating1 Total % of Total AAA $ 29.0 3.7 % AA 5.1 .7 A 133.3 17.3 BBB 165.8 21.5 Non-investment grade 438.3 56.8 Total $ 771.5 100.0 %Increase (decrease) in value 2.7 % 1The credit quality ratings in the table above are assigned by NRSROs; when we assign the NAIC ratings, none of our home equity securities are rated non-investment-grade securities (i.e., Group I). 54 -------------------------------------------------------------------------------- Commercial Mortgage-Backed Securities At September 30, 2014, 38.4% of our asset-backed securities were commercial mortgage-backed securities (CMBS bonds) and 3.3% were CMBS interest-only securities (IO), collectively the CMBS portfolio. We did not record any write-downs in our CMBS portfolios during either the third quarter or first nine months of 2014 or 2013. The following table details the credit quality rating and fair value of our CMBS and IO portfolios: Commercial Mortgage-Backed Securities (at September 30, 2014)1 ($ in millions) Non-Investment Category AAA AA A BBB Grade Total % of Total CMBS bonds $ 949.8 $ 416.7 $ 243.5 $ 354.1 $ 36.1 $ 2,000.2 92.1 % IO 168.6 0 0 0 3.7 172.3 7.9 Total fair value $ 1,118.4 $ 416.7 $ 243.5 $ 354.1 $ 39.8 $ 2,172.5 100.0 %% of Total fair value 51.5 % 19.2 % 11.2 % 16.3 % 1.8 % 100.0 % 1The credit quality ratings in the table above are assigned by NRSROs; when we assign the NAIC ratings for our CMBS bonds, the non-investment-grade securities (i.e., Group I) represent $3.7 million, or 0.2%, of the total. The securities in the CMBS bond portfolio that are rated BBB or lower had a net unrealized gain of $15.7 million at September 30, 2014 and an average duration of 4.1 years, compared to 3.0 years for the entire CMBS portfolio. The following table summarizes the composition of our CMBS bond portfolio: CMBS Bond Portfolio (at September 30, 2014) (millions) Vintage Multi-Borrower Single-Borrower Total 1997-2005 $ 242.7 $ 14.8 $ 257.5 2006-2008 27.6 4.0 31.6 2009-2014 335.6 1,375.5 1,711.1 Total $ 605.9 $ 1,394.3 $ 2,000.2 CMBS bonds that originated since 2009 are referred to in the market as "CMBS 2.0" and tend to have more conservative underwriting than the 2006-2008 vintages. We have no multi-borrower deal IOs originated after 2006, with the exception of $160.2 million in Freddie Mac senior multi-family IOs. MUNICIPAL SECURITIES Included in the fixed-income portfolio at September 30, 2014 and 2013, and December 31, 2013, were $2,172.8 million, $2,138.6 million, and $2,256.0 million, respectively, of state and local government obligations. These securities had a duration of 3.0 years and an overall credit quality rating of AA (excluding the benefit of credit support from bond insurance) at September 30, 2014, compared to 3.1 years and AA+ at September 30, 2013 and 3.1 years and AA at December 31, 2013. These securities had a net unrealized gain of $48.6 million at September 30, 2014, compared to $12.9 million and $8.7 million at September 30, 2013 and December 31, 2013, respectively. During the three and nine months ended September 30, 2014 and 2013, we did not record any write-downs on our municipal portfolio. The following table details the credit quality rating of our municipal securities at September 30, 2014, without the benefit of credit or bond insurance: Municipal Securities (at September 30, 2014) (millions) General Revenue Rating Obligations Bonds Total AAA $ 358.7 $ 486.4 $ 845.1 AA 315.2 673.4 988.6 A 0 327.7 327.7 BBB 0 10.9 10.9 Non-investment grade/non-rated 0 .5 .5 Total $ 673.9 $ 1,498.9 $ 2,172.8 55-------------------------------------------------------------------------------- Included in revenue bonds were $846.3 million of housing revenue bonds issued by state housing finance agencies, of which $482.7 million were supported by individual mortgages held by the state housing finance agencies and $363.6 million were supported by mortgage-backed securities. Of the programs supported by mortgage-backed securities, approximately 25% were collateralized by Fannie Mae and Freddie Mac mortgages; the remaining 75% were collateralized by Ginnie Mae loans, which are fully guaranteed by the U.S. Government. Of the programs supported by individual mortgages held by the state housing finance agencies, the overall credit quality rating was AA+. Most of these mortgages were supported by FHA, VA, or private mortgage insurance providers. Approximately 4%, or $96.8 million, of our total municipal securities were insured general obligation ($62.3 million) or revenue bonds ($34.5 million), with an overall credit quality rating of AA- at September 30, 2014, excluding the benefit of credit insurance provided by municipal bond insurers. These securities had a net unrealized gain of $2.0 million at September 30, 2014, compared to $3.5 million and $3.0 million at September 30, 2013 and December 31, 2013, respectively. We buy and hold these securities based on our evaluation of the underlying credit without reliance on the municipal bond insurance. Our investment policy does not require us to liquidate securities should the insurance provided by the municipal bond insurers cease to exist. CORPORATE SECURITIES Included in our fixed-income securities at September 30, 2014 and 2013, and December 31, 2013, were $2,519.1 million, $3,157.6 million, and $2,926.6 million, respectively, of corporate securities. These securities had a duration of 3.3 years at September 30, 2014, compared to 3.5 years at September 30, 2013 and 3.3 years at December 31, 2013. The overall credit quality rating was BBB- at September 30, 2014, compared to BBB at both September 30, 2013 and December 31, 2013. These securities had net unrealized gains of $17.6 million, $38.1 million, and $40.0 million at September 30, 2014 and 2013, and December 31, 2013, respectively. We did not record any write-downs on our corporate debt portfolio during the three and nine months ended September 30, 2014 or 2013. The table below shows the exposure break-down by sector and rating: Corporate Securities (at September 30, 2014) % of Non-Investment Corporate Sector AA A BBB Grade/Non-Rated Securities Consumer 0 % 0 % 15.8 % 16.3 % 32.1 % Industrial 0 2.3 18.5 6.4 27.2 Communications 0 1.4 11.2 2.0 14.6 Financial Services 1.2 3.1 14.1 5.1 23.5 Technology 0 0 .8 0 .8 Basic Materials 0 0 1.4 0 1.4 Energy 0 0 .4 0 .4 Total 1.2 % 6.8 % 62.2 % 29.8 % 100.0 % PREFERRED STOCKS - REDEEMABLE AND NONREDEEMABLE We hold both redeemable (i.e., mandatory redemption dates) and nonredeemable (i.e., perpetual with call dates) preferred stocks. At September 30, 2014, we held $284.8 million in redeemable preferred stocks and $763.3 million in nonredeemable preferred stocks, compared to $345.1 million and $726.0 million, respectively, at September 30, 2013, and $313.9 million and $711.2 million at December 31, 2013. Our preferred stock portfolio had net unrealized gains of $235.8 million, $289.8 million, and $268.6 million, at September 30, 2014 and 2013, and December 31, 2013, respectively. We did not record any write-downs during the three and nine months ended September 30, 2014 or 2013. 56 -------------------------------------------------------------------------------- Our preferred stock portfolio had a duration of 2.1 years at September 30, 2014, compared to 1.5 years at September 30, 2013, and 2.0 years at December 31, 2013. The overall credit quality rating was BB+ at September 30, 2014 and 2013, and December 31, 2013. Approximately 57% of our preferred stock securities are fixed-rate securities and 43% are floating-rate securities. All of our preferred securities have call or mandatory redemption features. Most of the securities are structured to provide some protection against extension risk in the event the issuer elects not to call such securities at their initial call date, by either paying a higher dividend amount or by paying floating-rate coupons. Of our fixed-rate securities, approximately 96% will convert to floating-rate dividend payments if not called at their initial call date. The interest rate duration of our preferred securities is calculated to reflect the call, floor, and floating rate features. Although a preferred security may remain outstanding if not called, its interest rate duration will reflect the variable nature of the dividend. The table below shows the exposure break-down by sector and rating at quarter end: Preferred Stocks (at September 30, 2014) Non-Investment % of Preferred Sector BBB Grade/Non-Rated Stock Portfolio Financial Services U.S. banks 30.0 % 24.9 % 54.9 % Foreign banks 2.4 2.1 4.5 Insurance holdings 4.7 14.0 18.7 Other financial institutions .6 3.7 4.3 Total financial services 37.7 44.7 82.4 Industrials 7.3 4.1 11.4 Utilities 6.2 0 6.2 Total 51.2 % 48.8 % 100.0 % Approximately 65% of our preferred stock securities pay dividends that have tax preferential characteristics, while the balance pay dividends that are fully taxable. In addition, our non-investment-grade preferred stocks were with issuers that primarily maintain investment-grade senior debt ratings. Common Equities Common equities, as reported on the balance sheet were comprised of the following: ($ in millions) September 30, 2014 September 30, 2013 December 31, 2013 Common stocks $ 2,379.0 99.9 % $ 2,287.4 98.3 % $ 2,530.0 99.9 % Other risk investments .4 .1 38.7 1.7 .5 .1 Total common equities $ 2,379.4 100.0 % $ 2,326.1 100.0 % $ 2,530.5 100.0 % At September 30, 2014, 12.5% of the total investment portfolio was in common equities, compared to 12.9% at September 30, 2013 and 14.0% at December 31, 2013. The decrease since December 31, 2013 reflects $296.3 million in sales from our equity-indexed portfolio during January 2014; these securities had a cost basis of $224.4 million. Our indexed common stock portfolio, which makes up 87.4% of our September 30, 2014 common stock holdings, is managed externally to track the Russell 1000 Index with an anticipated annual tracking error of +/- 50 basis points. Our individual holdings are selected based on their contribution to the correlation with the index. For all three periods reported in the table above, the GAAP basis total return was within the desired tracking error when compared to the Russell 1000 Index. We held 670 out of 1,039, or 64%, of the common stocks comprising the Russell 1000 Index at September 30, 2014, which made up 87% of the total market capitalization of the index. The remaining 12.6% of our common stock portfolio is actively managed by two external managers. At September 30, 2014, the fair value of the actively managed portfolio was $298.8 million, compared to a cost basis of $246.6 million. We recorded $0.1 million in write-downs on our common equities during the third quarter and first nine months of 2014, compared to $1.8 million and $3.2 million during the third quarter and first nine months of 2013, respectively. Other risk investments include private equity investments and limited partnership interests in private equity and mezzanine investment funds, which have no off-balance-sheet exposure or contingent obligations. 57 -------------------------------------------------------------------------------- Derivative Instruments 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 net derivative asset and 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. 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. INTEREST RATE SWAPS We entered into interest rate swaps primarily to manage the fixed-income portfolio duration. The $750 million notional value swaps reflected a loss for the first nine months of 2014, as interest rates in the ten-year maturity range have fallen during the year, compared to a gain during the first nine months of 2013 when interest rates increased after the positions were opened. The loss on the $1,263 million notional value swaps closed during the second quarter of 2013 reflected a decline in rates during the year. The following table summarizes our interest rate swap activity: Net Realized Gains (Losses) Notional Value (millions) Date September 30, Three Months Ended September 30, Nine Months Ended September 30, Term Effective Maturity Coupon 2014 2013 2014 2013 2014 2013 Open: 10-year 04/2013 04/2023 Receive variable $ 150 $ 150 $ (.2 ) $ (.4 ) $ (8.1 ) $ 9.6 10-year 04/2013 04/2023 Receive variable 185 185 (.3 ) (.5 ) (9.9 ) 11.9 10-year 04/2013 04/2023 Receive variable 415 415 (.7 ) (1.1 ) (22.4 ) 26.7 Total open positions $ 750 $ 750 $ (1.2 ) $ (2.0 ) $ (40.4 ) $ 48.2 Closed: 5-year NA NA Receive variable $ 0 $ 400 $ 0 $ 0 $ 0 $ (1.0 ) 5-year NA NA Receive variable 0 500 0 0 0 (1.6 ) 9-year NA NA Receive variable 0 363 0 0 0 (1.4 ) Total closed positions $ 0 $ 1,263 $ 0 $ 0 $ 0 $ (4.0 ) Total interest rate swaps $ 750 $ 2,013 $ (1.2 ) $ (2.0 ) $ (40.4 ) $ 44.2 NA = Not Applicable CASH FLOW HEDGES In April 2014, we issued $350 million of 4.35% Senior Notes due 2044 (the "4.35% Senior Notes"). Upon issuance of the 4.35% Senior Notes, we closed a forecasted debt issuance hedge, which was entered into to hedge against a possible rise in interest rates, and recognized a $1.6 million pretax loss as part of accumulated other comprehensive income (loss); the loss will be recognized as an adjustment to interest expense and amortized over the life of the 4.35% Senior Notes. During the third quarter 2014 and 2013, we repurchased, in the open market, $44.3 million and $54.1 million, respectively, in aggregate principal amount of our 6.70% Fixed-to-Floating Rate Junior Subordinated Debentures due 2067 (the "6.70% Debentures"). For the portion of the 6.70% Debentures we repurchased during 2014 and 2013, we reclassified $0.5 million and $0.8 million, respectively, on a pretax basis, of the unrealized gain on forecasted transactions from accumulated other comprehensive income on the balance sheet to net realized gains on securities on the comprehensive income statement. B. Investment Results Investment income (interest and dividends, before investment and interest expenses) was down for both the third quarter and first nine months of 2014, compared to the same periods last year, reflecting lower yields. We report total return to more accurately reflect our management philosophy governing the portfolio and our evaluation of investment results. The fully taxable equivalent (FTE) total return includes recurring investment income, adjusted to a fully taxable amount, based on certain securities that receive preferential tax treatment (e.g., municipal securities), net realized gains (losses) on securities, and changes in net unrealized gains (losses) on investments. 58 --------------------------------------------------------------------------------The following summarizes investment results for the periods ended September 30: Three Months Nine Months 2014 2013 2014 2013 Pretax recurring investment book yield 2.3 % 2.6 % 2.4 % 2.6 % Weighted average FTE book yield 2.6 % 2.9 % 2.7 % 2.9 % FTE total return: Fixed-income securities .3 % .6 % 2.7 % 1.0 % Common stocks .2 % 6.3 % 7.4 % 21.0 % Total portfolio .3 % 1.3 % 3.3 % 3.5 % A further break-down of our FTE total returns for our portfolio, including the net gains (losses) on our derivative positions, for the periods ended September 30, follows: Three Months Nine Months 2014 2013 2014 2013 Fixed-income securities: U.S. Treasury Notes 0 % .4 % 0 % 1.4 % Municipal bonds 1.3 % 1.1 % 5.2 % 1.5 % Corporate bonds (.4 )% 1.3 % 2.7 % .7 % Commercial mortgage-backed securities .2 % 1.2 % 3.8 % (.3 )% Collateralized mortgage obligations .4 % 1.2 % 2.2 % 2.6 % Asset-backed securities .6 % .4 % 2.4 % 1.5 % Preferred stocks .7 % (2.2 )% 10.7 % 2.9 % Common stock portfolios: Indexed .7 % 6.1 % 8.3 % 21.1 % Actively managed (2.7 )% 7.7 % 2.4 % 20.4 % The decline in FTE total return during 2014 reflects lower equity market returns in 2014, compared to 2013. Other-Than-Temporary Impairment (OTTI) Realized losses may include write-downs of securities determined to have had other-than-temporary declines in fair value. We routinely monitor our portfolio for pricing changes that might indicate potential impairments and perform detailed reviews of securities with unrealized losses. In such cases, changes in fair value are evaluated to determine the extent to which such changes are attributable to: (i) fundamental factors specific to the issuer, such as financial conditions, business prospects, or other factors, (ii) market-related factors, such as interest rates or equity market declines (e.g., negative return at either a sector index level or at the broader market level), or (iii) credit-related losses where the present value of cash flows expected to be collected is lower than the amortized cost basis of the security. Fixed-income securities and common equities with declines attributable to issuer-specific fundamentals are reviewed to identify all available evidence, circumstances, and influences to estimate the potential for, and timing of, recovery of the investment's impairment. An other-than-temporary impairment loss is deemed to have occurred when the potential for recovery does not satisfy the criteria set forth in the current accounting guidance. For fixed-income investments with unrealized losses due to market- or sector-related declines, the losses are not deemed to qualify as other-than-temporary if we do not have the intent to sell the investments, and it is more likely than not that we will not be required to sell the investments, prior to the periods of time that we anticipate to be necessary for the investments to recover their cost bases. In general, our policy for common equity securities with market- or sector-related declines is to recognize impairment losses on individual securities with losses we cannot reasonably conclude will recover in the near term under historical conditions by the earlier of: (i) when we are able to determine that the loss is other-than-temporary, or (ii) when the security has been in such a loss position for three consecutive quarters. 59 -------------------------------------------------------------------------------- When a security in our fixed-maturity portfolio has an unrealized loss and we intend to sell the security, or it is more likely than not that we will be required to sell the security, we write-down the security to its current fair value and recognize the entire unrealized loss through the comprehensive income statement as a realized loss. If a fixed-maturity security has an unrealized loss and it is more likely than not that we will hold the debt security until recovery (which could be maturity), then 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 the comprehensive income statement as a realized loss; any remaining unrealized loss on the security is considered to be due to other factors (e.g., interest rate and credit spread movements) and is reflected in shareholders' equity, along with unrealized gains or losses on securities that are not deemed to be other-than-temporarily impaired. The write-down activity recorded in the comprehensive income statement was as follows: Three Months Ended September 30, Nine Months Ended September 30, Write-downs Write-downs Write-downs on Securities Write-downs on Securities Total on Securities Held at Total on Securities Held at (millions) Write-downs Sold Period End Write-downs Sold Period End 2014 Residential mortgage-backed securities $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 Total fixed-income securities 0 0 0 0 0 0 Common equities .1 0 .1 .1 0 .1 Total portfolio $ .1 $ 0 $ .1 $ .1 $ 0 $ .1 2013 Residential mortgage-backed securities $ .1 $ 0 $ .1 $ .5 $ 0 $ .5 Total fixed-income securities .1 0 .1 .5 0 .5 Common equities 1.8 0 1.8 3.2 0 3.2 Total portfolio $ 1.9 $ 0 $ 1.9 $ 3.7 $ 0 $ 3.7 The following table stratifies the gross unrealized losses in our fixed-income and common equity portfolios at September 30, 2014, by duration in a loss position and magnitude of the loss as a percentage of the cost of the security: Total Gross Decline of Investment Value Fair Unrealized (millions) Value Losses >15% >25% >35% >45% Fixed Income: Unrealized loss for less than 12 months $ 2,866.3 $ 19.6 $ 0 $ 0 $ 0 $ 0 Unrealized loss for 12 months or greater 1,381.8 25.5 0 0 0 0 Total $ 4,248.1 $ 45.1 $ 0 $ 0 $ 0 $ 0 Common Equity: Unrealized loss for less than 12 months $ 45.7 $ 5.4 $ 3.9 $ 1.1 $ 1.0 $ .8 Unrealized loss for 12 months or greater 11.8 1.3 1.3 1.3 0 0 Total $ 57.5 $ 6.7 $ 5.2 $ 2.4 $ 1.0 $ .8 We completed a thorough review of the existing securities in these loss categories and determined that, applying the procedures and criteria discussed above, these securities were not other-than-temporarily impaired. We do not intend to sell these securities. We also determined that it is more likely than not that we will not be required to sell these securities for the periods of time necessary to recover their respective cost bases, and that there are no additional credit-related impairments on our debt securities. Since total unrealized losses are already a component of other comprehensive income and included in shareholders' equity, any recognition of these losses as additional OTTI losses would have no effect on our comprehensive income, book value, or reported investment total return. 60 -------------------------------------------------------------------------------- C. Repurchase and Reverse Repurchase Transactions From time to time we enter into reverse repurchase commitment transactions. In these transactions, we loan cash to internally approved counterparties and receive U.S. Treasury Notes pledged as collateral against the cash borrowed. We choose to enter into these transactions as rates and credit quality are more attractive than other short-term rates available in the market. Our exposure to credit risk is limited due to the nature of the collateral (i.e., U.S. Treasury Notes) received. The income generated on these transactions is calculated at the then applicable general collateral rates on the value of U.S. Treasury securities received. We have counterparty exposure on reverse repurchase agreements in the event of a counterparty default to the extent the general collateral security's value is below the amount of cash we delivered to acquire the collateral. The short-term duration of the transactions (primarily overnight investing) reduces that exposure. For the three and nine months ended September 30, 2014, and the three months ended September 30, 2013, we earned less than $50 thousand on the reverse repurchase commitments entered into during those periods. For the nine months ended September 30, 2013, we earned $0.2 million on these types of transactions. We did not have any open reverse repurchase commitments at September 30, 2014, compared to $278.1 million with two counterparties at September 30, 2013, and $200.0 million open with one counterparty at December 31, 2013. For the nine months ended September 30, 2014, our largest outstanding balance of reverse repurchase commitments was $500.0 million, which was open for one day; the average daily balance of reverse repurchase commitments was $169.9 million. We did not enter into any repurchase commitment transactions during the first nine months of 2014. During the first nine months of 2013, we entered into repurchase commitment transactions for 48 days, including 34 days during the third quarter. In these transactions, we loan U.S. Treasury securities to internally approved counterparties in exchange for cash equal to the fair value of the securities. The cash proceeds are invested in unsecured commercial paper issued by large, high-quality institutions. These transactions are entered into as overnight arrangements, and we had no open repurchase commitments at September 30, 2014 and 2013 or December 31, 2013. During the first nine months of 2013, the largest outstanding balance was $252.5 million, which was open for six days; the average daily balance of these repurchase commitments was $94.8 million. We earned income of approximately $43 thousand during the period these transactions were open in 2013. 61 -------------------------------------------------------------------------------- Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995: Statements in this report, or in the exhibits hereto, that are not historical fact are forward-looking statements that are subject to certain risks and uncertainties that could cause actual events and results to differ materially from those discussed herein. These risks and uncertainties include, without limitation, uncertainties related to estimates, assumptions, and projections generally; inflation and changes in economic conditions (including changes in interest rates and financial markets); the possible failure of one or more governmental, corporate, or other entities to make scheduled debt payments or satisfy other obligations; the potential or actual downgrading by one or more rating agencies of our securities or governmental, corporate, or other securities we hold; the financial condition of, and other issues relating to the strength of and liquidity available to, issuers of securities held in our investment portfolios and other companies with which we have ongoing business relationships, including counterparties to certain financial transactions; the accuracy and adequacy of our pricing and loss reserving methodologies; the competitiveness of our pricing and the effectiveness of our initiatives to attract and retain more customers; initiatives by competitors and the effectiveness of our response; our ability to obtain regulatory approval for requested rate changes and the timing thereof; the effectiveness of our brand strategy and advertising campaigns relative to those of competitors; legislative and regulatory developments at the state and federal levels, including, but not limited to, health care reform and tax law changes; the outcome of disputes relating to intellectual property rights; the outcome of litigation or governmental investigations that may be pending or filed against us; weather conditions (including the severity and frequency of storms, hurricanes, snowfalls, hail, and winter conditions); changes in driving patterns; our ability to accurately recognize and appropriately respond in a timely manner to changes in frequency and severity trends; technological advances; acts of war and terrorist activities; our ability to maintain the uninterrupted operation of our facilities, systems (including information technology systems), and business functions, and safeguard personal and sensitive information in our possession; our continued access to and functionality of third-party systems that are critical to our business; court decisions and trends in litigation and health care and auto repair costs; and other matters described from time to time in our releases and publications, and in our periodic reports and other documents filed with the United States Securities and Exchange Commission. In addition, investors should be aware that generally accepted accounting principles prescribe when a company may reserve for particular risks, including litigation exposures. Accordingly, results for a given reporting period could be significantly affected if and when a reserve is established for one or more contingencies. Also, our regular reserve reviews may result in adjustments of varying magnitude as additional information regarding claims activity becomes known. Reported results, therefore, may be volatile in certain accounting periods. 62-------------------------------------------------------------------------------- |