**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549





**FORM
      10-Q**





x **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**


**SECURITIES
      EXCHANGE ACT OF 1934**




For
      the
      quarterly period ended June 30, 2006




 ̈ **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**


**SECURITIES
      EXCHANGE ACT OF 1934**





For
      the
      transition period from  to





Commission
      File Number 0-6964







(Exact
      name of registrant as specified in its charter)






**Delaware**
            
            **95-1935264**(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification No.)**6301
                Owensmouth Avenue****Woodland
                Hills, California**
            
            **91367**(Address
                of principal executive offices)
            
            (Zip
                Code)**(818)
                704-3700**
            
            **www.21st.com**(Registrant’s
                telephone number, including area code)
            
            (Registrant’s
                web site)




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  Yes x No  ̈





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
      (Check one):




Large
                  accelerated filer ̈
              Accelerated
                  filerx
              Non-accelerated filer ̈





Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act).


Yes  ̈ No x





The
      number of shares outstanding of the issuer’s common stock as of July 13, 2006
      was 86,335,335.
















**TABLE
      OF CONTENTS**





Description
            Page
                Number**PART
                I - FINANCIAL INFORMATION**Item
                1.
            Financial
                Statements
            2Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition andResults
                of Operations
            18Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            35Item
                4.
            Controls
                and Procedures
            37**PART
                II - OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            38Item
                1A.
            Risk
                Factors
            38Item
                2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            38Item
                3.
            Defaults
                Upon Senior Securities
            38Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            38Item
                5.
            Other
                Information
            38Item
                6.
            Exhibits
            38**SIGNATURES**
            39**EXHIBIT
                INDEX**
            4031.1
            Certification
                of Principal Executive Officer Pursuant to Exchange Act Rule
                13a-14(a)31.2
            Certification
                of Principal Financial Officer Pursuant to Exchange Act Rule
                13a-14(a)32.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002





1





**PART
      I - FINANCIAL INFORMATION**





**ITEM
      1. FINANCIAL STATEMENTS**





**21ST
                CENTURY INSURANCE GROUP****CONDENSED
                CONSOLIDATED BALANCE SHEETS**Unaudited*AMOUNTS
                IN THOUSANDS, EXCEPT SHARE DATA*
            
            **June
                30, 2006**
            December
                31, 2005**Assets**Fixed
                maturity investments available-for-sale, at fair value(amortized
                cost: $1,472,300 and $1,365,948)
            
            **$**
            **1,426,728**
            
            $
            1,354,707Equity
                securities available-for-sale, at fair value (cost: $0 and
                $49,210)
            
            
            **—**
            
            
            47,367Total
                investments
            
            
            **1,426,728**
            
            
            1,402,074Cash
                and cash equivalents
            
            
            **40,188**
            
            
            68,668Accrued
                investment income
            
            
            **17,304**
            
            
            16,585Premiums
                receivable
            
            
            **98,887**
            
            
            100,900Reinsurance
                receivables and recoverables
            
            
            **6,521**
            
            
            6,539Prepaid
                reinsurance premiums
            
            
            **2,072**
            
            
            1,946Deferred
                income taxes
            
            
            **57,321**
            
            
            56,209Deferred
                policy acquisition costs
            
            
            **68,248**
            
            
            59,939Leased
                property under capital lease, net of deferred gain of $1,313 and
                $1,534
                and net of accumulated amortization of $39,542 and $36,995
            
            
            **20,568**
            
            
            22,651Property
                and equipment, at cost less accumulated depreciation of $100,295
                and
                $89,595
            
            
            **148,213**
            
            
            145,811Other
                assets
            
            
            **41,323**
            
            
            38,907Total
                assets
            
            **$**
            **1,927,373**
            
            $
            1,920,229**Liabilities
                and stockholders’ equity**Unpaid
                losses and loss adjustment expenses
            
            **$**
            **495,092**
            
            $
            523,835Unearned
                premiums
            
            
            **321,166**
            
            
            319,676Debt
            
            
            **121,619**
            
            
            127,972Claims
                checks payable
            
            
            **38,363**
            
            
            42,681Reinsurance
                payable
            
            
            **748**
            
            
            643Other
                liabilities
            
            
            **95,220**
            
            
            75,450Total
                liabilities
            
            
            **1,072,208**
            
            
            1,090,257Commitments
                and contingenciesStockholders’
                equity:Common
                stock, par value $0.001 per share; 110,000,000 shares authorized;
                shares
                issued 86,341,626 and 85,939,889
            
            
            **86**
            
            
            86Additional
                paid-in capital
            
            
            **435,894**
            
            
            425,454Treasury
                stock; at cost shares: 6,291 and 5,929
            
            
            **(89**
            **)**
            
            (84
            )Retained
                earnings
            
            
            **450,774**
            
            
            414,898Accumulated
                other comprehensive loss
            
            
            **(31,500**
            **)**
            
            (10,382
            )Total
                stockholders’ equity
            
            
            **855,165**
            
            
            829,972Total
                liabilities and stockholders’ equity
            
            **$**
            **1,927,373**
            
            $
            1,920,229




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





2




**21ST
                CENTURY INSURANCE GROUP****CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS**
              Unaudited*Three
                Months Ended June30,*
            *Six
                Months Ended June 30,**AMOUNTS
                IN THOUSANDS, EXCEPT SHARE DATA*
            
            **2006**
            2005
            **2006**
            2005**Revenues**Net
                premiums earned
            
            **$**
            **325,512**
            
            $
            336,845
            
            **$**
            **651,336**
            
            $
            673,209Net
                investment income
            
            
            **17,174**
            
            
            17,006
            
            
            **34,929**
            
            
            34,043Other
                income
            
            
            **10**
            
            
            367
            
            
            **10**
            
            
            367Net
                realized investment gains (losses)
            
            
            **30**
            
            
            (1,267
            )
            
            **(1,037**
            **)**
            
            (1,727
            )Total
                revenues
            
            
            **342,726**
            
            
            352,951
            
            
            **685,238**
            
            
            705,892**Losses
                and expenses**Net
                losses and loss adjustment expenses
            
            
            **223,094**
            
            
            248,284
            
            
            **459,590**
            
            
            499,315Policy
                acquisition costs
            
            
            **64,887**
            
            
            63,755
            
            
            **124,219**
            
            
            128,078Other
                underwriting expenses
            
            
            **9,504**
            
            
            8,765
            
            
            **22,104**
            
            
            16,123Other
                expense
            
            
            **923**
            
            
            —
            
            
            **923**
            
            
            —Interest
                and fees expense
            
            
            **1,854**
            
            
            2,031
            
            
            **3,752**
            
            
            4,088Total
                losses and expenses
            
            
            **300,262**
            
            
            322,835
            
            
            **610,588**
            
            
            647,604Income
                before provision for income taxes
            
            
            **42,464**
            
            
            30,116
            
            
            **74,650**
            
            
            58,288Provision
                for income taxes
            
            
            **14,143**
            
            
            9,621
            
            
            **25,011**
            
            
            18,356Net
                income
            
            **$**
            **28,321**
            
            $
            20,495
            
            **$**
            **49,639**
            
            $
            39,932**Earnings
                per common share**Basic
                earnings per share
            
            **$**
            **0.33**
            
            $
            0.24
            
            **$**
            **0.58**
            
            $
            0.47Diluted
                earnings per share
            
            **$**
            **0.33**
            
            $
            0.24
            
            **$**
            **0.57**
            
            $
            0.47Weighted-average
                shares outstanding —basic
            
            
            **85,968,155**
            
            
            85,704,165
            
            
            **85,918,791**
            
            
            85,613,043Weighted-average
                shares outstanding —diluted
            
            
            **86,232,103**
            
            
            85,890,984
            
            
            **86,373,845**
            
            
            85,803,214




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





3




**21ST
      CENTURY INSURANCE GROUP**


**CONDENSED
      CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**


Unaudited





*Common
                Stock**$0.001
                par value**AMOUNTS
                IN THOUSANDS,*
              *EXCEPT
                SHARE DATA*
            
            *Issued**Shares*
            *Amount*
            *Additional*
              *Paid-in
                Capital*
            *Treasury
                Stock*
            *Retained
                Earnings*
            *Accumulated
                Other Comprehensive*
              *Loss*
            *Total*Balance
                - January 1, 2006
            
            
            85,939,889
            
            $
            86
            
            $
            425,454
            
            $
            (84
            )
            $
            414,898
            
            $
            (10,382
            )
            $
            829,972Comprehensive
                income (loss)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            49,639
            (1)
            
            (21,118
            )(2)
            
            28,521Cash
                dividends declared on common stock ($0.16 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (13,763
            )
            
            
            
            
            (13,763
            )Exercise
                of stock options
            
            
            293,187
            
            
            
            
            
            3,844
            
            
            
            
            
            
            
            
            
            
            
            3,844Issuance
                of restricted stock
            
            
            108,550
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            —Forfeiture
                of 362 shares of restricted stock
            
            
            
            
            
            
            
            
            5
            
            
            (5
            )
            
            
            
            
            
            
            
            —Stock-based
                compensation cost
            
            
            
            
            
            
            
            
            6,478
            
            
            
            
            
            
            
            
            
            
            
            6,478Excess
                tax benefits of stock-based compensation
            
            
            
            
            
            
            
            
            113
            
            
            
            
            
            
            
            
            
            
            
            113Balance
                - June 30, 2006
            
            
            86,341,626
            
            $
            86
            
            $
            435,894
            
            $
            (89
            )
            $
            450,774
            
            $
            (31,500
            )
            $
            855,165





(1)
            Net
                income for the six months ended June 30,
                2006.




(2)
              Net
                  change in accumulated other comprehensive loss
                  follows:


*Six
                Months Ended*
              *June
                30, 2006*Unrealized
                holding losses arising during the period, net of tax benefit of
                $11,734
            
            $
            (21,792
            )Reclassification
                adjustment for investment losses included in net income, net of tax
                benefit of $363
            
            
            674Total
            
            $
            (21,118
            )





*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





4




**21ST
      CENTURY INSURANCE GROUP**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


Unaudited





*AMOUNTS
                IN THOUSANDS, EXCEPT SHARE DATA**Six
                Months Ended June 30,*
            
            **2006**
            2005**Operating
                activities**Net
                income
            
            **$**
            **49,639**
            
            $
            39,932Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            **13,304**
            
            
            14,995Net
                amortization of investment premiums and discounts
            
            
            **4,496**
            
            
            4,840Stock-based
                compensation cost
            
            
            **6,478**
            
            
            138Provision
                for deferred income taxes
            
            
            **9,431**
            
            
            5,903Net
                realized investment losses
            
            
            **1,037**
            
            
            1,717**Changes
                in assets and liabilities**Premiums
                receivable
            
            
            **2,013**
            
            
            234Deferred
                policy acquisition costs
            
            
            **(8,309**
            **)**
            
            (3,446
            )Reinsurance
                receivables and recoverables
            
            
            **(3**
            **)**
            
            1,377Federal
                income taxes
            
            
            **2,786**
            
            
            (69
            )Other
                assets
            
            
            **(1,866**
            **)**
            
            5,241Unpaid
                losses and loss adjustment expenses
            
            
            **(28,743**
            **)**
            
            (20
            )Unearned
                premiums
            
            
            **1,490**
            
            
            5,207Claims
                checks payable
            
            
            **(4,318**
            **)**
            
            (170
            )Other
                liabilities
            
            
            **16,983**
            
            
            (5,638
            )Net
                cash provided by operating activities
            
            
            **64,418**
            
            
            70,241**Investing
                activities**Purchases
                of:Fixed
                maturity investments available-for-sale
            
            
            **(180,179**
            **)**
            
            (76,575
            )Equity
                securities available-for-sale
            
            
            **(35,627**
            **)**
            
            (160,730
            )Property
                and equipment
            
            
            **(13,346**
            **)**
            
            (12,591
            )Maturities
                and calls of fixed maturity investments available-for-sale
            
            
            **12,618**
            
            
            17,225Sales
                of:Fixed
                maturity investments available-for-sale
            
            
            **55,346**
            
            
            27,192Equity
                securities available-for-sale
            
            
            **84,836**
            
            
            152,688Net
                cash used in investing activities
            
            
            **(76,352**
            **)**
            
            (52,791
            )**Financing
                activities**Repayment
                of debt
            
            
            **(6,740**
            **)**
            
            (5,953
            )Dividends
                paid (per share: $0.16 and $0.08)
            
            
            **(13,763**
            **)**
            
            (6,847
            )Proceeds
                from the exercise of stock options
            
            
            **3,844**
            
            
            1,975Excess
                tax benefits from stock-based compensation
            
            
            **113**
            
            
            —Net
                cash used in financing activities
            
            
            **(16,546**
            **)**
            
            (10,825
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            **(28,480**
            **)**
            
            6,625Cash
                and cash equivalents, beginning of period
            
            
            **68,668**
            
            
            34,697Cash
                and cash equivalents, end of period
            
            **$**
            **40,188**
            
            $
            41,322**Supplemental
                information:**Income
                taxes paid
            
            **$**
            **12,863**
            
            $
            9,434Interest
                paid
            
            
            **3,682**
            
            
            4,017




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*




5




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED




**NOTE** **1** **.
      FINANCIAL STATEMENT PRESENTATION**





***General***





21st
      Century Insurance Group and subsidiaries (the “Company”) prepared the
      accompanying unaudited condensed consolidated financial statements in accordance
      with the rules and regulations of the Securities and Exchange Commission for
      interim reporting. As permitted under those rules and regulations, certain
      notes
      or other information that are normally required by accounting principles
      generally accepted in the United States of America (“GAAP”) have been condensed
      or omitted if they substantially duplicate the disclosures contained in the
      annual audited consolidated financial statements. The unaudited condensed
      consolidated financial statements should be read in conjunction with the audited
      consolidated financial statements and notes thereto included in the Company’s
      Annual Report on Form 10-K for the year ended December 31, 2005.




These
      unaudited condensed consolidated financial statements include all adjustments
      (including normal, recurring accruals) that are considered necessary for the
      fair presentation of our financial position and results of operations in
      accordance with GAAP. Intercompany accounts and transactions have been
      eliminated in consolidation. Operating results for the six-month period ended
      June 30, 2006 are not necessarily indicative of results that may be expected
      for
      the remaining interim periods or the year as a whole.





***Earnings
      Per Share (“EPS”)***





For
      each
      of the quarters ended June 30, 2006 and 2005, the numerator for the calculation
      of both basic and diluted earnings per share is equal to net income reported
      for
      that period. The difference between basic and diluted EPS denominators is due
      to
      dilutive common stock equivalents (stock options and restricted stock). Basic
      earnings per share excludes dilution and reflects net income divided by the
      weighted-average shares of common stock outstanding during the periods
      presented. The denominator for the computation of basic EPS was 85,968,155
      and
      85,918,791 shares for the three and six months ended June 30, 2006,
      respectively, and 85,704,165 and 85,613,043 shares for the three and six months
      ended June 30, 2005, respectively.





Diluted
      earnings per share is based upon the weighted-average shares of common stock
      and
      dilutive common stock equivalents outstanding during the periods presented.
      Common stock equivalents arising from dilutive stock options and restricted
      common stock are computed using the treasury stock method. For the three and
      six
      months ended June 30, 2006, this amounted to 86,232,103 and 86,373,845 shares,
      respectively, which include 263,948 and 455,054 dilutive common stock
      equivalents, respectively. For the three and six months ended June 30, 2005,
      this amounted to 85,890,984 and 85,803,214 shares, respectively, which include
      186,819 and 190,171 dilutive common stock equivalents,
      respectively.





Options
      to purchase an aggregate of 6,157,293 and 5,359,356 shares of common stock
      during the three and six months ended June 30, 2006, respectively, and 7,475,427
      and 7,341,859 shares of common stock during the three and six months ended
      June
      30, 2005, respectively,  were
      not
      included in the computation of diluted earnings per share because the options’
exercise prices were greater than the average market prices of the common stock
      for each respective period. These options expire at various points in time
      through 2016.





***Stock-Based
      Compensation***





Prior
      to
      January 1, 2006, the Company accounted for its stock-based compensation plans
      under the measurement and recognition provisions of Accounting Principles Board
      Opinion No. (“APB”) 25, *Accounting
      for Stock Issued to Employees* ,
      and
      related Interpretations, as permitted by Statement of Financial Accounting
      Standards No. (“FAS”) 123, *Accounting
      for Stock-Based Compensation* .
      Under
      the intrinsic-value method prescribed by APB 25, compensation cost for stock
      options was measured at the date of grant as the excess, if any, of the quoted
      market price of the Company’s stock over the exercise price of the options. All
      employee stock options were granted at or above the grant date market price.
      Accordingly, no compensation cost was recognized for fixed stock option grants
      in prior periods; however, stock-based compensation measured in accordance
      with
      the fair-value based method was included as a pro forma disclosure in the
      consolidated financial statement footnotes.





6




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





Effective
      January 1, 2006, the Company adopted FAS 123 (revised 2004), *Share-Based
      Payment* (“FAS 123R”), which requires all stock-based payments to employees,
      including grants of employee stock options, to be recognized in the statements
      of operations based on their fair values. Determining the fair value of
      share-based awards at the grant date requires judgment in estimating the
      volatility and dividends over the expected term that the stock options will
      be
      outstanding prior to exercise. Judgment is also required in estimating the
      amount of stock-based awards expected to be forfeited prior to vesting. If
      actual results differ significantly from these estimates, stock-based
      compensation expense could be materially impacted.




In
      accordance with FAS 123R, the Company began recognizing the cost of all employee
      stock options on a straight-line basis over their respective vesting periods,
      net of estimated forfeitures, using the modified-prospective transition method.
      Under this transition method, results for prior periods have not been restated
      and 2006 results include:





·
            Stock-based
                compensation cost related to stock options granted on or prior to,
                but not
                vested as of, December 31, 2005, based on the grant date fair value
                originally estimated for the pro forma disclosures in accordance
                with the
                original provisions of FAS 123; and




·
            All
                stock-based payments granted subsequent to December 31, 2005, based
                on the
                grant date fair value estimated in accordance with the provisions
                of FAS
                123R.





FAS
      123R
      also prescribes the recognition of expense using the non-substantive vesting
      period approach for grants made after December 31, 2005. This expense
      attribution method requires recognition of compensation expense from the date
      of
      grant to the earlier of the vesting date or the date retirement eligibility
      is
      achieved for awards with retirement eligibility options. The use of the
      non-substantive vesting period approach will not affect the overall amount
      of
      compensation expense recognized, but could accelerate the recognition of expense
      for grants made since January 1, 2006. However, the Company will continue to
      follow the nominal vesting approach for the remaining portion of unvested awards
      that were granted prior to January 1, 2006 and will continue to recognize
      expense from the grant date to the earlier of the actual date of retirement
      or
      the vesting date.





Generally,
      stock-based awards are forfeited when employees terminate prior to the vesting
      date and any compensation cost previously recognized with respect to such
      unvested stock awards is reversed in the period of forfeiture. Upon share option
      exercise or restricted share unit conversion, the Company issues new shares,
      unless the Company elects to use available treasury shares. The Company records
      forfeitures of restricted stock as treasury share repurchases.





Prior
      to
      the adoption of FAS 123R, the Company previously presented all benefits of
      tax
      deductions resulting from the exercise of share-based compensation as operating
      cash flows in the Condensed Consolidated Statements of Cash Flows. FAS 123R
      requires the benefits of tax deductions in excess of the compensation cost
      recognized for those options (excess tax benefits) to be classified as financing
      cash flows.







***Recent
      Accounting Standards***





In
      June
      2006, the Financial Accounting Standards Board (“FASB”) issued interpretation of
      FASB Statement No. 109, *Accounting
      for Uncertainty in Income Taxes* (“FIN
      48”). This interpretation clarifies the accounting for uncertainty in income
      taxes recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN
      48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. This interpretation will be effective
      January 1, 2007. The Company is currently assessing the effect of implementing
      FIN 48.





Statement
      of Position (“SOP”) 05-1 *,
      Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
      with Modifications or Exchanges of Insurance Contracts,* becomes
      effective January ** 1,
      2007.
      SOP 05-1 provides guidance on accounting for deferred acquisition costs on
      internal replacements of insurance and investment contracts other than those
      specifically described in FAS 97, *Accounting
      and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
      and
      for Realized Gains and Losses from the Sale of Investments* .
      The SOP
      defines an internal replacement as a modification in product benefits, features,
      rights, or coverage that occurs by the exchange of a contract for a new
      contract, or by amendment, endorsement, or rider to a contract, or by the
      election of a feature or coverage within a contract. The Company is currently
      assessing the effect of implementing this guidance.





7




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





**NOTE
      2** **.
      STOCK-BASED COMPENSATION**





***2006
      Stock-based Compensation Summary***





The
      effect of the adoption of FAS 123R on the condensed consolidated statements
      of
      operations and cash flows is as follows:




*Three
                  Months Ended*
                *June
                  30, 2006*
              
              *Six
                  Months Ended*
                *June
                  30, 2006**AMOUNTS
                  IN THOUSANDS, EXCEPT SHARE DATA*
              
              *Without*
                *FAS
                  123R**1*
              *FAS
                  123R Impact*
              *With
                  FAS 123R*
              
              *Without*
                *FAS
                  123R 1*
              *FAS
                  123R Impact*
              *With
                  FAS 123R*Total
                  revenues
              
              $
              342,726
              
              $
              —
              
              $
              342,726
              
              
              $
              685,238
              
              $
              —
              
              $
              685,238Losses
                  and expensesNet
                  losses and loss adjustment expenses
              
              
              222,335
              
              
              759
              
              
              223,094
              
              
              
              457,697
              
              
              1,893
              
              
              459,590Policy
                  acquisition costs
              
              
              64,439
              
              
              448
              
              
              64,887
              
              
              
              123,284
              
              
              935
              
              
              124,219Other
                  underwriting expenses
              
              
              9,070
              
              
              434
              
              
              9,504
              
              
              
              19,835
              
              
              2,269
              
              
              22,104Other
                  expense
              
              
              923
              
              
              —
              
              
              923
              
              
              
              923
              
              
              —
              
              
              923Interest
                  and fees expense
              
              
              1,854
              
              
              —
              
              
              1,854
              
              
              
              3,752
              
              
              —
              
              
              3,752Total
                  losses and expenses
              
              
              298,621
              
              
              1,641
              
              
              300,262
              
              
              
              605,491
              
              
              5,097
              
              
              610,588Income
                  before provision for income taxes
              
              
              44,105
              
              
              (1,641
              )
              
              42,464
              
              
              
              79,747
              
              
              (5,097
              )
              
              74,650Provision
                  for income taxes
              
              
              14,431
              
              
              (288
              )
              
              14,143
              
              
              
              26,056
              
              
              (1,045
              )
              
              25,011Net
                  income
              
              $
              29,674
              
              $
              (1,353
              )
              $
              28,321
              
              
              $
              53,691
              
              $
              (4,052
              )
              $
              49,639Basic
                  earnings per share2
              
              $
              0.35
              
              $
              (0.02
              )
              $
              0.33
              
              
              $
              0.62
              
              $
              (0.05
              )
              $
              0.58Diluted
                  earnings per share2
              
              $
              0.34
              
              $
              (0.02
              )
              $
              0.33
              
              
              $
              0.62
              
              $
              (0.05
              )
              $
              0.57


The
      six
      months ended June 30, 2006 results include $0.7 million and $1.4 million,
      respectively, of accelerated costs incurred during the first quarter to
      recognize the effect of retirement eligibility in accordance with the
      non-substantive vesting period approach and actual vesting in accordance with
      an
      executive retention agreement, respectively. As compensation costs for certain
      employees are included in deferred policy acquisition costs, pre-tax
      compensation cost related to stock-based compensation of $0.9 million was
      deferred, for the six months ended June 30, 2006. The remaining unrecognized
      compensation cost related to unvested awards as of June 30, 2006, was $13.4
      million and the weighted-average period over which this cost will be recognized
      is 2.1 years. The six-month period ended June 30, 2006, results included $113
      thousand of excess tax benefits as a financing cash inflow and an increase
      of
      additional paid-in capital.





***2005
      Stock-based Compensation Pro Forma Summary***





Had
      compensation cost for the Company’s stock-based compensation plans been
      determined in the prior year based on the fair-value-based method for all
      awards, net income would have been reduced by $1.3 million and $2.6 million
      for
      the three and six months ended June 30, 2005, respectively. The Company followed
      the nominal vesting period approach, which recognizes compensation cost over
      the
      vesting period unless the employee retired before the end of the vesting period
      at which time the Company recognizes any remaining unrecognized compensation
      cost at the date of retirement. The Company did not determine the amount of
      stock-based compensation cost that would have been deferred as policy
      acquisition costs in its pro forma footnotes under FAS 123.




1
              Includes
                  $0.3 million and $0.5 million stock-based compensation related
                  to
                  restricted shares and $0.1 million and $0.2 million associated
                  tax, as the
                  previous accounting under APB 25 was consistent with that of FAS
                  123, for
                  the three months and six months ended June 30, 2006,
                  respectively.
 2
              Earnings
                  per share figuresmay
                  not total due to rounding.





8




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





The
      pro
      forma net income and earnings per share amounts follow:




*Three
                  Months Ended*
              *Six
                  Months Ended**AMOUNTS
                  IN THOUSANDS, EXCEPT SHARE DATA*
              
              *June
                  30, 2005*
              *June
                  30, 2005***Net
                  income, as reported**
              
              $
              20,495
              
              $
              39,932*Add:*Stock-based employee compensation expense included in reported
                  net income,
                  net of related tax effects
              
              
              68
              
              
              90*Deduct:*Total stock-based employee compensation expense determined under
                  fair-value-based method for all awards, net of related tax
                  effects
              
              
              (1,298
              )
              
              (2,565
              )**Net
                  income, pro forma**
              
              $
              19,265
              
              $
              37,457**Basic
                  and diluted earnings per share**As
                  reported
              
              $
              0.24
              
              $
              0.47Pro
                  forma
              
              $
              0.22
              
              $
              0.44





***Stock
      Option Plans***





The
      stockholders approved the 2004 Stock Option Plan (the “2004 Plan”) at the Annual
      Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995
      Stock
      Option Plan (the “1995 Plan”), which remains in effect only as to outstanding
      awards under the 1995 Plan. The 2004 Plan authorizes a Committee of the Board
      of
      Directors to grant stock options for up to 4,000,000 shares to eligible
      employees and nonemployee directors, subject to the terms of the 2004 Plan.
      Additionally, under the 2004 Plan, the Committee may grant stock options that
      were subject to outstanding awards under the 1995 Plan to the extent such awards
      expire, are terminated, are canceled, or are forfeited for any reason without
      shares being issued.





Options
      granted to employees generally have ten-year terms and vest ratably over three
      years. Nonemployee director options vest over one year, provided that the
      nonemployee director is in the service of the Company during that time. Options
      granted to nonemployee directors expire one year after a nonemployee director
      ceases service with the Company, or ten years from the date of grant, whichever
      is sooner.





*Issuable
      and Issued Securities*





A
      summary
      of securities issuable and issued for the Company’s stock option plans at June
      30, 2006, follows:





*AMOUNTS
                IN THOUSANDS*
            
            *1995
                Stock*
              *Option
                Plan*
            *2004
                Stock*
              *Option
                Plan*Total
                number of securities authorized
            
            
            10,000
            
            
            4,000Number
                of securities issued
            
            
            (975
            )
            
            (204
            )Number
                of securities issuable upon the exercise of all outstanding
                options
            
            
            (6,710
            )
            
            (3,617
            )Number
                of securities forfeited
            
            
            (2,600
            )
            
            (74
            )Number
                of forfeited securities returned to plan
            
            
            2,600
            
            
            74Unused
                options assumed by 2004 Stock Option Plan
            
            
            (2,315
            )
            
            2,315Number
                of securities available for future grants under each plan
            
            
            —
            
            
            2,494





9




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





*Current
      Activity*





A
      summary
      of the Company’s stock option activity for the six months ended June 30, 2006
      follows:


*AMOUNTS
                IN THOUSANDS, EXCEPT PRICE DATA*
            
            *Number
                of Options*
            *Weighted-Average
                Exercise Price*Options
                outstanding December 31, 2005
            
            
            8,869
            
            $
            16.22Granted
                in 2006
            
            
            2,000
            
            
            16.55Exercised
                in 2006
            
            
            (293
            )
            
            13.11Forfeited
                in 2006
            
            
            (9
            )
            
            14.59Canceled
                in 2006
            
            
            (240
            )
            
            19.51Options
                outstanding June 30, 2006
            
            
            10,327
            
            
            16.30





A
      summary
      of the Company’s stock option activity and related information
      follows:





*Three
                Months Ended*
              *June30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Fair
                value of stock options granted
            
            **$**
            **900**
            
            $
            2,214
            
            
            **$**
            **9,994**
            
            $
            8,186Intrinsic
                value of options exercised
            
            
            **266**
            
            
            114
            
            
            
            **483**
            
            
            353Grant
                date fair value of options vested
            
            
            **884**
            
            
            284
            
            
            
            **7,399**
            
            
            5,241Proceeds
                from exercise of stock options
            
            
            **3,126**
            
            
            666
            
            
            
            **3,844**
            
            
            1,975Tax
                benefit realized as a result of stock option exercises
            
            
            **53**
            
            
            23
            
            
            
            **97**
            
            
            70*SHARE
                DATA*Weighted-average
                fair value per option granted
            
            **$**
            **4.82**
            
            $
            4.46
            
            
            **$**
            **5.00**
            
            $
            4.75





*Black-Scholes
      Assumptions*





The
      fair
      value of each option grant was estimated on the date of grant using the
      Black-Scholes option-pricing model with the following assumptions:




*Six
                Months Ended June 30,*
            
            **2006**
            2005
              Pro
                FormaRisk-free
                interest rate:Minimum
            
            
            **4.5**
            **%**
            
            3.7
            %Maximum
            
            
            **4.8**
            **%**
            
            4.3
            %Dividend
                yield
            
            
            **1.9**
            **%**
            
            1.1
            %Volatility
                factor of the expected market price of the Company’s common
                stock:Minimum
            
            
            **29.4**
            
            
            28.6Maximum
            
            
            **29.4**
            
            
            32.2Expected
                option term
            
            
            **6
                years**
            
            
            6
                years





The
      expected term for options granted during the six months ended June 30, 2006,
      was
      calculated using the simplified method in accordance with Staff Accounting
      Bulletin No. 107. The expected volatility of employee stock options was based
      on
      the historical volatility of key competitors in the property & casualty
      insurance industry (based on six years of closing stock prices). The Company
      believes that the use of historical competitor volatility better reflects
      current market expectations of the Company’s stock price volatility. The
      Company’s own historical stock price volatility is not representative of
      expected volatility due to significant prior year events, such as the effects
      of
      the 1994 Northridge earthquake and SB 1899, which would not be expected to
      significantly impact results in the future. The annual risk-free interest rate
      is based on a traded zero-coupon U.S. Treasury bond on the grant date with
      a
      term equal to the option’s expected term .





10




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





*Outstanding
      Options*





The
      following table summarizes information about stock options outstanding at June
      30, 2006 (amounts in thousands, except price data):




*Outstanding*
                
                *Exercisable**Range
                    of*
                  *Exercise
                    Prices*
                *Number
                    of*
                  *Options*
                *Weighted-*
                  *Average*
                  *Remaining*
                  *Contractual*
                  *Term*
                *Weighted-*
                  *Average*
                  *Exercise*
                  *Price*
                *Aggregate*
                  *Intrinsic*
                  *Value*
                
                *Number
                    of*
                  *Options*
                *Weighted-*
                  *Average*
                  *Remaining*
                  *Contractual*
                  *Term*
                *Weighted-*
                  *Average*
                  *Exercise*
                  *Price*
                *Aggregate*
                  *Intrinsic*
                  *Value*$11.68
                    -$13.00
                
                
                1,260
                
                6.7
                    Years
                $
                11.73
                
                $
                3,361
                
                
                
                1,249
                
                6.7
                    Years
                $
                11.72
                
                $
                3,34513.01
                    - 15.00
                
                
                2,910
                
                8.2
                    Years
                
                14.28
                
                
                355
                
                
                
                1,491
                
                8.1
                    Years
                
                14.30
                
                
                15315.01
                    - 17.00
                
                
                3,357
                
                8.0
                    Years
                
                16.38
                
                
                —
                
                
                
                1,490
                
                5.8
                    Years
                
                16.18
                
                
                —17.01
                    - 19.00
                
                
                1,776
                
                4.2
                    Years
                
                18.05
                
                
                —
                
                
                
                1,776
                
                4.2
                    Years
                
                18.05
                
                
                —19.01
                    - 22.00
                
                
                246
                
                1.4
                    Years
                
                20.75
                
                
                —
                
                
                
                246
                
                1.4
                    Years
                
                20.75
                
                
                —22.01
                    - 29.25
                
                
                778
                
                2.9
                    Years
                
                25.43
                
                
                —
                
                
                
                778
                
                2.9
                    Years
                
                25.43
                
                
                —$11.68
                    -$29.25
                
                
                10,327
                
                6.7
                    Years
                $
                16.30
                
                $
                3,716
                
                
                
                7,030
                
                5.6
                    Years
                $
                16.65
                
                $
                3,498





***Restricted
      Shares Plan***





The
      Restricted Shares Plan, which was approved by the Company’s stockholders,
      currently authorizes grants of up to 1,421,920 shares of common stock to be
      made
      available to key employees. In general, one third of the shares granted vest
      on
      the anniversary date of each of the three years following the year of grant.
      The
      Company may also grant vested shares that contain sale restrictions. The Company
      becomes entitled to an income tax deduction in an amount equal to the taxable
      income reported by the holders upon vesting of the restricted
      shares.





Total
      compensation expense relating to the Restricted Shares Plan was $0.4 million
      and
      $0.5 million for the three and six months ended June 30, 2006, respectively,
      and
      $0.1 million for the three and six months ended June 30, 2005. Unrecognized
      compensation cost in connection with restricted stock grants totaled $2.2
      million at June 30, 2006. The cost is expected to be recognized over a
      weighted-average period of 2.4 years.





*Restricted
      Shares Issuable and Issued*





A
      summary
      of securities issuable and issued for the Company’s Restricted Shares Plan at
      June 30, 2006, follows:





*AMOUNTS
                IN THOUSANDS*
            
            *Restricted*
              *Shares
                Plan*Total
                number of securities authorized
            
            
            1,422Number
                of securities issued
            
            
            (1,252
            )Number
                of forfeited securities returned to plan
            
            
            162Number
                of securities remaining available for future grants under the
                plan
            
            
            332





11




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





*Current
      Restricted Shares Activity*





The
      following table summarizes activity under the Restricted Shares Plan for the
      six
      months ended June 30, 2006:





*AMOUNTS
                IN THOUSANDS, EXCEPT PRICE DATA*
            
            *Number
                of*
              *Shares*
            *Weighted-Average
                Market Price Per Share on Date of Grant*Non-vested,
                December 31, 2005
            
            
            87
            
            $
            14.08Vested
                in 2006
            
            
            (33)
            
            
            14.38Granted
                in 2006
            
            
            109
            
            
            15.90Non-vested,
                June 30, 2006
            
            
            163
            
            
            15.22





A
      summary
      of the Restricted Shares Plan activity and related information
      follows:




*Three
                Months Ended*
              *June30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Fair
                value of restricted stock awards granted
            
            **$**
            **80**
            
            $
            1,267
            
            
            **$**
            **1,724**
            
            $
            1,267Fair
                value of restricted stock awards vested
            
            
            **475**
            
            
            30
            
            
            
            **475**
            
            
            183





*SHARE
                DATA*Weighted-average
                fair value per share for restricted shares granted
            
            **$**
            **16.01**
            
            $
            14.10
            
            
            **$**
            **15.90**
            
            $
            14.10








**NOTE
      3. HOMEOWNER AND EARTHQUAKE LINES IN RUNOFF**




California
      Senate Bill 1899 (“SB 1899”), effective from January 1, 2001 to December 31,
      2001, allowed the re-opening of previously closed earthquake claims arising
      out
      of the 1994 Northridge earthquake. More than ninety-nine percent of the claims
      submitted and litigation brought against the Company as a result of California
      SB 1899 have been resolved. The Company’s total loss and loss adjustment
      expenses (“LAE”) reserves for SB 1899 claims as of June 30, 2006 and December
      31, 2005, were less than $0.1 million and $0.5 million,
      respectively.





Loss
      and
      LAE incurred for the homeowner and earthquake lines in runoff were $0.3 million
      for the three and six months ended June 30, 2006, compared to $0.2 million
      and
      $0.4 million for the same periods in 2005, respectively.








**NOTE
      4** **.
      COMMITMENTS AND CONTINGENCIES**





***Legal
      Proceedings***





In
      the
      normal course of business, the Company is named as a defendant in lawsuits
      related to claims and insurance policy issues, both on individual policy files
      and by class actions seeking to attack the Company’s business practices. Many
      suits seek unspecified extra-contractual and punitive damages as well as
      contractual damages under the Company’s insurance policies in excess of the
      Company’s estimates of its obligations under such policies. The Company cannot
      estimate the amount or range of loss that could result from an unfavorable
      outcome on these suits and it denies liability for any such alleged damages.
      The
      Company has not established reserves for potential extra-contractual or punitive
      damages, or for contractual damages in excess of estimates the Company believes
      are correct and reasonable under its insurance policies. Nevertheless,
      extra-contractual and punitive damages, if assessed against the Company, could
      be material in an individual case or in the aggregate. The Company may choose
      to
      settle litigated cases for amounts in excess of its own estimate of contractual
      damages to avoid the expense and risk of litigation.  Other
      than possibly for the contingencies discussed below, the Company does not
      believe the ultimate outcome of these matters will be material to its results
      of
      operations, financial condition or cash flows.





In
      addition, the Company denies liability and has not established a reserve for
      the
      matters discussed below. A range of potential losses in the event of a negative
      outcome is discussed where known.





12




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





*Poss
      v. 21st Century Insurance Company* ** was
      filed
      on June 13, 2003, in Los Angeles Superior Court. The complaint sought injunctive
      and unspecified restitutionary relief against the Company under Business and
      Professions Code (“B&P”) Sec. 17200 for alleged unfair business practices in
      violation of California Insurance Code Sec. 1861.02(c) relating to Company
      rating practices. Based on California’s Proposition 64, passed in November 2004,
      the court granted the Company’s motion to dismiss the complaint, but allowed the
      addition of a second plaintiff, Leacy. The court stayed discovery in this
      litigation pending appellate court decisions involving similar issues by other
      parties. To date, these decisions have favored the Company’s position. Because
      this matter is in the pleading stages and no discovery has taken place, no
      estimate of the range of potential losses in the event of a negative outcome
      can
      be made at this time.




*Cecelia
      Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia
      Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th
      Century Insurance* was
      filed on July 3, 1997, in Los Angeles Superior Court. Plaintiffs allege bad
      faith, emotional distress, and estoppel involving the Company’s (the Company was
      formerly named 20th Century Insurance) handling of a 1994 homeowner’s claim. On
      March 1, 1994, Ramon Aguilera, a homeowner policyholder, shot and killed Mr.
      Gonzalez (the minor children’s father) and was later sued by Ms. Encarnacion for
      wrongful death. On August 30, 1996, judgment was entered against Ramon Aguilera
      for $5.6 million. The Company paid for Aguilera’s defense costs through the
      civil trial; however, the homeowner’s policy did not provide indemnity coverage
      for the incident, and the Company refused to pay the judgment. After the trial,
      Aguilera assigned a portion of his action against the Company to Encarnacion
      and
      the minor children. Aguilera and the Encarnacion family then sued the Company
      alleging that the Company had promised to pay its bodily injury policy limit
      if
      Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial
      court held a bench trial on the limited issues of promissory and equitable
      estoppel, and policy forfeiture. On September 26, 2003, the trial court issued
      a
      ruling that the Company cannot invoke any policy exclusions as a defense to
      coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs’ motion
      for summary adjudication, ordering that the Company must pay the full amount
      of
      the underlying judgment of $5.6 million, plus interest, for a total of $10.5
      million. The Company disagrees with this ruling as it appears inconsistent
      with
      the court’s simultaneous ruling denying the Company’s motion for summary
      judgment on grounds that there are triable issues of material fact as to whether
      plaintiffs are precluded from recovering damages as a consequence of Aguilera’s
      inequitable conduct. The Company also believes that the court’s decision was not
      supported by the evidence in the case, demonstrating that no promise to settle
      was ever made. The Company has appealed the judgment as to the Encarnacions.
      The
      trial as to Aguilera concluded on December 9, 2005, on his claims for bad faith,
      emotional distress, punitive damages and attorney fees. A jury found he
      sustained no damages as to these claims. The Company’s exposure in this case
      includes the aforementioned $10.5 million judgment plus post-judgment interest,
      which currently totals $1.8 million.





*Insurance
      Company cases (Ramona Goldenburg)* was
      originally filed as *Bryan
      Speck, individually, and on behalf of others similarly situated v. 21st Century
      Insurance Company, 21st Century Casualty Company, and 21st Century Insurance
      Group* .
      The
      original action was filed on June 20, 2002, in Los Angeles Superior Court.
      Plaintiff seeks California class action certification, injunctive relief, and
      unspecified actual and punitive damages. The complaint contends that the Company
      uses “biased” software in determining the value of total-loss automobiles.
      Specifically, Plaintiff alleges that database providers use improper methodology
      to establish comparable auto values and populate their databases with biased
      figures and that the Company and other carriers allegedly subscribe to the
      programs to unfairly reduce claims costs. This case is consolidated with similar
      actions against other insurers for discovery and pre-trial motions. A
      court-ordered appraisal of Speck’s vehicle was favorable to the Company and
      Ramona Goldenberg was substituted as a Plaintiff, replacing Speck, and a new
      appraisal has been ordered. The Company intends to vigorously defend the suit
      with other defendants in the coordinated proceedings. This matter is in the
      pleading stage of litigation and no reasonable estimate of potential losses
      in
      the event of a negative outcome can be made at this time.





*Thomas
      Theis, on his own behalf and on behalf of all others similarly situated v.
      21st
      Century Insurance* was
      filed on June 17, 2002, in Los Angeles Superior Court. Plaintiff seeks
      California class action certification, injunctive relief, and unspecified actual
      and punitive damages. The complaint contends that after insureds receive medical
      treatment, the Company used a medical-review program to adjust expenses to
      reasonable and necessary amounts for a given geographic area and the adjusted
      amount is “predetermined” and “biased.” This case is consolidated with similar
      actions against other insurers for discovery and pre-trial motions. Depositions
      have recently been taken and the Company intends to vigorously defend the suit.
      This matter is in the discovery stage of litigation and no reasonable estimate
      of potential losses in the event of a negative outcome can be made at this
      time.





13




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





*Silvia
      Quintana, on her own behalf and on behalf of all others similarly situated
      v.
      21st Century Insurance* was
      filed on November 16, 2005 .
      This
      purported class action, filed in San Diego, names the Company in four causes
      of
      action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust
      enrichment and, 4) declaratory relief. Silvia Quintana alleges that the
      Company’s demand for reimbursement of the medical payments it made to her
      pursuant to her insurance contract violates the “made-whole rule.” The Company
      anticipates that if the matter survives the initial pleading stage, it will
      be
      consolidated, for discovery and pre-trial motions, with actions alleging similar
      facts against other insurers. This matter is in the initial stages of pleading
      and no reasonable estimate of potential losses in the event of a negative
      outcome can be made at this time.






**NOTE
      5. ACCUMULATED OTHER COMPREHENSIVE LOSS**





Accumulated
      other comprehensive loss is a component of stockholders’ equity and includes all
      changes in unrealized gains and losses; reclassification adjustments for
      investment losses and gains included in net income; and changes in minimum
      pension liability in excess of unamortized prior service cost.





A
      summary
      of accumulated other comprehensive loss follows:




**June
                30,**
              **2006**
            December
                31,
              2005Net
                unrealized losses on available-for-sale investments, net of deferred
                income taxes of $15,950 and $4,579
            
            **$**
            **(29,622**
            **)**
            $
            (8,504
            )Minimum
                pension liability in excess of unamortized prior service cost, net
                of
                deferred income taxes of $1,011 and $1,011
            
            
            **(1,878**
            **)**
            
            (1,878
            )Total
                accumulated other comprehensive loss
            
            **$**
            **(31,500**
            **)**
            $
            (10,382
            )





**NOTE** **6.
      EMPLOYEE BENEFIT PLANS**





The
      Company has both funded and unfunded non-contributory defined benefit pension
      plans, which together cover essentially all employees who have completed at
      least one year of service. For certain key employees designated by the Board
      of
      Directors, the Company sponsors an unfunded non-qualified supplemental executive
      retirement plan. The supplemental plan benefits are based on years of service
      and compensation during the three highest of the last ten years of employment
      prior to retirement and are reduced by the benefit payable from the pension
      plan
      and 50% of the social security benefit. For other eligible employees, the
      pension benefits are based on employees’ compensation during all years of
      service. The Company’s funding policy for the qualified plan is to make annual
      contributions as required by applicable regulations.




***Components
      of Net Periodic Cost***





Net
      pension costs for all plans were as follows:




*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,***2006**
            2005
            
            **2006**
            2005Service
                cost
            
            **$**
            **1,693**
            
            $
            1,762
            
            
            **$**
            **3,565**
            
            $
            3,524Interest
                cost
            
            
            **1,898**
            
            
            1,855
            
            
            
            **3,869**
            
            
            3,710Expected
                return on plan assets
            
            
            **(2,112**
            **)**
            
            (1,830
            )
            
            
            **(4,220**
            **)**
            
            (3,660
            )Amortization
                of prior service cost
            
            
            **39**
            
            
            27
            
            
            
            **73**
            
            
            54Amortization
                of net loss
            
            
            **628**
            
            
            507
            
            
            
            **1,306**
            
            
            1,014Total
            
            **$**
            **2,
                146**
            
            $
            2,321
            
            
            **$**
            **4,593**
            
            $
            4,642




14




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





***Pension
      Plan Contributions***





The
      Company previously disclosed in its consolidated financial statements for the
      year ended December 31, 2005, that it did not expect to contribute to its
      qualified defined benefit pension plan in 2006. As of June 30, 2006, no
      contributions have been made. However, the amount and timing of future
      contributions to the Company’s qualified defined benefit pension plan depends on
      a number of assumptions including statutory funding requirements, the market
      performance of the plan’s assets and future changes in interest rates that
      affect the actuarial measurement of the plan’s obligations.





Contributions
      to our non-qualified defined benefit pension plan generally are limited to
      amounts needed to make benefit payments to retirees, which are expected to
      total
      approximately $0.9 million in 2006.





***Defined
      Contribution Plans***





The
      Company sponsors a contributory savings and security plan for eligible employees
      and officers. The Company provides matching contributions equal to 75% of the
      lesser of 6% of an employee’s eligible compensation or the amount contributed by
      the employee up to the maximum allowable under Internal Revenue Service
      regulations. The plan offers a variety of investment types among which employees
      exercise complete discretion as to choice and investment duration. The Company
      also sponsors a 401(k) supplemental plan to provide specified benefits to a
      select group of management and highly compensated employees. Company
      contributions to both plans were $1.2 million and $3.1 million for the three
      and
      six months ended June 30, 2006, respectively, and $0.9 million and $2.3 million
      for the same periods in 2005.





**NOTE
      7. SEGMENT INFORMATION**





The
      Company’s “Personal Auto Lines” reportable segment primarily markets and
      underwrites personal auto, motorcycle and personal umbrella insurance. The
      Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment manages
      the runoff of the Company’s homeowner and earthquake programs. The Company has
      not written any earthquake coverage since 1994 and ceased writing homeowner
      policies in February 2002.





Insurers
      offering homeowner insurance in California are required to participate in the
      California FAIR Plan (“FAIR Plan”). The FAIR Plan is a state administered pool
      of difficult to insure homeowners’ exposures. Each participating insurer is
      allocated a percentage of the total premiums written and losses and LAE incurred
      by the pool according to its share of total homeowner direct premiums written
      in
      the state. Participation in the current year FAIR Plan operations is based
      on
      premiums written from two years prior. Since the Company ceased writing
      homeowners business in 2002, the Company no longer receives assignments for
      plan
      years beyond 2004, but continues to participate in prior plan year activity,
      which is in runoff.





The
      Company evaluates segment performance based on pre-tax underwriting profit
      or
      loss. The Company does not allocate assets, net investment income, net realized
      investment gains or losses, other revenues, nonrecurring items, interest and
      fees expense, or income taxes to operating segments. The accounting policies
      of
      the reportable segments are the same as those described in Note 2 of the*Notes to Consolidated Financial Statements* included in our Annual Report on
      Form 10-K for the year ended December 31, 2005. All revenues are generated
      from
      external customers and the Company does not rely on any major
      customer.





15




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





The
      following table presents net premiums earned, depreciation and amortization
      expense, and segment profit (loss) for the Company’s segments.





*Personal
                Auto Lines*
            *Homeowner
                and Earthquake Lines in Runoff**3*
            *Total**Three
                Months Ended June 30, 2006*Net
                premiums earned
            
            **$**
            **325,512**
            
            **$**
            —
            
            **$**
            **325,512**Depreciation
                and amortization expense
            
            
            **6,642**
            
            
            **1**
            
            
            **6,643**Segment
                profit (loss)
            
            
            **28,293**
            
            
            **(266**
            **)**
            
            **28,027***Three
                Months Ended June 30, 2005*Net
                premiums earned
            
            $
            336,842
            
            $
            3
            
            $
            336,845Depreciation
                and amortization expense
            
            
            8,391
            
            
            2
            
            
            8,393Segment
                profit (loss)
            
            
            16,239
            
            
            (198
            )
            
            16,041*Six
                Months Ended June 30, 2006*Net
                premiums earned
            
            **$**
            **651,336**
            
            **$**
            —
            
            **$**
            **651,336**Depreciation
                and amortization expense
            
            
            **13,301**
            
            
            **3**
            
            
            **13,304**Segment
                profit (loss)
            
            
            **45,765**
            
            
            **(342**
            **)**
            
            **45,423***Six
                Months Ended June 30, 2005*Net
                premiums earned
            
            $
            673,203
            
            $
            6
            
            $
            673,209Depreciation
                and amortization expense
            
            
            14,990
            
            
            5
            
            
            14,995Segment
                profit (loss)
            
            
            30,063
            
            
            (370
            )
            
            29,693





The
      following table reconciles segment profit to consolidated income before
      provision for income taxes:





*Three
                Months Ended*
            
            *Six
                Months Ended**June
                30,*
            
            *June
                30,***2006**
            2005
            
            **2006**
            2005Segment
                profit
            
            **$**
            **28,027**
            
            $
            16,041
            
            
            **$**
            **45,423**
            
            $
            29,693Net
                investment income
            
            
            **17,174**
            
            
            17,006
            
            
            
            **34,929**
            
            
            34,043Other
                income
            
            
            **10**
            
            
            367
            
            
            
            **10**
            
            
            367Net
                realized investment gains (losses)
            
            
            **30**
            
            
            (1,267
            )
            
            
            **(1,037**
            **)**
            
            (1,727
            )Other
                expense
            
            
            **(923**
            **)**
            
            **—**
            
            
            
            **(923**
            **)**
            
            **—**Interest
                and fees expense
            
            
            **(1,854**
            **)**
            
            (2,031
            )
            
            
            **(3,752**
            **)**
            
            (4,088
            )Income
                before provision for income taxes
            
            **$**
            **42,464**
            
            $
            30,116
            
            
            **$**
            **74,650**
            
            $
            58,288




3  Homeowner
        and earthquake lines in runoff segment revenue represents premium earned
        as a
        result of the Company’s participation in the California FAIR Plan.


16




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**


**June
      30, 2006**


DOLLAR
      AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





**NOTE
      8. VARIABLE INTEREST ENTITIES**





In
      January 2003, the FASB issued FASB Interpretation No. 46, *Consolidation
      of Variable Interest Entities, an interpretation of Accounting Research Bulletin
      No. 51* (“FIN
      46”), and amended it in December 2003. An entity is subject to the consolidation
      rules of FIN 46 and is referred to as a variable interest entity (“VIE”) if it
      lacks sufficient equity to finance its activities without additional financial
      support from other parties or if its equity holders lack adequate decision
      making ability based on criteria set forth in the interpretation. FIN 46 also
      requires disclosures about VIEs that a company is not required to consolidate,
      but in which a company has a significant variable interest.





The
      Company has decided to purchase investments that provide housing and other
      services to economically disadvantaged communities. To that end, the Company
      is
      a voluntary member, along with other participating insurance organizations,
      of
      Impact Community Capital, LLC (“Impact”). Impact’s charter is to facilitate
      loans and other investments in such communities.





The
      VIE
      structure provides a wider range of investment options through which insurance
      companies and other institutional investors can address the investment needs
      of
      these communities. The Company’s maximum participation in Impact C.I.L., LLC
      (“Impact C.I.L.”), a subsidiary of Impact and a VIE, is for up to 11.1% ($24.0
      million) of $216.0 million of the entity’s funding activities. These commitments
      consist of a $4.8 million minimum investment and a $19.2 million guarantee
      of a
      warehouse lending facility. Potential losses are limited to the Company’s
      participation as well as associated operating fees. The Company’s pro rata share
      of these advances to Impact C.I.L., which in turn makes housing investments
      in
      economically disadvantaged communities, was approximately 11.1%, or $4.9
      million, and $5.0 million as of June 30, 2006 and December 31, 2005,
      respectively. The revolving member loan and the warehouse financing agreement
      do
      not significantly impact the Company’s liquidity or capital.





The
      Company is not the primary beneficiary of any of the VIEs as the Company has
      voting rights, beneficiary rights, obligations, and ownership in proportion
      to
      each of its Impact related investments, none of which exceeds
      11.1%.





In
      addition to the above, the Company held $6.0 million and $6.2 million in other
      Impact related fixed-income investments as of June 30, 2006 and December 31,
      2005, respectively. The Company also held $0.3 million in other Impact related
      private equity investments reclassified as other assets as of June 30, 2006.
      There were no private equity investments for the same period in the prior year.
      Total Impact related investment income was $0.2 million and $0.5 million for
      the
      three and six months ended June 30, 2006, respectively, and $0.2 million and
      $0.3 million for the same periods in 2005, respectively.




The
      Company does not have any other material VIEs that it needs, or will need,
      to
      consolidate or disclose.







**NOTE
      9. TRANSACTIONS WITH RELATED PARTIES**





In
      June
      2006, the Company executed a $35 million funding commitment for a private equity
      investments program. The program will be managed by AIG Global Investment Corp.
      (“AIGGIC”), which provides investment management and investment accounting
      services to the Company. In the event that the Company does not respond to
      a
      capital call during the investment term, the General Partner of the fund (“GP”)
      may apply the following default provisions: withhold 50% of distributions due
      to
      the Company at the time of the default and 50% of future distributions due
      to
      the Company; hold the Company liable for fund expenses above and beyond
      investments made by the Company (with the right of offset); terminate the
      Company’s Limited Partner status and not allow it any further investments; or
      charge interest on the defaulted capital commitment amount and fees at LIBOR
      +
      4% (with the right of offset). However, the GP may choose not to designate
      the
      Company a “defaulting limited partner” and waive the default provisions. The
      investment term ends after the underlying investments are liquidated, but in
      no
      event later than 10 years. Multiple investments are expected to be purchased
      and
      liquidated over the investment term. The Company funded $9.1 million of the
      commitment in July 2006.





17





**ITEM
      2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND** **RESULTS OF OPERATIONS**





**OVERVIEW**





***General***





21st
      Century Insurance Group is an insurance holding company registered on the New
      York Stock Exchange. For convenience, the terms “Company”, “21st”, “we”, “us” or
“our” are used to refer collectively to the parent company and its subsidiaries.
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations (“MD&A”) should be read in conjunction with the accompanying
      condensed consolidated financial statements.





Founded
      in 1958, we are a direct-to-consumer provider of personal auto insurance. With
      $1.4 billion of revenue in 2005, we insure over 1.5 million vehicles in Arizona,
      California, Florida, Georgia, Illinois, Indiana, Nevada, Ohio, Oregon,
      Pennsylvania, Texas and Washington. We provide superior policy features and
      customer service at a competitive price. Customers can receive a quote, purchase
      a policy, service their policy, or report a claim at *www.21st.com* or on
      the phone with our licensed insurance professionals at 1-800-211-SAVE. Service
      is offered in English and Spanish, both on the phone and on the web, 24 hours
      a
      day, 365 days a year. Our insurance subsidiaries, 21st Century Insurance
      Company, 21st Century Casualty Company, and 21st Century Insurance Company
      of
      the Southwest (“21st of the Southwest”), are rated A+ by A.M. Best, Fitch
      Ratings and Standard & Poor’s. The Company’s A+ rating was affirmed by A.M.
      Best on June 13, 2006.





Our
      long-term financial goals include achieving a 96% or lower combined ratio,
      15%
      annual growth in premiums written, 15% return on stockholders’ equity, and
      strong financial ratings.





***National
      Expansion***





The
      Company is implementing a multi-year strategy for national expansion. In the
      second quarter of 2006, the Company began operations in Florida, Georgia and
      Pennsylvania, increasing the percentage of the U.S. personal auto market that
      the Company operates in to 49%. The Company plans to add three additional states
      in the second half of 2006. Growth in direct premiums written in non-California
      markets in the second quarter of 2006 was 51.8%. The ultimate benefits of the
      national expansion should include economies of scale, lower unit marketing
      costs
      due to the cost efficiency of buying advertising on a national basis, less
      dependency on any single market and the operating flexibility to focus resources
      on attractive markets and deemphasize less attractive markets.





***Highlights***





Financial
      highlights for the second quarter ended June 30:




·
            Total
                direct premiums written decreased 3.6% to $316.8 million in 2006,
                from
                $328.7 million for same period in
                2005.




·
            California
                direct premiums written decreased 7.1% to $287.4 million in 2006,
                compared
                to $309.2 million for the same period in 2005.




·
            Non-California
                direct premiums written increased by 51.8% to $29.4 million for the
                quarter ended June 30, 2006, compared to $19.5 million for the same
                period
                in 2005.




·
            Our
                consolidated combined ratio of 91.4% was favorably impacted by 5.6
                points
                of prior accident year loss and LAE reserve decreases, versus 95.2%
                for
                the second quarter of 2005, which was favorably impacted by 3.5
                points.







Financial
      highlights for the six months ended June 30:




·
            Total
                direct premiums written declined 3.7% to $655.4 million in 2006,
                from
                $680.8 million for the same period in
                2005.




·
            California
                direct premiums written decreased 6.6% to $599.2 million in 2006,
                compared
                to $641.8 million for the same period in
                2005.




·
            Non-California
                direct premiums written increased by 44.1% to $56.2 million in 2006,
                compared to $39.0 million for the same period in
                2005.




·
            Our
                consolidated combined ratio of 93.0% was favorably impacted by 3.9
                points
                of prior accident year loss and LAE reserves, versus 95.6% for the
                same
                period in 2005, which was favorably impacted by 2.9
                points.




18




For
      the
      three months and six months ended June 30, 2006, 21st’s insurance subsidiaries
      achieved underwriting profitability, but total direct premiums written declined.
      In recent quarters, the California market, which represented 90.7% of our total
      direct premiums written during the second quarter, has seen stable to declining
      rates from competitors and a reduced level of shopping behavior by consumers.
      Both of these factors reduced our opportunities for profitable growth in this
      state.





In
      July
      2006, the California Department of Insurance (the “CDI”) obtained approval for
      changes to regulations (the “Auto Rating Factor Regulations”) relating to
      automobile insurance rating factors, particularly concerning territorial rating.
      Because the new Auto Rating Factor Regulations require every personal auto
      insurance company operating in California to make a class plan and rate level
      filing in the third quarter of 2006, competitive rate levels may change and
      consumer shopping behavior may increase in the future. It is not possible at
      this time to predict the ultimate timing or impact of these changes, which
      could
      have either a materially favorable or materially adverse impact on the Company.
      See further discussion in *Part II - Item 1A. Risk Factors*.





Also
      in
      July 2006, the CDI proposed new amended rate approval regulations (the "Rate
      Approval Regulations"), affecting personal auto, homeowners and most lines
      of
      commercial property & casualty insurance written in California. If
      approved without modification, the Rate Approval Regulations could have a
      materially adverse impact on the Company’s results. See further discussion
      in *Part
      II -* *Item
      1A. Risk Factors.*





Net
      income increased 38% to $28.3 million for the three months ended June 30, 2006,
      or $0.33 per basic share, compared to $20.5 million, or $0.24 per basic share,
      for the same period in 2005. The second quarter 2006 results include prior
      year
      favorable reserve development totaling $18.1 million, versus $11.9 million
      in
      the second quarter of 2005. Net income increased 24% to $49.6 million for the
      six months ended June 30, 2006, or $0.58 per basic share, compared to $39.9
      million, or $0.47 per basic share, for the same six-month period in 2005. The
      six months ended June 30, 2006 include favorable prior year reserve development
      totaling $25.1 million, versus $19.6 million for the same period in
      2005.





The
      underwriting expense to net premiums earned ratio increased to 22.9% for the
      three months ended June 30, 2006 from 21.5% for the same period in 2005. For
      the
      six months ended June 30, 2006, the underwriting expense to net premiums earned
      ratio increased to 22.4% from 21.4% for the same period in 2005. These
      underwriting expense ratio increases are primarily the result of expenses
      associated with the Company’s national expansion efforts and the 2006 recognition of stock-based
      compensation, which were partially offset by increases in deferred policy
      acquisition costs. Underwriting expenses during the six months ended June 30,
      2006, were also impacted by severance costs and corporate litigation incurred
      during the first quarter.




The
      recognition of stock-based compensation resulted from our adoption of Statement
      of Financial Accounting Standards No. 123 (revised 2004), *Share-Based
      Payment* (“FAS
      123R”). FAS 123R requires the recognition of compensation expense in the
      Condensed Consolidated Statements of Operations based on the estimated fair
      value of the employee share-based options. See *Critical
      Accounting Estimates - Stock-Based Compensation Expense* for
      further discussion. Stock-based compensation classified as underwriting expense
      for the three and six months ended June 30, 2006, was $0.9 million and $3.2
      million, respectively.




***Non-GAAP
      Measures***





Premiums
      written and statutory surplus have been presented to enhance investors’
understanding of the Company’s operations. These financial measures are not
      presented in accordance with accounting principles generally accepted in the
      United States of America (“GAAP”). Premiums written represent the premiums
      charged on policies issued during a fiscal period. The most directly comparable
      GAAP measure, premiums earned, represents the portion of premiums written that
      is recognized as income on a pro rata basis over the terms of the policies.
      Statutory surplus represents equity as of the end of a fiscal period for the
      Company’s insurance subsidiaries, determined in accordance with statutory
      accounting principles prescribed by insurance regulatory authorities.
      Stockholders’ equity is the most directly comparable GAAP measure to statutory
      surplus. ** The
      reconciliations of these financial measures to the most directly comparable
      GAAP
      measures are located in *Results
      of Operations* and *Liquidity
      and Capital Resources* ,
      respectively. These financial measures are not intended to replace, and should
      be read in conjunction with, the GAAP financial measures.





See *Results
      of Operations* for more
      details as to our overall and personal auto lines results.





The
      remainder of this MD&A includes the following sections:





·
            Results
                of Operations


·
            Financial
                Condition


·
            Liquidity
                and Capital Resources


·
            Transactions
                with Related Parties


·
            Contractual
                Obligations and Commitments


·
            Critical
                Accounting Estimates


·
            Recent
                Accounting Standards


·
            Forward-Looking
                Statements




19




**RESULTS
      OF OPERATIONS**





***Consolidated
      Results***





The
      following table summarizes the Company’s condensed consolidated results of
      operations:





*Three
                Months Ended*
              *June
                30,*
            
            
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS,*
              *EXCEPT
                SHARE DATA*
            
            **2006**
            2005
            *Increase/*
              *(Decrease)*
            
            **2006**
            2005
            *Increase/*
              *(Decrease)*Direct
                premiums written
            
            **$**
            **316,837**
            
            $
            328,669
            
            
            (3.6
            )%
            
            **$**
            **655,406**
            
            $
            680,786
            
            
            (3.7
            )%Net
                premiums earned
            
            
            **325,512**
            
            
            336,845
            
            
            (3.4
            )
            
            
            **651,336**
            
            
            673,209
            
            
            (3.2
            )Net
                income
            
            
            **28,321**
            
            
            20,495
            
            
            38.2
            
            
            
            **49,639**
            
            
            39,932
            
            
            24.3Basic
                earnings per share
            
            
            **0.33**
            
            
            0.24
            
            
            45.8
            
            
            
            **0.58**
            
            
            0.47
            
            
            23.4Diluted
                earnings per share
            
            
            **0.33**
            
            
            0.24
            
            
            45.8
            
            
            
            **0.57**
            
            
            0.47
            
            
            21.3





For
      the
      three months ended June 30, 2005, the results include net realized capital
      losses of $1.3 million. For the six months ended June 30, 2006, the results
      included net realized capital losses of $1.0 million compared to net realized
      capital losses of $1.7 million for the same period in 2005.





The
      following table summarizes losses and loss adjustment expenses (“LAE”) incurred,
      net of applicable reinsurance, for the periods indicated:





*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Net
                losses and LAE incurred related to insured events in:Current
                year personal auto lines
            
            **$**
            **241,215**
            
            $
            260,200
            
            
            **$**
            **484,726**
            
            $
            518,902Prior
                accident years:Personal
                auto lines
            
            
            **(18,387**
            **)**
            
            (12,116
            )
            
            
            **(25,479**
            **)**
            
            (19,963
            )Homeowner
                and earthquake lines in runoff
            
            
            **266**
            
            
            200
            
            
            
            **343**
            
            
            376Total
                prior years’ redundancy recorded in current year
            
            
            **(18,121**
            **)**
            
            (11,916
            )
            
            
            **(25,136**
            **)**
            
            (19,587
            )Total
                net losses and LAE incurred
            
            **$**
            **223,094**
            
            $
            248,284
            
            
            **$**
            **459,590**
            
            $
            499,315





While
      we
      perform quarterly reviews of the adequacy of carried unpaid losses and LAE,
      these estimates depend on many assumptions about the outcome of future events.
      There can be no assurance that our ultimate unpaid losses and LAE will not
      develop redundancies or deficiencies and materially differ from our unpaid
      losses and LAE as of June 30, 2006. In the future, if the unpaid losses and
      LAE
      develop redundancies or deficiencies, such redundancy or deficiency would have
      a
      positive or adverse impact, respectively, on future results of operations.
      See *Critical
      Accounting Estimates - Losses and Loss Adjustment Expenses* for
      additional discussion of our reserving policy.





Personal
      automobile insurance is our primary line of business. Non-California vehicles
      accounted for 9.3% of our direct premiums written for the three months ended
      June 30, 2006, compared to 5.9% for the same period in 2005. For the six months
      ended June 30, 2006, non-California vehicles accounted for 8.6% of our direct
      premiums written, compared to 5.7% for the same period in 2005. This increase
      is
      due to our ongoing national expansion program, which includes marketing in
      non-California states. The Company is currently selling policies in 12 states
      and plans to expand into three additional states during the second half of
      2006
      as part of its national expansion strategy.





20





***Personal
      Auto Lines Underwriting Results***





The
      following table presents the components of our personal auto lines underwriting
      profit and the components of the combined ratio:




*Three
                Months Ended*
              *June
                30,*
            
            
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN**T**HOUSANDS*
            
            **2006**
            2005
            *Increase/*
              *(Decrease)*
            
            **2006**
            2005
            *Increase/*
              *(Decrease)*Direct
                premiums written
            
            **$**
            **316,837**
            
            $
            328,669
            
            
            (3.6
            )%
            
            **$**
            **655,406**
            
            $
            680,786
            
            
            (3.7
            )%Net
                premiums written
            
            **$**
            **315,476**
            
            $
            327,479
            
            
            (3.7
            )%
            
            **$**
            **652,700**
            
            $
            678,420
            
            
            (3.8
            )%Net
                premiums earned
            
            **$**
            **325,512**
            
            $
            336,842
            
            
            (3.4
            )%
            
            **$**
            **651,336**
            
            $
            673,203
            
            
            (3.2
            )%Net
                losses and LAE
            
            
            **222,828**
            
            
            248,083
            
            
            (10.2
            )
            
            
            **459,248**
            
            
            498,939
            
            
            (8.0
            )Underwriting
                expenses
            
            
            **74,391**
            
            
            72,520
            
            
            2.6
            
            
            
            **146,323**
            
            
            144,201
            
            
            1.5Underwriting
                profit
            
            **$**
            **28,293**
            
            $
            16,239
            
            
            74.2
            %
            
            **$**
            **45,765**
            
            $
            30,063
            
            
            52.2
            %Ratios:Loss
                and LAE ratio
            
            
            **68.5**
            **%**
            
            73.7
            %
            
            (5.2
            )%
            
            
            **70.5**
            **%**
            
            74.1
            %
            
            (3.6
            )%Underwriting
                expense ratio
            
            
            **22.9**
            
            
            21.5
            
            
            1.4
            
            
            
            **22.5**
            
            
            21.4
            
            
            1.1Combined
                ratio
            
            
            **91.4**
            **%**
            
            95.2
            %
            
            (3.8
            )%
            
            
            **93.0**
            **%**
            
            95.5
            %
            
            (2.5
            )%




The
      following table reconciles our personal auto lines underwriting profit to our
      consolidated net income:




*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Personal
                auto lines underwriting profit
            
            **$**
            **28,293**
            
            $
            16,239
            
            
            **$**
            **45,765**
            
            $
            30,063Homeowner
                and earthquake lines in runoff underwriting loss
            
            
            **(266**
            **)**
            
            (198
            )
            
            
            **(342**
            **)**
            
            (370
            )Net
                investment income
            
            
            **17,174**
            
            
            17,006
            
            
            
            **34,929**
            
            
            34,043Other
                income
            
            
            **10**
            
            
            367
            
            
            
            **10**
            
            
            367Net
                realized investment gains (losses)
            
            
            **30**
            
            
            (1,267
            )
            
            
            **(1,037**
            **)**
            
            (1,727
            )Other
                expense
            
            
            **(923**
            **)**
            
            **—**
            
            
            
            **(923**
            **)**
            
            **—**Interest
                and fees expense
            
            
            **(1,854**
            **)**
            
            (2,031
            )
            
            
            **(3,752**
            **)**
            
            (4,088
            )Provision
                for income taxes
            
            
            **(14,143**
            **)**
            
            (9,621
            )
            
            
            **(25,011**
            **)**
            
            (18,356
            )Net
                income
            
            **$**
            **28,321**
            
            $
            20,495
            
            
            **$**
            **49,639**
            
            $
            39,932







The
      following table reconciles our personal auto lines direct premiums written
      to
      net premiums earned:




*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Direct
                premiums written
            
            **$**
            **316,837**
            
            $
            328,669
            
            
            **$**
            **655,406**
            
            $
            680,786Ceded
                premiums written
            
            
            **(1,361**
            **)**
            
            (1,190
            )
            
            
            **(2,706**
            **)**
            
            (2,366
            )Net
                premiums written
            
            
            **315,476**
            
            
            327,479
            
            
            
            **652,700**
            
            
            678,420Net
                change in unearned premiums
            
            
            **10,036**
            
            
            9,363
            
            
            
            **(1,364**
            **)**
            
            (5,217
            )Net
                premiums earned
            
            **$**
            **325,512**
            
            $
            336,842
            
            
            **$**
            **651,336**
            
            $
            673,203





We
      remain
      focused on achieving our long-term goals of a combined ratio of 96% or lower
      and
      15% annual growth in direct premiums written.




Direct
      premiums written decreased in the three months and six months ended June 30,
      2006, as compared to the same period in 2005, primarily due to continued
      competitiveness in the California market. As discussed in the *Operating
      Highlights* ,
      in July
      2006, the California Department of Insurance issued changes to regulations
      relating to automobile insurance rating factors, particularly concerning
      territorial rating. It is not possible at this time to predict the ultimate
      timing or impact of these changes, which could have either a materially
      favorable or materially adverse impact on the Company. Also in July 2006, the
      CDI proposed new amended rate approval regulations, which if approved without
      modification, could have a materially adverse impact on the Company’s California
      results. See further discussion in *Item
      1A. Risk Factors.*





21





As
      the
      Company proceeds with its national expansion, we believe that achieving our
      long-term growth goal will steadily depend less on the California marketplace.
      Net premiums earned decreased in the three months and six months ended June
      30,
      2006, compared to the same periods a year ago, consistent with the decline
      in
      direct premiums written during the same periods. The Company’s national
      expansion efforts will provide us with flexibility to use combinations of local
      and national marketing media, as appropriate, and the ability to focus our
      marketing expenditures and company resources on attractive markets, while
      minimizing costs in less attractive markets.





The
      declines in the loss and LAE ratios for the three months and six months ended
      June 30, 2006 of 5.2 points and 3.6 points, respectively, are partially due
      to
      the effect of favorable development related to prior accident years. The loss
      and LAE ratios for the three months ended June 30, 2006 included 5.6 points
      ($18.4 million) of favorable development compared to 3.6 points ($12.1 million)
      in the same period of 2005. Similarly, the six months ended June 30, 2006 loss
      and LAE ratio included 3.9 points ($25.5 million) of favorable reserve
      development in 2006 compared to 2.9 points ($20.0 million) in the same period
      of
      2005. Changes in estimates are recorded in the period in which new information
      becomes available indicating that a change is warranted. The remaining decrease
      in the loss and LAE ratios for both periods was primarily attributable to the
      decline in frequency.





The
      underwriting expense to net premiums earned ratios increased in the three months
      and six months ended June 30, 2006, as compared to the same periods in the
      prior
      year. This was primarily due to our investments in the Company’s national
      expansion efforts and the 2006 recognition of stock-based compensation partially
      offset by an increase in deferred policy acquisition costs. Also, the
      underwriting expense ratio for the six months ended June 30, 2006 was impacted
      by severance costs and corporate litigation
      incurred during the three months ended March 31, 2006.





The
      combined ratio was 91.4% for the quarter ended June 30, 2006, compared to 95.2%
      for the same period in 2005. The decrease was mainly due to the 5.2 point
      decrease in the loss and LAE ratio partially offset by 1.4 point increase in
      the
      underwriting expense ratio as a result of the items discussed above. The
      combined ratios for the six months ended June 30, 2006 and 2005 were 93.0%
      and
      95.5%, respectively. The decrease was mainly due to favorable prior accident
      year loss and LAE development of $25.5 million.





***Homeowner
      and Earthquake Lines in Runoff***





We
      have
      not written any earthquake policies since 1994 and exited the homeowner
      insurance business in 2002. Underwriting results of the homeowner and earthquake
      lines, which are in runoff, include losses and LAE incurred of $0.3 million
      for
      the three months ended June 30, 2006, compared to $0.2 million for the same
      period a year ago. For the six months ended June 30, 2006 and 2005, losses
      and
      LAE for those same lines were $0.3 million and $0.4 million, respectively,
      of
      which the earthquake lines accounted for less than $0.1 million in loss and
      LAE
      during the three months and six months ended June 30, 2006.





***Net
      Investment Income***





We
      utilize a conservative investment philosophy. No derivatives or nontraditional
      securities are held in our investment portfolio and there were no equity
      securities at June 30, 2006. Substantially the entire fixed maturity portfolio
      is investment grade (weighted-average Standard & Poor’s credit quality of
“AA”).





The
      components of net investment income were as follows:





*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Fixed
                maturity investments available-for-sale
            
            **$**
            **16,886**
            
            $
            15,187
            
            
            **$**
            **33,495**
            
            $
            30,673Equity
                securities available-for-sale
            
            
            —
            
            
            1,601
            
            
            
            **811**
            
            
            2,977Cash
                and cash equivalents
            
            
            **288**
            
            
            218
            
            
            
            **623**
            
            
            393Net
                investment income
            
            **$**
            **17,174**
            
            $
            17,006
            
            
            **$**
            **34,929**
            
            $
            34,043





22





The
      average annual yields on fixed income assets were as follows:





*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,***2006**
            2005
            
            **2006**
            2005Pre-tax
                - fixed maturity securities
            
            
            **4.6**
            **%**
            
            4.5
            %
            
            
            **4.7**
            **%**
            
            4.6
            %After-tax
                - fixed maturity securities
            
            
            **3.3**
            
            
            3.3
            
            
            
            **3.4**
            
            
            3.3





The
      fixed
      maturity portfolio, which comprised 97% and 95% of the total investment
      portfolio at June 30, 2006 and December 31, 2005, respectively, displayed a
      10
      basis point improvement, on a pre-tax basis, in both the three and six month
      periods ended June 30, 2006, when compared to the same periods in 2005. This
      yield improvement was due to the reinvestment of funds from investment sales
      and
      maturities into higher yielding fixed maturity securities during a rising rate
      environment in 2006.





At
      June
      30, 2006, $383.0 million, or 26.9%, of our total fixed maturity investments
      at
      fair value were invested in tax-exempt bonds with the remainder, representing
      73.1% of the portfolio, invested in taxable securities, compared to 23.1% and
      76.9%, respectively, at December 31, 2005 and 21.0% and 79.0%, respectively,
      at
      June 30, 2005. As of June 30, 2006, no investments were rated below investment
      grade.





The
      net
      realized gains (losses) on investments were as follows:




*Three
                Months Ended*
              *June
                30,*
            
            *Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Gross
                realized gains1
            
            $
            **97**
            
            $
            1,966
            
            
            $
            **1,549**
            
            $
            3,304Gross
                realized losses2
            
            
            **(67**
            **)**
            
            (3,233
            )
            
            
            **(2,586**
            **)**
            
            (5,031
            )Net
                realized gains (losses) on investments
            
            **$**
            **30**
            
            $
            (1,267
            )
            
            **$**
            **(1,037**
            **)**
            $
            (1,727
            )





Our
      policy is to investigate, on a quarterly basis, all investments for possible
      “other-than-temporary” impairment when the fair value of a security falls below
      its amortized cost, based on all relevant facts and circumstances. No such
      impairments were recorded in the three and six months ended June 30, 2006 or
      2005. See discussion under *Critical
      Accounting Estimates - Investments* for
      further information.





***Other
      Income and Expense***





Other
      income consists of interest income relating to a refund claim with the IRS.
      Other expense of $0.9 million in the second quarter of 2006 relates to an
      impairment charge incurred in connection with vacated space in our headquarters
      in Woodland Hills, California, which will be sublet starting in the third
      quarter.








**FINANCIAL
      CONDITION**





Investments
      and cash were approximately $1.5 billion at June 30, 2006 and December 31,
      2005.
      The Company initiated the sale of its equity securities during the first quarter
      of 2006 and did not hold any equity securities as of June 30, 2006. Applicable
      funds realized from the sale of equity securities were primarily reinvested
      in
      fixed maturity investments. However, the Company executed a $35 million funding
      commitment for a private equity investment program during the second quarter
      of
      2006, as described in Note 9 of the *Notes
      to Condensed Consolidated Financial Statements* .





The
      Company also has unrated, community investments representing 0.2% of total
      investments. These investments have been made in an effort to provide housing
      and other services to economically disadvantaged communities. See Note 8 of
      the *Notes
      to Condensed Consolidated Financial Statements* for
      additional information.




Increased
      advertising, sales and customer service costs in the second quarter of 2006
      contributed to an increase in deferred policy acquisition costs (“DPAC”) of $8.3
      million to $68.2 million, compared to $59.9 million at December 31, 2005. Our
      DPAC is estimated to be fully recoverable (see *Critical
      Accounting Estimates - Deferred Policy Acquisition Costs* ).




1
              Gross
                  realized gains during the three months ended June 30, 2006 and
                  2005
                  include $64 thousand and $1.9 million, respectively, from the sale
                  of
                  equity securities. Gross realized gains during the six months ended
                  June
                  30, 2006 and 2005, include $1.2 million and $3.3 million from the
                  sale of
                  equity securities, respectively.
 2
              Gross
                  realized losses during the three months ended June 30, 2006 and
                  2005
                  include $67 thousand and $3.2 million, respectively, from the sale
                  of
                  equity securities. Gross realized losses during the six months
                  ended June
                  30, 2006 and 2005, include $2.6 million and $5.0 million from the
                  sale of
                  equity securities,
                  respectively.




23





The
      following table summarizes unpaid losses and LAE, gross and net of applicable
      reinsurance, with respect to our lines of business:





**June
                30, 2006**
            
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            **Gross**
            **Net**
            
            Gross
            NetUnpaid
                losses and LAEPersonal
                auto lines
            
            **$**
            **493,584**
            
            **$**
            **488,397**
            
            
            $
            521,528
            
            $
            516,849Homeowner
                and earthquake lines in runoff
            
            
            **1,508**
            
            
            **783**
            
            
            
            2,307
            
            
            1,368Total
            
            **$**
            **495,092**
            
            **$**
            **489,180**
            
            
            $
            523,835
            
            $
            518,217





At
      June
      30, 2006, gross unpaid losses and LAE decreased $28.7 million, primarily due
      to
      a reserve decrease of $27.9 million in the personal auto lines as a result
      of
      $25.5 million of favorable loss development related to prior accident years
      recorded during the six months ended June 30, 2006 and fewer number of
      exposures. The gross unpaid losses and LAE in the homeowner and earthquake
      lines
      decreased $0.8 million as the result of continued runoff activity (see *Critical
      Accounting Estimates - Losses and Loss Adjustment Expenses* for
      a
      description of the Company’s reserving process).




Debt
      of
      $121.6 million consists of $21.7 million of capital lease obligations and $99.9
      million of Senior Notes, net of discount. The decrease in debt of $6.4 million
      during the six months ended June 30, 2006 is primarily attributable to principal
      payments on the capital leases.





Stockholders’
      equity and book value per share increased to $855.2 million and $9.91,
      respectively, at June 30, 2006, compared to $830.0 million and $9.66 at December
      31, 2005, respectively. The increase in stockholders’ equity for the six months
      ended June 30, 2006 was primarily due to net income of $49.6 million,
      stock-based compensation cost of $6.7 million, and $3.8 million exercised stock
      options. This was partially offset by dividends to stockholders of $13.8 million
      and an increase in accumulated other comprehensive loss of $21.1 million
      (resulting from a $32.5 million increase in net unrealized losses on the
      investment portfolio due to rising market yields).





**LIQUIDITY
      AND CAPITAL RESOURCES**





***21st
      Century Insurance Group***




Our
      holding company’s main sources of liquidity historically have been dividends
      received from our insurance subsidiaries and proceeds from issuance of debt
      or
      equity securities. Apart from the exercise of stock options and restricted
      stock
      grants to employees, the effects of which have not been significant, we have
      not
      issued any equity securities since 1998 when American International Group,
      Inc.
      (“AIG”) exercised its warrants to purchase common stock for cash of $145.6
      million. Our insurance subsidiaries have not paid any dividends to our holding
      company since 2001. As of June 30, 2006, our insurance subsidiaries could pay
      $113.0 million as dividends to the holding company without prior written
      approval from insurance regulatory authorities.




Effective
      December 31, 2003, the California Department of Insurance (“CDI”), approved an
      intercompany lease whereby 21st Century Insurance Company leases certain
      computer software from our holding company. The monthly lease payment, currently
      $0.8 million, started in January 2004 and is subject to upward adjustment based
      on the cost incurred by the holding company to enhance the software.




On
      November 30, 2005, the CDI approved an amendment to a term loan line that
      increased the available amount from $40 million to $150 million that our
      insurance subsidiary, 21st Century Insurance Company, can loan to our holding
      company. The outstanding balance of the term loan line as of June 30, 2006,
      was
      $71.0 million.




Our
      holding company’s significant cash obligations over the next several years,
      exclusive of any dividends to stockholders that our directors may declare,
      consist of the following:




·
            Ongoing
                costs to enhance our computer
                software;




·
            The
                repayment of the $100 million principal on the Senior Notes due in
                2013;




·
            The
                repayment of $71.0 million principal on the term loan line to the
                insurance subsidiary (scheduled payments include $18 million, $40
                million,
                and $13 million in 2007, 2008,and 2009, respectively);
                and




·
            Related
                interest on the obligations above.





We
      expect
      to be able to meet those obligations from sources of cash currently available
      (i.e., cash and investments at the holding company, which totaled $19.5 million
      at June 30, 2006, payments received from the intercompany lease, and borrowing
      from our insurance subsidiary), additional funds that may be obtainable from
      the
      capital markets or dividends received from our insurance subsidiaries. The
      effective 2006 California state income tax rate applicable to any such dividends
      paid from our subsidiaries, if taxable, is approximately 1.8%, or 1.2% net
      of
      federal benefit.




24





***Insurance
      Subsidiaries***




We
      have
      achieved underwriting profits in our core auto insurance operations since 2001
      and have thereby enhanced our liquidity. Our cash flows from operations and
      short-term cash position generally are more than sufficient to meet obligations
      for claim payments, which by the nature of the personal automobile insurance
      business tend to have an average duration of less than a year. Our underwriting
      results are impacted by rate changes. Although in the past years we have been
      successful in gaining California regulatory approval for rate increases, there
      can be no assurance that insurance regulators will grant future rate increases
      that may be necessary to offset possible future increases in claims cost trends.
      As discussed in the *Operating
      Highlights* ,
      in July
      2006, the CDI issued changes to regulations relating to automobile insurance
      rating factors, particularly concerning territorial rating. It is not possible
      at this time to predict the ultimate timing or impact of these changes, which
      could have either a materially favorable or materially adverse impact on the
      Company. Also in July 2006, the CDI proposed new amended rate approval
      regulations, which if approved without modification, could have a materially
      adverse impact on the Company’s California results. See further discussion in *Item
      1A. Risk Factors.*




Also,
      in
      the event of adverse claims results, we could be forced to liquidate investments
      to pay claims, possibly during unfavorable market conditions, which could lead
      to the realization of losses on sales of investments. Adverse outcomes to any
      of
      the foregoing uncertainties would create some degree of downward pressure on
      the
      insurance subsidiaries’ earnings or cash flows, which in turn, could negatively
      impact our liquidity.




As
      of
      June 30, 2006, our insurance subsidiaries had a combined statutory surplus
      of
      $755.3 million compared to $704.7 million at December 31, 2005. The increase
      in
      statutory surplus was primarily due to statutory net income of $59.2 million
      and
      an increase in net unrealized investment gains of $1.2 million, offset by a
      $7.1
      million increase in the deferred income tax asset and an increase in nonadmitted
      assets of $2.6 million. The net premiums written to statutory surplus ratio,
      which is required to be below 3.0, was 1.7 at June 30, 2006, compared to 1.9
      at
      December 31, 2005.





Certain
      of our subsidiaries must comply with minimum capital and surplus requirements
      under applicable state laws and regulations, and must have adequate reserves
      for
      claims. We believe that as of June 30, 2006, all of our insurance subsidiaries
      met their respective regulatory requirements.





The
      following is a reconciliation of our stockholders’ equity to statutory
      surplus:




*AMOUNTS
                IN THOUSANDS*
            
            **June
                30,**
              **2006**
            December
                31,
              2005Stockholders’
                equity - GAAP
            
            **$**
            **855,165**
            
            $
            829,972Condensed
                adjustments to reconcile GAAP shareholders’ equity to statutory
                surplus:Net
                book value of fixed assets under capital leases
            
            
            **(21,880**
            **)**
            
            (24,185
            )Deferred
                gain under capital lease transactions
            
            
            **(497**
            **)**
            
            (914
            )Capital
                lease obligation
            
            
            **21,715**
            
            
            28,074Nonadmitted
                net deferred tax assets
            
            
            **(24,078**
            **)**
            
            (34,936
            )Net
                deferred tax assets related to items nonadmitted under SAP
            
            
            **24,438**
            
            
            38,544Intercompany
                receivables
            
            
            **(64,647**
            **)**
            
            (57,683
            )Fixed
                assets
            
            
            **(21,720**
            **)**
            
            (22,492
            )Equity
                in non-insurance entities
            
            
            **39,558**
            
            
            26,798Net
                unrealized losses on investments
            
            
            **44,778**
            
            
            10,788Deferred
                policy acquisition costs
            
            
            **(68,248**
            **)**
            
            (59,939
            )Prepaid
                pension costs and intangible pension asset
            
            
            **(18,435**
            **)**
            
            (21,309
            )Other
                prepaid expenses
            
            
            **(14,693**
            **)**
            
            (11,049
            )Other,
                net
            
            
            **3,870**
            
            
            3,002Statutory
                surplus
            
            **$**
            **755,326**
            
            $
            704,671





25





***Operating
      Cash Flows***





Our
      operating cash flows were as follows:





*Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Decrease*Net
                cash provided by operating activities
            
            **$**
            **64,418**
            
            $
            70,241
            
            $
            5,823





Net
      cash
      provided by operating activities decreased primarily due to a decline in direct
      premiums collected resulting from the decline in premiums written. This was
      partially offset by decreases in loss and LAE payments. Also, while underwriting
      expenses and deferred policy acquisition costs increased since the prior
      year, cash paid for underwriting expenses did not increase significantly due
      to
      the increase in other liabilities of $19.8 million, primarily as a result of
      unpaid expenditures incurred towards the end of the quarter in connection with
      the Company’s national expansion efforts.





***Investing
      Activities***





Our
      cash
      flow from investing activities is primarily impacted by the sales, maturities
      and purchases of our available-for-sale investment securities. Our investment
      objective is to maintain a low level of risk and to preserve principal by
      investing in high quality, investment grade securities while maintaining
      liquidity in each portfolio sufficient to meet our cash flow
      requirements.





Our
      cash
      flows from investing activities were as follows:





*Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Increase*Net
                cash used in investing activities
            
            **$**
            **76,352**
            
            $
            52,791
            
            $
            23,561





Net
      cash
      used in investing activities increased primarily due to payments for the
      purchase of investments and purchase of property and equipment of $21.5 million
      and $0.8 million, respectively, partially offset by net sales and maturities
      of
      investments of $44.3 million.





***Financing
      Activities***





Our
      cash
      flows from investing activities were as follows:





*Six
                Months Ended*
              *June
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Increase*Net
                cash used in financing activities
            
            **$**
            **16,546**
            
            $
            10,825
            
            $
            5,721





Net
      cash
      used in financing activities increased due to the doubling of the dividend
      since
      the prior year from $0.04 per share to $0.08 per share, partially offset by
      a
      $1.0 million increase in cash receipts provided by stock option
      exercises.




**TRANSACTIONS
      WITH RELATED PARTIES**





Several
      subsidiaries of AIG together own approximately 62% of our outstanding common
      stock and four of the eleven members of our Board of Directors are employees
      of
      AIG. Since 1995, the Company has entered into transactions with AIG
      subsidiaries, including reinsurance agreements, insurance coverage contracts,
      and investment management and investment accounting.




26





***Reinsurance
      agreements***




The
      Company’s catastrophe reinsurance coverage for its personal auto lines is
      provided by three participating entities, two of which are AIG subsidiaries.
      Together they reinsure any covered event up to $45.0 million in excess of $20.0
      million. This coverage was renewed effective January 1, 2005 and 2006. Total
      premiums ceded to AIG subsidiaries were $0.3 million and $0.5 million for the
      three and six months ended June 30, 2006, respectively, and $0.2 million and
      $0.5 million for the three and six months ended June 30, 2005, respectively.
      Total reinsurance recoverables, net of payables, from AIG subsidiaries were
      $0.4
      million and $0.6 million as of June 30, 2006 and December 31, 2005,
      respectively.





***Corporate
      insurance coverage***





The
      Company has obtained the following corporate insurance policies from AIG
      subsidiaries:





·
            Workers’
                compensation insurance





·
            General
                liability insurance





·
            Property
                insurance





·
            Umbrella
                excess insurance





·
            Fiduciary
                liability insurance





·
            Fidelity
                insurance





·
            Auto
                insurance





·
            Employment
                practices liability insurance




Errors
      and omissions insurance was carried with AIG through September 30,
      2005.





Insurance
      expense attributable to AIG corporate insurance coverages was $1.3 million
      and
      $2.1 million for the three and six months ended June 30, 2006, respectively,
      and
      $1.1 million and $2.5 million for the three and six months ended June 30, 2005,
      respectively.





***Investment
      management and investment accounting***





In
      October 2003, as a result of a competitive bidding process, we entered into
      an
      agreement with AIG Global Investment Corp. (“AIGGIC”) to provide investment
      management and investment accounting services to the Company. The fees are
      determined as a percentage of the average invested asset balance and are
      classified with net investment income. This agreement was approved by the CDI.
      Investment management and accounting expense was $0.2 million and $0.4 million
      for the three and six months ended June 30, 2006, respectively, and $0.2 million
      and $0.5 million for the three and six months ended June 30, 2005,
      respectively.





In
      June
      2006, the Company executed a $35 million funding commitment with AIGGIC for
      a
      program that will manage a portfolio of private equity transactions. In the
      event that the Company does not respond to a capital call during the investment
      term, the General Partner of the fund (“GP”) may apply the following default
      provisions: withhold 50% of distributions due to the Company at the time of
      the
      default and 50% of future distributions due to the Company; hold the Company
      liable for fund expenses above and beyond investments made by the Company (with
      the right of offset); terminate the Company’s Limited Partner status and not
      allow it any further investments; or charge interest on the defaulted capital
      commitment amount and fees at LIBOR + 4% (with the right of offset). However,
      the GP may choose not to designate the Company a "defaulting limited partner"
      and waive the default provisions. The investment term ends after the underlying
      investments are liquidated, but in no event later than 10 years. Typically,
      multiple investments are purchased and liquidated over the investment term.
      The
      Company funded $9.1 million of the commitment in July 2006.





27





**CONTRACTUAL
      OBLIGATIONS AND COMMITMENTS**





See
      our
      discussion about variable interest entities and commitments in Note 8 of the *Notes
      to Condensed Consolidated Financial Statements* .
      There
      were no material changes outside the ordinary course of our business in our
      contractual obligations during the
      six-month period ended June 30, 2006.








**CRITICAL
      ACCOUNTING ESTIMATES**





Our
      condensed consolidated financial statements are prepared in accordance with
      GAAP. The financial information contained within these statements is, to a
      significant extent, financial information that is based on estimates and
      assumptions. Our significant accounting policies are essential to understanding
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations. Some of our accounting policies require significant judgment to
      estimate values of either assets or liabilities. In addition, significant
      judgment may be needed to apply what often are complex accounting principles
      to
      individual transactions to determine the most appropriate treatment. We have
      established procedures and processes to facilitate making the judgments
      necessary to prepare the condensed consolidated financial statements.





The
      following is a summary of the more judgmental and complex accounting estimates
      and principles. In each area, we have discussed the assumptions most important
      in the estimation process. We have used the best information available to
      estimate the related items involved. Actual performance that differs from our
      estimates and future changes in the key assumptions could change future
      valuations and materially impact our financial condition and results of
      operations.





Management
      has discussed our critical accounting policies and estimates, together with
      any
      changes therein, with the Audit Committee of our Board of Directors.





***Losses
      and Loss Adjustment Expenses***




The
      estimated liabilities for losses and LAE include estimates of losses for known
      claims reported on or prior to the balance sheet dates, estimates of losses
      for
      claims incurred but not reported, estimates of expenses for investigating,
      adjusting and settling all incurred claims. Amounts reported are estimates
      of
      the ultimate costs of settlement, net of estimated salvage and subrogation.
      The
      estimated liabilities are necessarily subject to the outcome of future events,
      such as changes in medical and repair costs, as well as economic and social
      conditions that impact the settlement of claims. In addition, time can be a
      critical part of reserving determinations since the longer the span between
      the
      incidence of a loss and the payment or settlement of the claim, the more
      variable the ultimate settlement amount can be.




The
      methods used to determine such estimates and to establish the resulting reserves
      are continually reviewed and updated. Any resulting adjustments are reflected
      in
      current operating income on a dollar-for-dollar basis. For example, an upward
      revision of $1 million in the estimated recorded liability for unpaid losses
      and
      LAE would decrease underwriting profit, and pre-tax income, by the same $1
      million amount. Conversely, a downward revision of $1 million would increase
      pre-tax income by the same $1 million amount.





It
      is
      management’s belief that the reserves for losses and LAE are adequate to cover
      unpaid losses and LAE as of June 30, 2006. While we perform quarterly reviews
      of
      the adequacy of established unpaid losses and LAE reserves, there can be no
      assurance that our ultimate unpaid losses and LAE will not develop redundancies
      or deficiencies and possibly differ materially from our unpaid losses and LAE
      as
      of June 30, 2006. In the future, if the unpaid losses and LAE develop
      redundancies or deficiencies, then such redundancy or deficiency would have
      a
      positive or adverse impact, respectively, on future results of
      operations.





The
      process of making changes to unpaid losses and LAE begins with the review of
      the
      actual claims experience, actual rate changes achieved, actual changes in
      coverage, mix of business, and changes in certain other factors such as weather
      and recent tort activity that may affect the loss and LAE ratio. Based on this
      review, our actuaries prepare several point estimates of unpaid losses and
      LAE
      for each of the coverages, and they use their experience and judgment to arrive
      at an overall actuarial point estimate of the unpaid losses and LAE for that
      coverage.





Meetings
      are held with appropriate departments to discuss significant issues as a result
      of the review. This process culminates in a reserve meeting to review the unpaid
      losses and LAE. The basis for carried unpaid losses and LAE is the overall
      actuarial point estimate. Other relevant internal and external factors
      considered include a qualitative assessment of inflation and other economic
      conditions, changes in the legal, regulatory, judicial and social environments,
      underlying policy pricing, exposure and policy forms, claims handling, and
      geographic distribution shifts. As a result of the meeting, unpaid losses and
      LAE are finalized and we record quarterly changes in unpaid losses and LAE
      for
      each of our coverages. The overall change in our unpaid losses and LAE is based
      on the sum of these coverage level changes.





28





The
      point
      estimate methods include the use of paid loss triangles, incurred loss
      triangles, claim count triangles, and severity triangles, as well as expected
      loss ratio methods. Quantitative techniques frequently have to be supplemented
      by subjective consideration, including managerial judgment, to assure management
      satisfaction that the overall unpaid losses and LAE are adequate to meet
      projected losses. For example, in property damage coverages, repair cost trends
      by geographic region vary significantly. These factors are periodically reviewed
      and subsequently adjusted, as appropriate, to reflect emerging trends that
      are
      based upon past loss experience. Thus, many factors are implicitly considered
      in
      estimating the loss costs recognized.





Judgment
      is required in analyzing the appropriateness of the various methods and factors
      to avoid overreacting to data anomalies that may distort such prior trends.
      For
      example, changes in limits distributions or development in the most recent
      accident quarters would require more actuarial judgment. We do not believe
      disclosure of specific point estimates calculated by the actuaries would be
      meaningful. Any one actuarial point estimate is based on a particular series
      of
      judgments and assumptions of the actuary. Another actuary may make different
      assumptions, and therefore reach a different point estimate.





There
      is
      a potential for significant variation in ultimate development of unpaid losses
      and LAE. Most automobile claims are reported within two to three months whereas
      the estimate of ultimate severities exhibits greater variability at the same
      maturity. Generally, actual historical loss development factors are used to
      project future loss development and there can be no assurance that future loss
      development patterns will be the same as in the past. However, we believe that
      our reserving methodologies are in line with other personal lines insurers
      and
      would generally expect ultimate unpaid losses and LAE development to vary
      approximately 5% from the carried unpaid losses and LAE.




The
      Company has experienced changes in the mix of business and policy limits. We
      believe that the assumption with the highest likelihood of change that could
      materially affect carried unpaid losses and LAE is the estimate of the frequency
      of unpaid bodily injury claims. The Company has experienced approximately 15%
      lower bodily injury claim frequency over accident years 2003 through 2005 in
      California. A 5% change in the estimate of the frequency of unpaid bodily injury
      claims for accident year 2005 would result in an approximate increase or
      decrease in total  unpaid
      losses and LAE of 1.3%, or $6.2 million, at June 30, 2006.




***Investments***




Investment
      securities generally must be classified as held-to-maturity, available-for-sale
      or trading. The appropriate classification is based partially on our ability
      to
      hold the securities to maturity and largely on management’s intentions at
      inception with respect to either holding or selling the securities. The
      classification of investment securities is significant since it directly impacts
      the accounting for unrealized gains and losses on securities. Unrealized gains
      and losses on trading securities flow directly through earnings during the
      periods in which they arise, whereas for available-for-sale securities they
      are
      recorded as a separate component of stockholders’ equity (accumulated other
      comprehensive income or loss) and do not affect earnings until realized. The
      fair values of our investment securities are generally determined by reference
      to quoted market prices and reliable independent sources. The cost of investment
      securities sold is determined by the specific identification
      method.




We
      are
      obligated to assess, at each reporting date, whether there is an
“other-than-temporary” impairment to our investment securities. In general, a
      security is considered a candidate for impairment if it meets any of the
      following criteria:





·
            Trading
                at a significant (25% or more) discount to par, amortized cost (if
                lower)
                or cost for an extended period of time (nine months or
                longer);





·
            The
                occurrence of a discrete credit event resulting in*(i)*the
                issuer defaulting on a material outstanding obligation; or*(ii)*the
                issuer seeking protection from creditors under the bankruptcy laws
                or any
                similar laws intended for the court supervised reorganization of
                insolvent
                enterprises; or*(iii)*the
                issuer proposing a voluntary reorganization pursuant to which creditors
                are asked to exchange their claims for cash or securities having
                a fair
                value substantially lower than par value of their claims;
                or





·
            In
                the opinion of the Company’s management, it is possible that the Company
                may not realize a full recovery on its investment, irrespective of
                the
                occurrence of one of the foregoing
                events.





For
      investments with unrealized losses due to market conditions or industry-related
      events, where the Company has the positive intent and ability to hold the
      investment for a period of time sufficient to allow a market recovery or to
      maturity, declines in value below cost are not assumed to be
      other-than-temporary. Where declines in values of securities below cost or
      amortized cost are considered to be other-than-temporary, such as when it is
      determined that an issuer is unable to repay the entire principal, a charge
      is
      required to be reflected in income for the difference between cost or amortized
      cost and the fair value.





29





The
      determination of whether a decline in market value is “other-than-temporary” is
      necessarily a matter of subjective judgment. No such charges were recorded
      in
      the three or six months ended June 30, 2006 or 2005. The timing and amount
      of
      realized losses and gains reported in income could vary if conclusions other
      than those made by management were to determine whether an other-than-temporary
      impairment exists. However, there would be no impact on equity as of the periods
      presented because any unrealized losses would be already included in accumulated
      other comprehensive income (loss).





Substantially
      the entire fixed maturity portfolio is investment grade. The following is a
      summary of the Standard & Poor’s credit rating for the fixed maturity
      portfolio (the weighted average is “AA”):





**June
                30, 2006**
            
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            ***#
                issues***
            ***Fair
                Value***
            
            *#
                issues*
            *Fair
                Value*AAA
            
            
            **320**
            
            **$**
            **706,286**
            
            
            
            286
            
            $
            604,812AA
            
            
            **114**
            
            
            **174,147**
            
            
            
            116
            
            
            169,708A
            
            
            **118**
            
            
            **428,461**
            
            
            
            118
            
            
            486,338BBB
            
            
            **45**
            
            
            **115,092**
            
            
            
            44
            
            
            88,918BB
            
            
            **—**
            
            
            **—**
            
            
            
            3
            
            
            2,495Not
                Rated
            
            
            **5**
            
            
            **2,742**
            
            
            
            2
            
            
            2,436Total
                fixed maturity investments
            
            
            **602**
            
            **$**
            **1,426,728**
            
            
            
            569
            
            $
            1,354,707








The
      following is a summary by issuer of non-investment grade securities and unrated
      securities held (at fair value):





**June
                30,**
            December
                31,*AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005Non-investment
                grade equity securities:AmerUs
                Group Co.3
            
            **$**
            **—**
            
            $
            864Non-investment
                grade fixed maturity securities (i.e., rated below BBB-):Ford
                Motor Credit Company 4
            
            
            **—**
            
            
            2,495Unrated
                fixed maturity securities:5Impact
                Community Capital, LLC
            
            
            **1,999**
            
            
            2,023Impact
                Healthcare, LLC
            
            
            **413**
            
            
            413Impact
                Childcare, LLC
            
            
            **330**
            
            
            **—**Total
                non-investment grade and unrated fixed maturity securities
            
            
            **2,742**
            
            
            4,931Total
                non-investment grade and unrated securities
            
            **$**
            **2,742**
            
            $
            5,795Percentage
                of total investments, at fair value
            
            
            **0.2**
            **%**
            
            0.4
            %




3
              The
                  AmerUs Group Co. was a preferred stock holding that had an unrealized
                  gain
                  as of December 31, 2005.
 4
              The
                  Ford Motor Credit Company security matured in the first quarter
                  of 2006
                  and the Company received all amounts due, thereby incurring no
                  loss.
 5
              Impact
                  Community Capital is a limited partnership that was voluntarily
                  established by a group of California insurers to make loans and
                  otherinvestments
                  that provide housing and other services to economically disadvantaged
                  communities. See further discussion in Note 8 of the*Notes
                  to the**Condensed
                  Consolidated Financial
                  Statements.*




30





The
      following table summarizes investments held by us having an unrealized loss
      of
      $0.1 million or more and aggregate information relating to all other investments
      in unrealized loss positions as of June 30, 2006 and December 31,
      2005:





**June
                30, 2006**
            
            December
                31, 2005*AMOUNTS
                IN THOUSANDS,*
              *EXCEPT
                NUMBER OF ISSUES*
            
            ***#
                issues***
            ***Fair
                Value***
            ***Unrealized
                Loss***
            
            *#
                issues*
            *Fair
                Value*
            *Unrealized
                Loss*Investments
                with unrealized losses:Fixed
                maturity securities:Exceeding
                $0.1 million and in a loss position for:Less
                than 6 months
            
            
            **8**
            
            **$**
            **47,774**
            
            **$**
            **1,384**
            
            
            
            16
            
            $
            141,034
            
            $
            3,0746-12
                months
            
            
            **48**
            
            
            **297,042**
            
            
            **15,406**
            
            
            
            16
            
            
            129,044
            
            
            4,072More
                than 1 year
            
            
            **75**
            
            
            **500,926**
            
            
            **32,761**
            
            
            
            56
            
            
            433,368
            
            
            16,896Less
                than $0.1 million
            
            
            **130**
            
            
            **221,316**
            
            
            **5,052**
            
            
            
            113
            
            
            204,724
            
            
            4,347Total
                fixed maturity securities with unrealized losses
            
            
            **261**
            
            
            **1,067,058**
            
            
            **54,603**
            
            
            
            201
            
            
            908,170
            
            
            28,389Equity
                securities:Exceeding
                $0.1 million
            
            
            —
            
            
            **—**
            
            
            **—**
            
            
            
            2
            
            
            578
            
            
            305Less
                than $0.1 million
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            
            245
            
            
            35,672
            
            
            1,873Total
                equity securities with unrealized losses
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            
            247
            
            
            36,250
            
            
            2,178Total
                investments with unrealized losses6
            
            
            **261**
            
            **$**
            **1,067,058**
            
            **$**
            **54,603**
            
            
            
            448
            
            $
            944,420
            
            $
            30,567





Unrealized
      losses on fixed maturity investments primarily arose from rising interest rates
      in the current period. If our portfolio were to be impaired by market or
      issuer-specific conditions to a substantial degree, our liquidity, financial
      position and financial results could be materially adversely affected. Further,
      our income from these investments could be materially reduced, and write-downs
      of the value of certain securities could further reduce our profitability.
      In
      addition, a decrease in value of our investment portfolio could put our
      subsidiaries at risk of failing to satisfy regulatory capital requirements.
      If
      we were not at that time able to supplement our capital by issuing debt or
      equity securities on acceptable terms, our ability to continue growing could
      be
      adversely affected. ** See
      further discussion in *Item
      3. Quantitative and Qualitative Disclosures About Market Risk.*





A
      summary
      by contractual maturity of fixed maturity securities in an unrealized loss
      position by year of maturity follows:





**June
                30, 2006**
            
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            ***Amortized
                Cost***
            ***Fair
                Value***
            ***Unrealized
                Loss***
            
            *Amortized
                Cost*
            *Fair
                Value*
            *Unrealized
                Loss*Fixed
                maturity securities:Due
                in one year or less
            
            **$**
            **2,019**
            
            **$**
            **1,994**
            
            **$**
            **25**
            
            
            $
            5,562
            
            $
            5,512
            
            $
            50Due
                after one year through five years
            
            
            **440,835**
            
            
            **421,282**
            
            
            **19,553**
            
            
            
            205,363
            
            
            200,075
            
            
            5,288Due
                after five years through ten years
            
            
            **320,898**
            
            
            **303,371**
            
            
            **17,527**
            
            
            
            415,417
            
            
            401,533
            
            
            13,884Due
                after ten years
            
            
            **357,909**
            
            
            **340,411**
            
            
            **17,498**
            
            
            
            310,217
            
            
            301,050
            
            
            9,167Total
                fixed maturity securities with unrealized losses
            
            **$**
            **1,121,661**
            
            **$**
            **1,067,058**
            
            **$**
            **54,603**
            
            
            $
            936,559
            
            $
            908,170
            
            $
            28,389




***Income
      Taxes***




Determining
      the consolidated provision for income tax expense, deferred tax assets and
      liabilities and any related valuation allowance involves judgment. GAAP require
      deferred tax assets and liabilities (“DTAs” and “DTLs,” respectively) to be
      recognized for the estimated future tax effects attributed to temporary
      differences and carryforwards based on provisions of the enacted tax law. The
      effects of future changes in tax laws or rates are not anticipated. Temporary
      differences are differences between the tax basis of an asset or liability
      and
      its reported amount in the condensed consolidated financial statements. For
      example, we have a DTA because the tax bases of our loss and LAE reserves are
      smaller than their book bases. Similarly, we have a DTL because the book basis
      of our capitalized software exceeds its tax basis. Carryforwards include such
      items as alternative minimum tax credits, which may be carried forward
      indefinitely, and net operating losses (“NOLs”), which can be carried forward 15
      years for losses incurred before 1998 and 20 years thereafter.




6
              Unrealized
                  losses represent 5.1% and 3.2% of the total carrying value of investments
                  with unrealized losses at June 30, 2006 and December 31,2005,
                  respectively.




31





At
      June
      30, 2006, our DTAs totaled $127.1 million and our DTLs totaled $69.8 million.
      The net of those amounts, $57.3 million, represents the net deferred tax asset
      reported in the condensed consolidated balance sheets.  At
      December 31, 2005, our DTAs total $128.5 million and our DTLs total $72.3
      million. The net of those amounts, $56.2 million, represents the net deferred
      tax asset reported in the condensed consolidated balance sheets.




We
      are
      required to reduce DTAs (but not DTLs) by a valuation allowance to the extent
      that, based on the weight of available evidence, it is “more likely than not”
(i.e., a likelihood of more than 50%) that any DTAs will not be realized.
      Recognition of a valuation allowance would decrease reported earnings on a
      dollar-for-dollar basis in the year in which any such recognition were to occur.
      The determination of whether a valuation allowance is appropriate requires
      the
      exercise of management judgment. In making this judgment, management is required
      to weigh the positive and negative evidence as to the likelihood that the DTAs
      will be realized.




The
      Company’s net deferred tax assets include a net operating loss (“NOL”)
      carryforward for regular federal corporate tax purposes of approximately $27.9
      million, representing an unrealized tax benefit of $9.8 million at June 30,
      2006, compared to $33.6 million at December 31, 2005. The steady decline in
      the
      unrealized tax benefit of the NOL since 2002 resulted from the generation of
      taxable underwriting and investment income in the intervening years. At the
      current rate of utilization, the Company’s remaining NOL, excluding 21st of the
      Southwest, should be fully utilized by the end of 2006, but in any event long
      before its statutory expiration.





Portions
      of our NOL carryforward are scheduled to expire beginning in 2017, as shown
      in
      the table below (amounts in thousands):




**Year
                of Expiration**
            
            **NOL
                Excluding 21st**
              **of
                the Southwest**
            **SRLY7****NOL of 21st**
              **of
                the Southwest**
            **Consolidated
                NOL**2017
            
            $
            ―
            
            $
            1,496
            
            $
            1,4962018
            
            
            ―
            
            
            1,068
            
            
            1,0682019
            
            
            ―
            
            
            1,466
            
            
            1,4662020
            
            
            ―
            
            
            3,172
            
            
            3,1722021
            
            
            ―
            
            
            2,180
            
            
            2,1802022
            
            
            18,505
            
            
            ―
            
            
            18,505Total
            
            $
            18,505
            
            $
            9,382
            
            $
            27,887





Our
      ability to fully utilize the NOL of 21st of the Southwest depends on future
      taxable income either from continued operating profitability or from tax
      planning strategies we could implement, such as increasing the taxable portion
      of our investment portfolio. Because of the Company’s history of profitability
      over the past four years,  management
      believes it is reasonable to expect future underwriting profits and to conclude
      it is at least more likely than not that we will be able to realize the benefits
      of all of our DTAs, including our NOL. Accordingly, no valuation allowance
      has
      been recognized as of June 30, 2006. However, generating future taxable income
      is dependent on a number of factors, including regulatory and competitive
      influences that may be beyond our ability to control. Future underwriting losses
      could possibly jeopardize our ability to utilize our NOLs. In the event adverse
      development or underwriting losses, management might be required to reach a
      different conclusion about the realization of the DTAs and, if so, recognize
      a
      valuation allowance at that time.





In
      a
      December 21, 2000, court ruling, *Ceridian
      Corporation v. Franchise Tax Board* ,
      a
      California statute that allowed a tax deduction for the dividends received
      from
      wholly-owned insurance subsidiaries was held unconstitutional on the grounds
      that it discriminated against out-of-state insurance holding companies.
      Subsequent to the court ruling, the staff of the California Franchise Tax Board
      (“FTB”) took the position that the discriminatory sections of the statute are
      not severable and the entire statute is invalid. As a result, the FTB began
      disallowing dividends-received deductions for all insurance holding companies,
      regardless of domicile, for open tax years ending on or after December 1, 1997.
      Although the FTB made no formal assessment, the Company anticipated a
      retroactive disallowance that would result in additional tax assessments and
      recorded a provision for this contingency in a prior year.




In
      the
      first quarter of 2005, the Company filed amended California tax returns and
      paid
      the State of California approximately $6.8 million to cover all issues
      outstanding with the FTB, including certain matters paid under protest as to
      which the Company reserved all its rights to file for refunds and appeal any
      adverse rulings by the FTB to the California State Board of Equalization
      (“SBE”). In September 2005, the FTB completed its audit and denied the Company’s
      refund claims. In December 2005, the Company filed an appeal with the SBE.
      The
      Company is unable to assess the likelihood that any refunds ultimately will
      be
      received from the State of California.




7
              “SRLY”
                  stands for Separate Return Limitation Year. Under the Federal tax
                  code,
                  only future income generated by 21st of the Southwest may be utilizedagainst
                  this portion of our NOL.




32





***Deferred
      Policy Acquisition Costs***




Deferred
      policy acquisition costs (“DPAC”) primarily include premium taxes, advertising,
      and other variable costs incurred with writing business. These costs are
      deferred and amortized over the 6-month policy period in which the related
      premiums are earned.




Management
      assesses the recoverability of deferred policy acquisition costs on a quarterly
      basis. The assessment calculates the relationship of estimated costs incurred
      to
      premiums from contracts issued or renewed for the period. We do not consider
      anticipated investment income in determining the recoverability of these costs.
      Based on current indications, management believes the DPAC costs are fully
      recoverable as of June 30, 2006.




The
      loss
      and LAE ratio used in the recoverability estimate is based primarily on expected
      ultimate ratios provided by our actuaries. While management believes that is
      a
      reasonable assumption, actual results could differ materially from such
      estimates.




***Property
      and Equipment***




At
      June
      30, 2006, property and equipment included $126.8 million in software. Accounting
      standards require a write-off to be recognized when an asset is vacated or
      an
      asset group’s carrying value exceeds its fair value. For purposes of recognition
      and measurement of an impairment loss, a long-lived asset or assets are grouped
      with other assets and liabilities at the lowest level for which identifiable
      cash flows are largely independent of the cash flows of other assets and
      liabilities. Accounting standards require asset groups to be tested for possible
      impairment under certain conditions. There have been no events or circumstances
      in the second quarter of 2006 that would require a reassessment of any asset
      group for impairment.




***Stock-Based
      Compensation Expense***





For
      periods prior to January 1, 2006, the Company accounted for share-based payment
      transactions with employees in accordance with Statement of Financial Accounting
      Standard No. (“FAS”) 123, *Accounting
      for Stock-Based Compensation* .
      Under
      the provisions of FAS 123, we had elected to continue using the intrinsic-value
      method of accounting for stock-based awards granted to employees in accordance
      with Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* .
      We did
      not recognize in income any compensation expense for the fair value of stock
      options awarded to employees as all employee stock options were granted at
      or
      above the grant date market price. However, stock-based employee compensation
      cost relating to restricted stock was recognized in the statements of operations
      for periods prior to January 1, 2006. Effective January 1, 2006, the Company
      adopted the fair value recognition provisions of FAS 123 (revised 2004), *Share-Based
      Payment* (“FAS
      123R”). Unlike FAS 123, which was elective, FAS 123R requires that companies use
      a fair value method to value share-based payments and recognize the related
      compensation expense in net earnings. The Company uses the Black-Scholes
      option-pricing model to calculate the fair value of the employee stock options.





The
      Company adopted FAS 123R using the modified-prospective application method,
      and
      accordingly, financial statement amounts for the prior periods presented in
      this
      Form 10-Q have not been restated to reflect the fair value method of expensing
      share-based compensation under FAS 123R. The modified-prospective application
      method provides for the recognition of the fair value with respect to
      stock-based awards granted on or after January 1, 2006 and all previously
      granted, but unvested awards as of January 1, 2006.





The
      adoption of FAS 123R in the first quarter of 2006 resulted in additional
      stock-based compensation cost of $2.0 million and $6.0 million in the three
      and
      six months ended June 30, 2006, respectively, which previously would have been
      only presented in a pro forma footnote disclosure. The Company expects this
      cost
      to approximate $10.0 million for fiscal 2006. FAS 123R also requires the Company
      to estimate forfeitures in calculating the expense relating to stock-based
      compensation, as opposed to recognizing these forfeitures and corresponding
      reduction in expense as they occur. No cumulative adjustment was necessary
      for
      prior year forfeitures as these were estimated in the Company’s prior year pro
      forma financial statements. In addition, FAS 123R requires the Company to
      reflect the cash savings resulting from excess tax benefits (i.e., the benefit
      of the tax deduction for a share-based payment that exceeds the recognized
      compensation cost for that award) in its financial statements as a financing
      cash flow, rather than as an operating cash flow as in prior periods. Basic
      earnings per share for the three and six months ended June 30, 2006 would have
      been $0.35 and $0.62, respectively, if the Company had not adopted FAS 123R,
      compared to reported basic earnings per share of $0.33 and $0.58, respectively.





For
      grants made on or after January 1, 2006, the Company applied the non-substantive
      vesting period approach, which requires recognition of compensation expense
      from
      the grant date to the earlier of the vesting date or the date retirement
      eligibility is achieved for awards with retirement eligibility options. The
      use
      of the non-substantive vesting approach will not affect the overall amount
      of
      compensation expense recognized, but will accelerate the recognition of expense.
      This resulted in $0.7 million in accelerated vesting of awards incurred during
      the first quarter of 2006. In the first quarter of 2006, the Company recognized
      $1.4 million in stock-based compensation expense in connection with the
      accelerated vesting of awards as part of an executive retention agreement.
      For
      the remaining portion of awards that were unvested and granted prior to January
      1, 2006, the Company will continue to follow the nominal vesting period
      approach, and accordingly recognize the expense from the grant date to the
      earlier of the actual date of retirement or the vesting date.





33





See
      additional discussion in Notes 1 and 2 of the *Notes
      to Condensed Consolidated Financial Statements* .





**RECENT
      ACCOUNTING STANDARDS**





In
      June
      2006, the Financial Accounting Standards Board (“FASB”) issued interpretation of
      FASB Statement No. 109, *Accounting
      for Uncertainty in Income Taxes* (“FIN
      48”). This interpretation clarifies the accounting for uncertainty in income
      taxes recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes.* FIN
      48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure, and transition. This interpretation will be effective
      January 1, 2007. The Company is currently assessing the effect of implementing
      FIN 48.








**FORWARD-LOOKING
      STATEMENTS**





This
      report contains statements that constitute forward-looking information.
      Investors are cautioned that these forward-looking statements are not guarantees
      of future performance or results and involve risks and uncertainties, and that
      actual results or developments may differ materially from the forward-looking
      statements as a result of various factors. You should not rely on
      forward-looking statements in this quarterly report on Form 10-Q.
      Forward-looking statements are statements not based on historical information
      and which relate to future operations, strategies, financial results or other
      developments. You can usually identify forward-looking statements by terminology
      such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,”
“estimate,” “predict,” “intend,” “potential,” or “continue” or with the negative
      of these terms or other comparable terminology.





Although
      we believe that the expectations reflected in these forward-looking statements
      are reasonable, we cannot guarantee our future results, level of activity,
      performance or achievements. Forward-looking statements include, among other
      things, discussions concerning our potential expectations, beliefs, estimates,
      forecasts, projections and assumptions. Forward-looking statements may address,
      among other things:





·
            Our
                strategy for growth;




·
            Underwriting
                results;




·
            Our
                expected combined ratio and growth of written
                premiums;




·
            Product
                development;




·
            Computer
                systems;




·
            Litigation,
                regulatory environment and
                approvals;




·
            Market
                position;




·
            Financial
                results;




·
            Dividend
                policy; and




·
            Reserves.





34





It
      is
      possible that our actual results, actions and financial condition may differ,
      possibly materially, from the anticipated results, actions and financial
      condition indicated in these forward-looking statements. Other important factors
      that could cause our actual results and actions to differ, possibly materially,
      from those in the specific forward-looking statements include those discussed
      in
      this report under the heading *Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations* as well
      as:





·
            The
                effects of competition and competitors’ pricing
                actions;




·
            Changes
                in consumer preferences or buying
                habits;




·
            Adverse
                underwriting and claims experience;




·
            Customer
                service problems;




·
            The
                impact on our operations of natural disasters, principally earthquake,
                or
                civil disturbance, due to the concentration of our facilities and
                employees in Southern California;




·
            Information
                system problems;




·
            Control
                environment failures;




·
            Adverse
                developments in financial markets or interest rates;




·
            Results
                of legislative, regulatory or legal actions, including the inability
                to
                obtain approval for necessary licenses, rate increases and product
                changes
                and possible adverse actions taken by state regulators in market
                conduct
                examinations and rate proceedings;
                and




·
            Our
                ability to service the Senior Notes, including our ability to receive
                dividends and/or sufficient payments from our subsidiaries to service
                our
                obligations.




We
      do not
      undertake any obligation to update or revise any forward-looking statements,
      whether as a result of new information, future events or otherwise.





**ITEM
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





Market
      risk is the risk of loss from adverse changes in market prices and interest
      rates. In addition to market risk, we are exposed to other risks, including
      the
      credit risk related to the issuers of the financial instruments in which we
      invest, the underlying insurance risk related to our core business and the
      exposure of the personal lines insurance business, as a regulated industry,
      to
      legal, legislative, judicial, political and regulatory action. Financial
      instruments are not used for trading purposes. The Company also obtained
      long-term fixed rate financing as a means of increasing the statutory surplus
      of
      the Company’s largest insurance subsidiary in 2002 and 2003. The following
      disclosure reflects estimated changes in value that may result from selected
      hypothetical changes in market rates and prices. Actual results may
      differ.




Our
      cash
      flow from operations and short-term cash position generally have been more
      than
      sufficient to meet our projected obligations for claim payments, which by the
      nature of the personal automobile insurance business, tend to have an average
      duration of less than one year. The Company primarily invests in fixed maturity
      investments.




***Fixed
      maturity financial instruments***




For
      all
      of our fixed maturity investments, we seek to provide for liquidity and
      diversification while maximizing income without sacrificing investment quality.
      The value of the fixed maturity portfolio is subject to interest rate risk
      where
      the value of the fixed maturity portfolio decreases as market interest rates
      increase, and conversely, when market interest rates decrease, the value of
      the
      fixed maturity portfolio increases. Duration is a common measure of the
      sensitivity of a fixed maturity security’s value to changes in interest rates.
      The higher the duration, the more sensitive a fixed maturity security is to
      market interest rate fluctuations. Effective duration also measures this
      sensitivity, but it takes into account call terms, as well as changes in
      remaining term, coupon rate, cash flow, and other items.




Since
      fixed maturity investments with longer remaining terms to maturity usually
      tend
      to realize higher yields, the Company’s investment philosophy through 2003
      typically resulted in a portfolio with an effective duration of over 6 years.
      Due to the changing interest rate environment in 2004, management, in
      consultation with the Investment Committee, began targeting a lower duration
      for
      the Company’s fixed maturity investment portfolio to reduce the negative impact
      of potential increases in interest rates.  As
      a
      result, the effective duration of the fixed maturity portfolio declined from
      4.7
      years as of December 31, 2005 to 4.1 years at June 30, 2006.




35





The
      graphical depiction of the relationship between the yield on bonds of the same
      credit quality with different maturities is usually referred to as a yield
      curve. Because the yield on U.S. Treasury securities is the base rate (or “risk
      free rate”) from which non-government bond yields are normally benchmarked, the
      most commonly constructed yield curve is derived from the observation of prices
      and yields in the Treasury market. An upward sloping curve, where yield rises
      steadily as maturity increases, is referred to as a normal yield
      curve.




The
      following table shows the carrying values of our fixed maturity investments,
      which are reported at fair value, and our debt, which is reported at amortized
      cost. The table also presents estimated fair values at adjusted market rates
      assuming a parallel 100 basis point increase in market interest rates, given
      the
      effective duration noted above, for the fixed maturity investment portfolio
      and
      a parallel 100 basis point decrease in market interest rates for the debt
      determined from a present value calculation. The following sensitivity analysis
      summarizes only the exposure to market interest rate risk:




*DOLLAR
                AMOUNTS IN MILLIONS*
              *June
                30, 2006*
            
            *Carrying
                Value*
            *Estimated
                Carrying Value at Adjusted Market Rates/Prices Indicated
                Above*
            *Change
                in Value as a Percentage of Carrying Value*Fixed
                maturity investments available-for-sale, at fair value
            
            $
            1,426.7
            
            $
            1,362.7
            
            
            (4.5
            %)Debt
            
            
            121.6
            
            
            128.2
            
            
            5.4
            %





The
      discussion above provides only a limited, point-in-time view of the market
      risk
      sensitivity of our fixed rate financial instruments. The actual impact of
      interest rate changes on our fixed maturity investments in particular may differ
      significantly from those shown, as the analysis assumes a parallel shift in
      market interest rates. The analysis also does not consider any actions we could
      take in response to actual and/or anticipated changes in interest rates.





Market
      participants usually refer to the difference between long-term Treasury yields
      and short-term Treasury yields as the “slope” of the yield curve. If the spread
      between the long end of the curve, where maturities are high, and the short
      end
      of the curve, where maturities are low, narrows, the yield curve is said to
      be
“flattening”. Conversely, if the spread between the long end of the curve and
      the short end of the curve widens, the yield curve is said to be “steepening”.
      If the yields on the long end of the curve fall below those of the short end
      of
      the curve, the yield curve is said to be “inverted.”





The
      analysis above assumes a parallel shift in interest rates. However, the curve
      may also steepen, flatten or become inverted. This type of behavior may affect
      certain sections of the curve in disproportionate amounts. For example, if
      short-term Treasury yields rise and the yield curve flattens, fixed maturity
      instruments with short duration may be impacted to a greater degree than fixed
      maturity instruments with longer duration. Conversely, if long-term Treasury
      yields rise and the yield curve steepens, fixed maturity instruments with long
      duration may be impacted to a greater degree than fixed maturity instruments
      with shorter duration. The following summarizes the effective duration
      distribution of our fixed maturity investments portfolio.





*Effective
                Duration Ranges (in years)**June
                30, 2006*
            
            Below
                1
            1
                to 3
            3
                to 5
            5
                to 7
            7
                to 10
            10
                to 20Market
                value percentage of fixed maturity investment portfolio
            
            
            1.5
            %
            
            16.5
            %
            
            58.1
            %
            
            21.0
            %
            
            1.8
            %
            
            1.1
            %





36





**ITEM
      4. CONTROLS AND PROCEDURES**





***Evaluation
      of Disclosure Controls and Procedures***





We
      have
      established disclosure controls and procedures to ensure that material
      information relating to the Company, including its consolidated subsidiaries,
      is
      made known to the officers who certify the Company’s financial reports and to
      other members of senior management and the Board of Directors.





Based
      on
      their evaluation of the effectiveness of 21st Century Insurance Group’s
      disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
      under the Securities Exchange Act of 1934) as of June 30, 2006, the Principal
      Executive Officer and Principal Financial Officer of 21st Century Insurance
      Group have concluded that such disclosure controls and procedures are effective
      to ensure that the information required to be disclosed by 21st Century
      Insurance Group in reports that it files or submits under the Securities
      Exchange Act of 1934 is recorded, processed, summarized and reported within
      the
      time periods specified in SEC rules and forms.





Management,
      with the participation of the Principal Executive Officer and Principal
      Financial Officer, has evaluated any changes in 21st Century Insurance Group’s
      internal control over financial reporting that occurred during the most recent
      fiscal quarter. Based on the evaluation, management, including the Principal
      Executive Officer and Principal Financial Officer, have concluded that no change
      in our internal control over financial reporting (as defined in Rule 13a-15(f)
      under the Securities Exchange Act of 1934) occurred during the quarter ended
      June 30, 2006 that has materially affected, or is reasonably likely to
      materially affect, our internal control over financial reporting.




***Inherent
      Limitations on Effectiveness of Controls***





A
      control
      system, no matter how well designed and operated, can provide only reasonable,
      not absolute, assurance that the control system’s objectives will be met.
      Further, no evaluation of controls can provide absolute assurance that
      misstatements due to error or fraud will not occur or that all control issues
      and instances of fraud, if any, have been detected. These inherent limitations
      include the realities that judgments in decision-making can be faulty and that
      breakdowns can occur because of simple error or mistake. Controls can also
      be
      circumvented by the individual acts of some persons, or by collusion of two
      or
      more people.





37





**PART
      II - OTHER INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS**





In
      the
      normal course of business, the Company is named as a defendant in lawsuits
      related to claims and insurance policy issues, both on individual policy files
      and by class actions seeking to attack the Company’s business practices. A
      description of the legal proceedings to which the Company and its subsidiaries
      are a party is contained in Note 4 of the *Notes
      to Condensed Consolidated Financial Statements* .





**ITEM
      1A. RISK FACTORS**





There
      are
      no material changes from the risk factors previously disclosed in Part I of
      Item
      1A. in our Annual Report on Form 10-K for the fiscal year ended December 31,
      2005, except as follows:





In
      July
      of 2006, the California Department of Insurance (the “CDI”) issued changes to
      regulations relating to automobile insurance rating factors, particularly
      concerning territorial rating (the “Auto Rating Factor Regulations”). The
      previous regulation had been validated by a court decision. The new rules
      require automobile insurance companies to make a class plan and rate filing
      during the third quarter to bring their automobile insurance rates in California
      into compliance with the Auto Rating Factor Regulations. Litigation to enjoin
      the implementation of the Auto Rating Factor Regulations and have them declared
      in violation of California law has been instituted by insurance trade
      organizations and other parties. If the litigation is not successful in
      preliminarily enjoining implementation of the Auto Rating Factor Regulations,
      the Company's class plan and rate filings will be reviewed by the CDI. The
      CDI
      may or may not approve the Company’s class plan and rate filings. If not
      approved, further administrative and legal proceedings related specifically
      to
      the Company may be required to resolve any dispute. As a result of such
      proceedings, the Company could ultimately be required to make changes in the
      structure of its rating plans and/or the level of its overall rates that it
      believes are actuarially unsound. In addition, because the new Auto Rating
      Factor Regulations require every company to make a rate filing in the third
      quarter of 2006, competitive rate levels may change and consumer shopping
      behavior may increase in the future. It is not possible at this time to predict
      the ultimate timing or impact of these proceedings and changes, which could
      have
      either a materially favorable or materially adverse impact on the
      Company.




Also
      in
      July 2006, the CDI proposed new amended rate approval regulations (the “Rate
      Approval Regulations”) that would determine how insurance rates for personal
      auto and most other lines of personal and commercial property and casualty
      lines
      of business are established in California. Multiple changes from the current
      regulations include capping the maximum permitted after-tax rate of return
      at
      11% of derived capital for all affected lines of insurance and use of a complete
      formula with established generic factors to determine the maximum rates that
      may
      be charged. The proposed amended Rate Approval Regulations provide for several
      “variances” from the rates specified by the formula. A hearing on the proposed
      Rate Approval Regulations is scheduled for September 13, 2006, after which
      the
      CDI could propose further changes or seek to have them implemented. The Company
      is currently reviewing the proposal in its entirety to determine its impact,
      but
      the proposed Rate Approval Regulations, if approved without modification, could
      have a materially adverse impact on the Company’s  results.





**ITEM
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS**





None.





**ITEM
      3. DEFAULTS UPON SENIOR SECURITIES**





None.





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**





None.





**ITEM
      5. OTHER INFORMATION**





None.





**ITEM
      6. EXHIBITS**





See
      accompanying exhibit index.





38





**SIGNATURES**





Pursuant
      to the requirements of the Securities and Exchange Act of 1934, the registrant
      has duly caused this report to be signed on its behalf by the undersigned
      thereunto duly authorized.







21ST
                CENTURY INSURANCE GROUP(Registrant)Date:
            July
                26, 2006
            
            /s/
                Bruce W. MarlowBRUCE
                W. MARLOWPresident
                and Chief Executive Officer(Principal
                Executive Officer)Date:
            July
                26, 2006
            
            /s/
                Steven P. ErwinSTEVEN
                P. ERWINSenior
                Vice President and Chief Financial Officer(Principal
                Financial Officer)





39





**EXHIBIT
      INDEX**




Exhibit
                No.
            Description31.1
            Certification
                of Principal Executive Officer Pursuant to Exchange Act Rule
                13a-14(a).31.2
            Certification
                of Principal Financial Officer Pursuant to Exchange Act Rule
                13a-14(a).32.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002.






40