**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 March 31, 2005





**o 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


**21ST
CENTURY INSURANCE GROUP**


(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
**o**





Indicate
by check mark whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act). Yes **x** No **o**





The
number of shares outstanding of the issuer’s common stock as of April 11, 2005
was 85,603,641.














**TABLE OF CONTENTS**





Description
    Page
      NumberPart I - Financial InformationItem 1. Financial StatementsCondensed Consolidated Balance Sheets
    2Condensed Consolidated Statements of
      Operations
    3Condensed Consolidated Statement of Stockholders’
      Equity
    4Condensed Consolidated Statements of Cash
      Flows
    5Notes to Condensed Consolidated Financial
      Statements
    6Item 2. Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
    15Item 3. Quantitative and Qualitative Disclosures About
      Market Risk
    29Item 4. Controls and Procedures
    30Part II - Other Information
    31Item 1. Legal Proceedings
    31Item 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
    31Item 3. Defaults Upon Senior Securities
    31Item 4. Submission of Matters to a Vote of Security
      Holders
    31Item 5. Other Information
    31Item 6. Exhibits
    31Signatures
    32Exhibit Index
    3331.1 Certification of President and Chief Executive
      Officer31.2 Certification of Chief Financial
      Officer32.1 Certification Pursuant to 18 U.S.C. Section 1350,
      as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002




1
 *Table of Contents*





**PART I** **-** **FINANCIAL
INFORMATION**




**ITEM 1. FINANCIAL STATEMENTS**


**21ST CENTURY INSURANCE GROUP****CONDENSED
      CONSOLIDATED BALANCE SHEETS**Unaudited**March
      31,**
    December
      31,*AMOUNTS
      IN THOUSANDS, EXCEPT SHARE DATA*
    
    **2005**
    2004**Assets**Fixed
      maturity investments available-for-sale, at fair value (amortized cost:
      $1,336,558 and $1,320,592)
    
    **$**
    **1,332,235**
    
    $
    1,342,130Equity
      securities available-for-sale, at fair value (cost: $42,813 and
      $41,450)
    
    
    **41,090**
    
    
    42,085Total
      investments
    
    
    **1,373,325**
    
    
    1,384,215Cash
      and cash equivalents
    
    
    **41,293**
    
    
    34,697Accrued
      investment income
    
    
    **15,991**
    
    
    16,161Premiums
      receivable
    
    
    **114,310**
    
    
    105,814Reinsurance
      receivables and recoverables
    
    
    **5,964**
    
    
    7,160Prepaid
      reinsurance premiums
    
    
    **1,790**
    
    
    1,787Deferred
      income taxes
    
    
    **62,553**
    
    
    56,135Deferred
      policy acquisition costs
    
    
    **67,395**
    
    
    58,759Leased
      property under capital lease, net of deferred gain of $2,720 and $3,116
      and net of accumulated amortization of $27,893 and $24,794
    
    
    **29,015**
    
    
    31,719Property
      and equipment, at cost less accumulated depreciation of $72,140 and
      $68,529
    
    
    **133,134**
    
    
    129,372Other
      assets
    
    
    **32,988**
    
    
    38,495Total
      assets
    
    **$**
    **1,877,758**
    
    $
    1,864,314**Liabilities
      and stockholders’ equity**Unpaid
      losses and loss adjustment expenses
    
    **$**
    **490,171**
    
    $
    495,542Unearned
      premiums
    
    
    **345,615**
    
    
    331,036Debt
    
    
    **135,338**
    
    
    138,290Claims
      checks payable
    
    
    **40,014**
    
    
    38,737Reinsurance
      payable
    
    
    **621**
    
    
    633Other
      liabilities
    
    
    **92,606**
    
    
    85,675Total
      liabilities
    
    
    **1,104,365**
    
    
    1,089,913Commitments
      and contingenciesStockholders’
      equity:Common
      stock, par value $0.001 per share; 110,000,000 shares authorized; shares
      issued and outstanding 85,599,941 and 85,489,061
    
    
    **85**
    
    
    85Additional
      paid-in capital
    
    
    **421,744**
    
    
    420,425Retained
      earnings
    
    
    **357,211**
    
    
    341,196Accumulated
      other comprehensive (loss) income:Net
      unrealized (losses) gains on available-for-sale investments, net of income
      tax benefit (expense) of $2,116 and $(7,760)
    
    
    **(3,930**
    **)**
    
    14,412Minimum
      pension liability in excess of unamortized prior service cost, net of
      income tax benefit of $925 and $925
    
    
    **(1,717**
    **)**
    
    (1,717
    )Total
      stockholders’ equity
    
    
    **773,393**
    
    
    774,401Total
      liabilities and stockholders’ equity
    
    **$**
    **1,877,758**
    
    $
    1,864,314


*See
accompanying Notes to Condensed Consolidated Financial
Statements.*





2
 *Table of Contents*




**21ST CENTURY INSURANCE GROUP****CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**Unaudited*AMOUNTS
      IN THOUSANDS, EXCEPT SHARE DATA**Three
      Months Ended March 31,*
    
    **2005**
    2004**Revenues**Net
      premiums earned
    
    **$**
    **336,364**
    
    $
    318,220Net
      investment income
    
    
    **17,037**
    
    
    13,146Net
      realized investment (losses) gains
    
    
    **(460**
    **)**
    
    7,646Total
      revenues
    
    
    **352,941**
    
    
    339,012**Losses
      and expenses**Net
      losses and loss adjustment expenses
    
    
    **251,031**
    
    
    247,514Policy
      acquisition costs
    
    
    **64,323**
    
    
    53,690Other
      operating expenses
    
    
    **7,358**
    
    
    6,400Interest
      and fees expense
    
    
    **2,057**
    
    
    2,226Total
      losses and expenses
    
    
    **324,769**
    
    
    309,830Income
      before provision for income taxes
    
    
    **28,172**
    
    
    29,182Provision
      for income taxes
    
    
    **8,735**
    
    
    9,357Net
      income
    
    **$**
    **19,437**
    
    $
    19,825**Earnings
      per common share**Basic
      and diluted
    
    **$**
    **0.23**
    
    $
    0.23Weighted
      average shares outstanding3⁄4basic
    
    
    **85,520,909**
    
    
    85,441,615Weighted
      average shares outstanding3⁄4diluted
    
    
    **85,714,469**
    
    
    85,618,231








*See
accompanying Notes to Condensed Consolidated Financial
Statements.*





3
 *Table of Contents*


**21STCENTURY INSURANCE GROUP**
 **CONDENSED
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**
 Unaudited
 
 *Common
      Stock**$0.001
      par value**AMOUNTS
      IN THOUSANDS,*
      *EXCEPT
      SHARE DATA*
    
    *Shares*
    *Amount*
    *Additional*
      *Paid-in*
      *Capital*
    *Retained*
      *Earnings*
    *Accumulated
      Other*
      *Comprehensive*
      *Income
      (Loss)*
    *Total*Balance
      - January 1, 2005
    
    
    85,489,061
    
    $
    85
    
    $
    420,425
    
    $
    341,196
    
    $
    12,695
    
    $
    774,401Comprehensive
      income (loss)
    
    
    —
    
    
    —
    
    
    —
    
    
    19,437
    (1)
    
    (18,342)
    (2)
    
    1,095Cash
      dividends declared on common stock ($0.04 per share)
    
    
    —
    
    
    —
    
    
    —
    
    
    (3,422
    )
    
    —
    
    
    (3,422
    )Other
    
    
    110,880
    
    
    —
    
    
    1,319
    
    
    —
    
    
    —
    
    
    1,319Balance
      - March 31, 2005
    
    
    85,599,941
    
    $
    85
    
    $
    421,744
    
    $
    357,211
    
    $
    (5,647
    )
    $
    773,393
  *(1)
Net income.*
 *(2)* *Net
change in accumulated other comprehensive income (loss) for the three months
ended March 31, 2005,*  *is as
follows:*


*AMOUNTS
      IN THOUSANDS*
    
    March
      31,
      2005Unrealized
      holding losses arising during the period, net of tax benefit of
      $10,036
    
    $
    (18,639
    )Reclassification
      adjustment for investment losses included in net income, net of tax
      benefit of $160
    
    
    297Total
    
    $
    (18,342
    )





*See
accompanying Notes to Condensed Consolidated Financial
Statements.*





4
 *Table of Contents*




**21ST
      CENTURY INSURANCE GROUP****CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**Unaudited*AMOUNTS
      IN THOUSANDS, EXCEPT SHARE DATA**Three
      Months Ended March 31,*
    
    **2005**
    
    2004**Operating
      activities**Net
      income
    
    **$**
    **19,437**
    
    $
    19,825Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
    
    
    **6,602**
    
    
    5,232Net
      amortization of investment premiums
    
    
    **2,371**
    
    
    1,173Amortization
      of restricted stock grants
    
    
    **34**
    
    
    99Provision
      for deferred income taxes
    
    
    **3,459**
    
    
    8,005Realized
      losses (gains) on sale of investments
    
    
    **454**
    
    
    (7,638
    )**Changes
      in assets and liabilities:**Reinsurance
      balances
    
    
    **1,181**
    
    
    1,823Federal
      income taxes
    
    
    **10,407**
    
    
    (556
    )Other
      assets
    
    
    **(14,243**
    **)**
    
    (11,736
    )Unpaid
      losses and loss adjustment expenses
    
    
    **(5,371**
    **)**
    
    8,985Unearned
      premiums
    
    
    **14,579**
    
    
    21,237Claims
      checks payable
    
    
    **1,277**
    
    
    (1,214
    )Other
      liabilities
    
    
    **(743**
    **)**
    
    12,341Net
      cash provided by operating activities
    
    
    **39,444**
    
    
    57,576**Investing
      activities**Investments
      available-for-salePurchases
    
    
    **(102,661**
    **)**
    
    (576,783
    )Calls
      or maturities
    
    
    **10,775**
    
    
    11,597Sales
    
    
    **71,735**
    
    
    515,988Purchases
      of property and equipment
    
    
    **(7,629**
    **)**
    
    (8,082
    )Net
      cash used in investing activities
    
    
    **(27,780**
    **)**
    
    (57,280
    )**Financing
      activities**Repayment
      of debt
    
    
    **(2,954**
    **)**
    
    (2,732
    )Dividends
      paid (per share: $0.04 and $0.04)
    
    
    **(3,422**
    **)**
    
    (3,417
    )Proceeds
      from the exercise of stock options
    
    
    **1,308**
    
    
    239Net
      cash used in financing activities
    
    
    **(5,068**
    **)**
    
    (5,910
    )Net
      increase (decrease) in cash and cash equivalents
    
    
    **6,596**
    
    
    (5,614
    )Cash
      and cash equivalents, beginning of period
    
    
    **34,697**
    
    
    65,010Cash
      and cash equivalents, end of period
    
    **$**
    **41,293**
    
    $
    59,396**Supplemental
      information:**Income
      taxes paid
    
    **$**
    **6,784**
    
    $
    1,277Interest
      paid
    
    
    **547**
    
    
    787


*See
accompanying Notes to Condensed Consolidated Financial
Statements.*





5
 *Table of Contents*





**21STCENTURY INSURANCE GROUP**


**NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**March
31, 2005**


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, 2004.





These
condensed consolidated financial statements include all adjustments (consisting
of 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 three-month period ended March 31, 2005
are not necessarily indicative of results that may be expected for any other
interim period or the year as a whole.





Certain
amounts in the 2004 condensed consolidated financial statements have been
reclassified to conform to the 2005 presentation.





**Earnings
Per Share**





For each
of the quarters ended March 31, 2005 and 2004, the numerator for the calculation
of both basic and diluted earnings per common share is equal to net income
reported for that period. The difference between basic and diluted earnings per
share denominators is due to dilutive stock options. Options
to purchase an aggregate of 7,208,291 and 6,649,960 ****** shares of
common stock were
considered anti-dilutive during
the quarters ended March 31, 2005 and 2004, respectively, and were not included
in the computation of diluted earnings per share because the options’ exercise
prices were greater than the average market price of the common stock for each
respective period. These
options expire at various points in time through February 2015.





**Stock-Based
Compensation**





Statement
of Financial Accounting Standard (“SFAS”) No. 148, *Accounting
for Stock-Based Compensation-Transition and Disclosure* , amends
the disclosure requirements of SFAS No. 123, *Accounting
for Stock-Based Compensation* , to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. As permitted by SFAS No. 148, the
Company accounts for its fixed stock options using the intrinsic-value method,
prescribed in Accounting Principles Board (“APB”) Opinion No. 25, *Accounting
for Stock Issued to Employees* , which
generally does not result in compensation expense recognition for stock options.
Under the intrinsic-value method, compensation cost for stock options is
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.





In
addition to stock options, the Company also grants restricted stock awards to
certain officers and employees. Upon issuance of grants under the plan, unearned
compensation equivalent to the market value on the date of grant is charged to
paid-in capital and subsequently amortized over the vesting period of the grant.
The Company becomes entitled to an income tax deduction in an amount equal to
the taxable income reported by the holders of the restricted shares when the
restrictions are released.




6
 *Table of Contents*


****


**21ST
CENTURY INSURANCE GROUP**


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


**March
31, 2005**


DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





Restricted
shares are forfeited if officers’ and employees’ employment with the company is
terminated prior to the lapsing of restrictions. We record forfeitures of
restricted stock as treasury share repurchases and any compensation cost
previously recognized with respect to unvested stock awards is reversed in the
period of forfeiture. This accounting treatment results in compensation expense
being recorded in a manner consistent with that required under SFAS No. 123, and
therefore, pro-forma net income and earnings per share amounts for the
Restricted Share Plan would be unchanged from those reported in the financial
statements.





Had
compensation cost for the Company’s stock-based compensation plans been
determined based on the fair value based method for all awards, net income and
earnings per share would have been reduced to the pro-forma amounts indicated
below:





*Three
      Months Ended**March
      31,**AMOUNTS
      IN THOUSANDS, EXCEPT SHARE DATA*
    
    **2005**
    2004**Net
      income, as reported**
    
    **$**
    **19,437**
    
    $
    19,825*Add:*Stock-based employee compensation expense included in reported net income,
      net of related tax effects
    
    
    **22**
    
    
    65*Deduct*:
      Total stock-based employee compensation expense determined under fair
      value based method for all awards, net of related tax
    effects
    
    
    **(1,268**
    **)**
    
    (1,979
    )**Net
      income, pro-forma**
    
    **$**
    **18,191**
    
    $
    17,911Basic
      and diluted earnings per share:As
      reported
    
    **$**
    **0.23**
    
    $
    0.23Pro-forma
    
    **$**
    **0.21**
    
    $
    0.21


For
pro-forma disclosure purposes, the fair value of stock options was estimated for
grants during the three-month periods ended March 31 using the Black-Scholes
valuation model with the following weighted-average assumptions:





*Three
      Months Ended*
      *March
      31,***2005**
    2004Risk-free
      interest rate:Minimum
    
    **3.92**
    **%**
    3.43
    %Maximum
    
    **3.92**
    **%**
    3.43
    %Dividend
      yield
    
    **1.12**
    **%**
    0.56
    %Volatility
      factor of the expected market price of the Company’s common
      stock:Minimum
    
    **0.32**
    
    0.41Maximum
    
    **0.32**
    
    0.41Weighted-average
      expected life of the options
    
    **6
      years**
    
    6
      years




7
 *Table of Contents*


****


**21ST
CENTURY INSURANCE GROUP**


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


**March
31, 2005**


DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





**Recent
Accounting Standards**





In
December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
123 (revised 2004) (“SFAS No. 123R”), *Share-based
Payment* , which
replaces SFAS No. 123, *Accounting
for Stock-Based Compensation* , and
supersedes APB No. 25, *Accounting
for Stock Issued to Employees* . 
As a result of SFAS No. 123R, the Company will be required to recognize the cost
of its stock options as an expense in the consolidated statement of operations
beginning in the first quarter of 2006. The Company is currently assessing the
impact that the adoption of SFAS No. 123R will have on its consolidated results
of operations. Although this assessment is ongoing, management believes the
effect of adopting SFAS No. 123R will be material to the Company’s consolidated
results of operations.





In
January 2003, the Financial Accounting Standards Board issued FASB
Interpretation No. 46, *Consolidation
of Variable Interest Entities, an interpretation of Accounting Research
Bulleting 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 companies are not required to
consolidate but in which a company has a significant variable interest. On
August 29, 2003, the Company funded a revolving loan agreement with Impact
C.I.L., LLC (“Impact C.I.L.”), a VIE. At present the Company has contributed
$5.1 million to be used to purchase mortgage loans in economically disadvantaged
areas. The Company is not the primary beneficiary of the VIE and participates at
an 11.11% level in the entity’s funding activities. Potential losses are limited
to the amount invested as well as associated operating fees.




The
Company’s maximum commitment is for up to 11.11% ($24.0 million) of $216.0
million of participation. The mortgages purchased with these funds may be
securitized. Otherwise, the loan will be liquidated in 10 years from the initial
date of the agreement.





Impact
C.I.L. is a subsidiary of Impact Community Capital, LLC (“Impact”), whose
charter is to provide real estate loans in economically disadvantaged areas. At
present, the Company has a $2.0 million note receivable from Impact in addition
to the $5.1 million investment noted above. The Company has voting rights and
ownership of Impact in proportion to its investment (approximately
10%).





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





**NOTE
2. 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. The discovery stay imposed in early 2002 was
lifted in the first quarter of 2003 and the Company obtained more information
with which to estimate the ultimate cost of resolving its SB 1899 claims. Based
on events occurring during the first quarter of 2003, the Company increased its
SB 1899 reserves by $37.0 million, resulting in an after-tax charge of $24.1
million. The revised estimate at that point was based on the pace and cost of
settlements reached thus far, the actual costs incurred during that quarter, and
the Company’s assessment of the expected length
and intensity of the litigation arising out of the remaining claims. The
estimate was subsequently increased by $1.0 million during the first quarter of
2004 based on the Company’s reassessment of its remaining estimated litigation
costs. Based upon information obtained in connection with settlement discussions
and mediations conducted during the fourth quarter of 2004, the Company updated
its case-by-case review of the remaining cases and reevaluated remaining
litigation costs for resolving outstanding matters. As a result of this
reassessment, the Company increased its reserve by $1.2 million during the
fourth quarter of 2004. The Company’s total reserve for SB 1899 claims as of
March 31, 2005, was $2.3 million.





8
 *Table of Contents*




**21ST
CENTURY INSURANCE GROUP**
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
 **March
31, 2005**
 DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED





More than
ninety-eight percent of the claims submitted and litigation brought against the
Company as a result of SB 1899 have been resolved. Substantially all of the
Company’s remaining 1994 Earthquake claims are in litigation. No class actions
have been certified and the trial court has denied class action status for the
two remaining cases seeking class action status. While the reserves established
are the Company’s current best estimate of the cost of resolving its 1994
Earthquake claims, including claims arising as a result of SB 1899, these
reserves continue to be highly uncertain because of the difficulty in predicting
how the remaining litigated cases will be resolved.  The estimate currently
recorded by the Company assumes that relatively few of the remaining cases will
require a full trial to resolve, that any trial costs will approximate those
encountered by the Company in the past, that most cases will be settled without
need for extensive pre-trial preparation, and that the trial court’s denial of
class action status for those cases seeking such status will be upheld on any
appeal. Current reserves contain no provisions for extra contractual or punitive
damages, bad faith judgments or similar unpredictable hazards of litigation that
possibly could result in the event an adverse verdict were to be sustained
against the Company1.
To the extent these and other underlying assumptions prove to be incorrect, the
ultimate amount to resolve these claims could exceed the Company’s current
reserves, possibly by a material amount. The Company continues to seek
reasonable settlements of claims brought under SB 1899 and other Northridge
earthquake related theories, but will vigorously defend itself against excessive
demands and fraudulent claims. The Company may, however, settle cases in excess
of its assessment of its contractual obligations in order to reduce the future
cost of litigation.





The
Company has received some Northridge earthquake claims reported after the
closing of the window established by SB 1899 which are based upon alternative
legal theories. The Company is contesting these claims and the earthquake
reserves include only nominal amounts for them. Should the courts determine that
these claims, or additional claims brought in the future, are not barred by the
applicable statute of limitations and the provisions of SB 1899, additional
reserves may be needed to resolve these claims.





Loss and
loss adjustment expenses for the homeowner and earthquake lines in runoff were
$0.2 million for the three months ended March 31, 2005, compared to $0.3 million
for the same period in 2004.





**NOTE
3** **.
COMMITMENTS AND CONTINGENCIES**





*Litigation.* 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. 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.





1
    The
      Company believes that the “ex post facto” clause of the U.S. Constitution
      prohibits the assessment of punitive damages in cases brought under SB
      1899. A California Court of Appeal has ruled against the Company on this
      issue. The Company is seeking review of this decision with the California
      Supreme Court.


9
 *Table of Contents*




**21ST
CENTURY INSURANCE GROUP**


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


**March
31, 2005**


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 (“CIC”) 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
on March 22, 2005, but gave plaintiff’s counsel 30 days to file an amended
complaint. 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 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 shooting 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 is set for August 2005 on his claims for bad faith,
emotional distress, punitive damages and attorney fees. The Company believes it
has meritorious defenses to these additional claims, but expects plaintiff’s
attorney fee claim alone to approach $4.0 million.





*Bryan
Speck, individually, and on behalf of others similarly situated v.
21* *st
Century Insurance Company, 21st Century Casualty Company, and 21st Century
Insurance Group* , 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 21st Century uses “biased”
software in determining the value of total-loss automobiles. 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. The Company intends to vigorously defend the
suit with other defendants in the coordinated proceedings. 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.





10
 *Table of Contents*




**21ST
CENTURY INSURANCE GROUP**


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


**March
31, 2005**


DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED






*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. Plaintiff alleges
that the adjusted amount is “predetermined” and “biased,” creating an unfair
pretext for reducing claims costs. This case is consolidated with similar
actions against other insurers for discovery and pre-trial motions. The Company
intends to vigorously defend the suit with other defendants in the coordinated
proceedings. 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.





**NOTE
4** **.
STOCK - BASED COMPENSATION**





**2004
Stock Option Plan**





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, which will remain in effect only as to outstanding awards under it.
The 2004 Plan authorizes a Committee of the Board of Directors to grant stock
options in respect of 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 in respect of shares that were
subject to outstanding awards under the 1995 Stock Option Plan to the extent
such awards expire, are terminated, are cancelled, or are forfeited for any
reason without shares being issued.





At March
31, 2005, 4,511,621 stock options remain available for future grants under the
2004 Plan. Options granted to employees generally have ten-year terms and vest
over various periods, generally three years. 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. Nonemployee
director options vest over one year, provided that the nonemployee director is
in the service of the Company at that time. Currently, the Company uses the
intrinsic-value method to account for stock-based compensation paid to employees
and nonemployee directors for their services.





A summary
of securities issuable and issued for the Company’s stock option plans and the
Restricted Shares Plan at March 31, 2005, follows:





*AMOUNTS
      IN THOUSANDS*
    
    *1995
      Stock*
      *Option
      Plan*
    *2004
      Stock*
      *Option
      Plan*
    *Restricted*
      *Shares
      Plan*Total
      number of securities authorized
    
    
    10,000
    
    
    4,000
    
    
    1,422Number
      of securities issued
    
    
    (636
    )
    
    —
    
    
    (1,053
    )Number
      of securities issuable upon the exercise of all outstanding
      options
    
    
    (7,456
    )
    
    (1,396
    )
    
    —Number
      of securities forfeited
    
    
    (2,194
    )
    
    —
    
    
    —Number
      of securities forfeited and returned to plan
    
    
    2,194
    
    
    —
    
    
    156Unused
      options assumed by 2004 Stock Option Plan
    
    
    (1,908
    )
    
    1,908
    
    
    —Number
      of securities remaining available for future grants under each
      plan
    
    
    —
    
    
    4,512
    
    
    525





Exercise
prices for options outstanding at March 31, 2005, ranged from $11.68 to $29.25.
The weighted-average remaining contractual life of those options is 7.0
years.




11
 *Table of Contents*


****
 **21ST
CENTURY INSURANCE GROUP**
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
 **March
31, 2005**
 DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED
   A summary of the Company’s stock option activity for the
three months ended March 31, 2005, and related information follows:


*AMOUNTS
      IN THOUSANDS, EXCEPT PRICE DATA*
    
    **Number
      of*Options*
    ***Weighted-*Average*Exercise
      Price*Options
      outstanding December 31, 2004
    
    
    8,109
    
    $
    16.49Granted
      in 2005
    
    
    1,228
    
    
    14.27Exercised
      in 2005
    
    
    (111
    )
    
    11.80Forfeited
      in 2005
    
    
    (374
    )
    
    16.39Options
      outstanding March 31, 2005
    
    
    8,852
    
    $
    16.25





Options
exercisable numbered 6,033,324 and 4,655,963 at March 31, 2005 and 2004,
respectively.





**NOTE** **5.
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 is to make annual contributions as
required by applicable regulations.




****


**Components
of Net Periodic Cost**





Net
pension costs for all plans were comprised of the following:




*Three
      Months Ended*
      *March
      31,***2005**
    2004Service
      cost
    
    **$**
    **1,762**
    
    $
    1,489Interest
      cost
    
    
    **1,855**
    
    
    1,611Expected
      return on plan assets
    
    
    **(1,830**
    **)**
    
    (1,611
    )Amortization
      of prior service cost
    
    
    **27**
    
    
    26Amortization
      of net loss
    
    
    **507**
    
    
    495Total
    
    **$**
    **2,321**
    
    $
    2,010




12
 *Table of Contents*




**21ST
CENTURY INSURANCE GROUP**
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
 **March
31, 2005**
 DOLLAR
AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED




Employer Contributions




The
Company previously disclosed in its financial statements for the year ended
December 31, 2004, that it did not expect to contribute to its qualified defined
benefit pension plan in 2005. As of March 31, 2005, no contributions have been
made. After consideration of currently available information, the Company
continues to anticipate that it will not contribute any funds to its qualified
defined benefit pension plan in 2005. However, the amount and timing of future
contributions to our qualified defined benefit pension plan depends on a number
of unpredictable factors including statutory funding requirements, the market
performance of the plan’s assets, cash requirements for benefit payments to
retirees, 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 $1.1
million in 2005.





**NOTE
6. SEGMENT INFORMATION**





The
Company’s “Personal Auto Lines” reportable segment primarily markets and
underwrites personal automobile, motorcycle and umbrella insurance. The
Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment, which
is in runoff, manages the wind-down 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”). FAIR Plan is a state administered pool of
difficult to insure homeowners. 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 the pool from
three years prior. Since the Company ceased writing homeowners business in 2002,
the Company will continue to receive assignments in the 2005 calendar
year.





The
Company evaluates segment performance based on pre-tax underwriting profit
(loss). The Company does not allocate assets, net investment income, net
realized investment gains (losses), other revenues, nonrecurring items, interest
and fees expense, or income taxes to operating segments. Depreciation and
amortization expense, excluding debt issuance cost amortization, was $6.6
million for the three months ended March 31, 2005, and $5.3 million for the same
period in 2004. 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, 2004. All revenues
are generated from external customers and the Company does not rely on any major
customer.





13
 *Table of Contents*




**21ST
CENTURY INSURANCE GROUP**
 **NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)**
 **March
31, 2005**
 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**2* **
    *Total**Three
      Months Ended March 31, 2005*Net
      premiums earned
    
    **$**
    **336,361**
    
    **$**
    **3**
    
    **$**
    **336,364**Depreciation
      and amortization expense
    
    
    **6,565**
    
    
    **2**
    
    
    **6,567**Segment
      profit (loss)
    
    
    **13,824**
    
    
    **(172**
    **)**
    
    **13,652***Three
      Months Ended March 31, 2004*Net
      premiums earned
    
    
    318,165
    
    
    55
    
    
    318,220Depreciation
      and amortization expense
    
    
    5,248
    
    
    40
    
    
    5,288Segment
      profit (loss)
    
    
    10,836
    
    
    (220
    )
    
    10,616





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





*Three
      Months Ended**March
      31,***2005**
    2004Segment
      profit
    
    **$**
    **13,652**
    
    $
    10,616Net
      investment income
    
    
    **17,037**
    
    
    13,146Net
      realized investment (losses) gains
    
    
    **(460**
    **)**
    
    7,646Interest
      and fees expense
    
    
    **(2,057**
    **)**
    
    (2,226
    )Income
      before provision for income taxes
    
    **$**
    **28,172**
    
    $
    29,182









2
    Segment
      revenue represents premium earned as a result of the Company’s
      participation in the California FAIR Plan.


14
 *Table of Contents*





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





**Overview**





Founded
in 1958, 21st Century Insurance Group is a direct-to-consumer provider of
personal auto insurance. With $1.3 billion of revenue in 2004, the Company
insures over 1.5 million vehicles in California, Texas, Illinois and six other
states. We also provide motorcycle and personal umbrella insurance in
California. We believe that we deliver superior policy features and customer
service at a competitive price.





Our
primary financial goals include achieving and sustaining 15% annual growth in
premiums written and a 96% combined ratio in our personal auto lines. Our
personal auto direct premiums written grew 3.4% ($11.5 million) to $352.1
million in the first quarter ended March 31, 2005, from $340.6 million in the
first quarter of 2004. Substantially all of the growth in direct premiums
written was generated outside of California. California direct premiums written
increased by 0.5% to $332.6 million, compared to $331.0 million for the same
period in 2004. Non-California direct premiums written increased by 103% to
$19.5 million, compared to $9.6 million for the same period in
2004.





Underwriting
profit increased 28.6% to $13.7 million in the first quarter of 2005, compared
to $10.6 million for the same period in 2004. The first quarter 2005
underwriting profit includes a $7.7 million release of reserves for prior
accident years, compared to a $0.4 million strengthening of reserves in the same
period of 2004.





The
combined ratio for personal auto improved 0.7% to 95.9% for the quarter ended
March 31, 2005, from 96.6% for the same period in 2004.





Net
income for the quarter ended March 31, 2005, was $19.4 million, or $0.23 per
share, compared to net income of $19.8 million,
or $0.23 per share, for the same period in 2004. The 2004 results include net
realized capital gains of $7.6 million, compared to a net realized capital loss
of $0.5 million for the same period in 2005.





For the
quarter ended March 31, 2005, cash flow from operations was $39.4 million
compared to $57.6 million for the same period in 2004. In February 2005, the
Company filed its California amended tax returns under California legislation AB
263 and paid an associated tax liability of $6.8 million. This tax payment,
along with an increase in underwriting expense, were contributors to the decline
in cash flow from operations in this quarter. Total assets were $1,877.8 million
at March 31, 2005 compared to $1,864.3 million at
December 31, 2004.





Statutory
surplus increased 0.4% to $617.3 million at March 31, 2005 from $614.9 million
at December 31, 2004. The net premiums written to statutory surplus ratio
remained stable at 2.2 at March 31, 2005, compared to 2.2 at December 31,
2004.





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. Premiums earned, the most
directly comparable GAAP measure, represents the portion of premiums written
that is recognized as income in the financial statements for the periods
presented and earned on a pro-rata basis over the term 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. ** The
reconciliations of these financial measures to the most directly comparable GAAP
measure 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 results.





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





15
 *Table of Contents*





The
remainder of our Management’s Discussion and Analysis of Financial Condition and
Results of Operations should be read in conjunction with the accompanying
financial statements. It includes the following sections:





·
    Financial
      Condition


·
    Liquidity
      and Capital Resources


·
    Contractual
      Obligations and Commitments


·
    Results
      of Operations


·
    Underwriting
      Results


·
    Investment
      Income


·
    Critical
      Accounting Estimates


·
    Forward-Looking
      Statements








**Financial
Condition**





Investments
and cash decreased $4.3 million (0.3%) since December 31, 2004, primarily due to
net unrealized capital losses arising during the period of $28.8 million, cash
outflows of $7.6 million for property and equipment, $3.4 million in shareholder
dividends, and $3.0 million of debt repayment, offset by $39.4 million of
operating cash flow. Of our total investments at March 31, 2005, approximately
21.0% was invested in tax-exempt, fixed maturity securities, compared to 29.6%
at March 31, 2004.





At March
31, 2005, investment-grade bonds comprised substantially all of the carrying
value of the fixed maturity portfolio. As of March 31, 2005, five positions in
fixed maturity securities were rated below BBB. These securities represent
approximately 1.0% of our total investments.





Increased
advertising, sales and customer service costs through March 31, 2005 contributed
to an increase in deferred policy acquisition costs (“DPAC”) of $8.6 million to
$67.4 million, compared to $58.8 million at December 31, 2004. Our DPAC is
estimated to be fully recoverable (see *Critical
Accounting Estimates - Deferred Policy Acquisition Costs* ).





The
following table summarizes unpaid losses and LAE with respect to our lines of
business:





***March
      31, 2005***
    *December
      31, 2004**AMOUNTS
      IN THOUSANDS*
    
    **Gross**
    **Net**
    Gross
    NetUnpaid
      Losses and LAEPersonal
      auto lines
    
    **$**
    **486,072**
    
    **$**
    **481,895**
    
    $
    489,411
    
    $
    485,759Homeowner
      and earthquake lines in runoff
    
    
    **4,099**
    
    
    **3,160**
    
    
    6,131
    
    
    5,138Total
    
    **$**
    **490,171**
    
    **$**
    **485,055**
    
    $
    495,542
    
    $
    490,897




16
 *Table of Contents*





The
following table summarizes losses and LAE incurred, net of applicable
reinsurance, for the periods indicated:


*Three
      Months Ended**March
      31,**AMOUNTS
      IN THOUSANDS*
    
    **2005**
    2004Net
      losses and LAE incurred related to insured events of:Current
      year:Personal
      auto lines
    
    **$**
    **258,702**
    
    $
    247,134Homeowner
      and earthquake lines in runoff
    
    
    **—**
    
    
    —Total
      current year
    
    **$**
    **258,702**
    
    $
    247,134Prior
      years:Personal
      auto lines
    
    **$**
    **(7,847**
    **)**
    $
    105Homeowner
      and earthquake lines in runoff
    
    
    **176**
    
    
    275Total
      prior years’ reserve (redundancy) deficiency recorded in current
      year
    
    
    **(7,671**
    **)**
    
    380Total
    
    **$**
    **251,031**
    
    $
    247,514





At March
31, 2005, gross unpaid losses and LAE decreased $5.4 million from the prior
year end to $490.2 million. This is primarily due to the decrease in prior
year loss estimates. The methods used to determine such estimates and to
establish the resulting reserves are continually reviewed and updated. Any
adjustments resulting therefrom are reflected in current operating income. It is
management’s belief that the unpaid losses and LAE are adequate to cover unpaid
losses and LAE as of March 31, 2005. While we perform quarterly reviews of the
adequacy of established unpaid losses and LAE, there can be no assurance that
our ultimate unpaid losses and LAE will not develop redundancies or adversely
develop and materially differ from our unpaid losses and LAE as of March 31,
2005. 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.





The
process of making quarterly changes to unpaid losses and LAE begins with the
preparation of several point estimates of unpaid losses and LAE, a review of the
actual claims experience in the quarter, 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.





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 change in unpaid losses and LAE for the quarter for
each coverage is the difference between net ultimate losses and LAE and the net
paid losses and LAE recorded through the end of the quarter. The overall change
in our unpaid losses and LAE is based on the sum of these coverage level
changes.





The point
estimate methods include the use of paid loss triangles, incurred loss
triangles, claim count triangles, 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 which are
based upon past loss experience. Thus, many factors are implicitly considered in
estimating loss costs to be recognized for the quarter.





17
 *Table of Contents*





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 developing unpaid losses and LAE. Most
automobile claims are reported within two to three months whereas the estimates
of ultimate severities exhibit greater variability at the same maturity.
Generally, 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 normally
expect ultimate unpaid losses and LAE development to vary by as much as 5% of
the carried unpaid losses and LAE.





As a
result of the significant growth in the non-Los Angeles County regions, the
Company has experienced changes in the mix of business relative to geography and
policy limits. We believe that the assumption with the highest likelihood of
change that could materially affect carried unpaid losses and LAE is property
damage and collision severity in the San Francisco and Bay Area regions of
California. These areas have significantly different repair costs and have
exhibited significant policy growth. A 5% change in the severity assumption for
these regions would result in an increase or decrease in total unpaid losses and
LAE of 0.13%, or $1.8 million.





While we
have settled a substantial majority of earthquake claims and are making progress
in resolving outstanding litigation, estimates of both the litigation costs and
ultimate settlement or judgment amounts related to these claims are subject to a
high degree of uncertainty. Please see Note 2 of the Notes to Condensed
Consolidated Financial Statements for additional background on the Northridge
Earthquake and SB 1899.





Debt
consists of a $35.4 m illion
capital lease obligation and the $99.9 million senior note offering, net of
discount, issued in December 2003, aggregating $135.3 million. The primary
purpose of both borrowings was to increase the statutory surplus of 21st Century
Insurance Company, our wholly-owned subsidiary. The decrease in debt of $3.0
million during the quarter is attributable to principal payments on the capital
lease.





Stockholders’
equity and book value per share decreased to $773.4 million and $9.03 at March
31, 2005, respectively, compared to $774.4 million and
$9.06 at December 31, 2004, respectively. The decrease in stockholders’ equity
for the three months ended March 31, 2005 was primarily due to net income of
$19.4 million and $1.3 million in proceeds from stock option exercises offset by
a decrease in net unrealized investment gains of $18.3 million and dividends to
stockholders of $3.4 million.





**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 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 due to the
previous uncertainty that surrounded the taxability of dividends received by
holding companies from their insurance subsidiaries in California. See further
discussion of the *Ceridian* case in *Critical
Accounting Estimates - Income Taxes* .





In
December 2003, we completed a private offering of $100 million principal amount
of 5.9 percent Senior Notes due in December 2013. The effective interest rate on
the Senior Notes when all offering costs are taken into account and amortized
over the term of the Senior Notes is approximately 6 percent per annum. Of the
$99.2 million net proceeds from the offering, $85.0 million was used to increase
the statutory surplus of our wholly-owned insurance subsidiary, 21st Century
Insurance Company, and the balance was retained by our holding company. On July
8, 2004, the Company completed an exchange offer in which all of the private
offering notes were exchanged for publicly registered notes having the same
terms.





18
 *Table of Contents*





Effective
December 31, 2003, the California Department of Insurance (“CDI”) approved an
intercompany lease whereby 21st Century Insurance Company has leased certain
computer software from our holding company. The monthly lease payment, currently
$0.7 million, started in January 2004 and is subject to upward adjustment based
on the cost incurred by the holding company to complete certain enhancements to
the software.





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 interest payments on the Senior Notes (approximately $5.9 million
annually) and the repayment of the $100 million principal on the Senior Notes
due in 2013. We expect to be able to meet those obligations from sources of cash
currently available (i.e., payments received from the intercompany lease and
cash and investments at the holding company, which totaled $17.7 million at
March 31, 2005), additional funds obtainable from the capital markets or from
dividends received from our insurance subsidiaries. California currently levies
state income taxes of approximately 1.8% on the amount of any such dividends
received.





Our
insurance subsidiaries in 2005 could pay $109.8 million as dividends to the
holding company without prior written approval from insurance regulatory
authorities.





*Insurance
Subsidiaries* . We have
achieved underwriting profits in our core auto insurance operations for the last
thirteen quarters and have thereby enhanced our liquidity. Our cash flow 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. In California, where approximately 94.5% of our premiums were written for
the three months ended March 31, 2005, underwriting profit improved in 2004 and
2005 without additional rate increases. We implemented a 3.9% auto premium rate
increase effective March 31, 2003 and a 5.7% rate increase in May of 2002, both
of which continued a series of actions we began taking in 2000 to restore
underwriting profitability.





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. Also, more than ninety-eight percent of the
claims and litigation against the Company as a result of SB 1899 have been
resolved, but we remain exposed to possible upward development in previously
recorded reserves for such claims. As a result of such uncertainties,
underwriting losses could occur in the future. Further, we could be required 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
March 31, 2005, our insurance subsidiaries had a combined statutory surplus of
$617.3 million compared to $614.9 million at December 31, 2004. The increase in
statutory surplus was primarily due to statutory net income of $16.3 million
partially offset by a decrease in nonadmitted assets of $9.6 million, an
increase in net unrealized investment losses of $1.5 million, and a $2.7 million
decrease in the deferred income tax asset. The net premiums written to statutory
surplus ratio remained stable at 2.2 at March 31, 2005, compared to 2.2 at
December 31, 2004.





19
 *Table of Contents*





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





*AMOUNTS
      IN THOUSANDS*
    
    **March
      31,**
      **2005**
    December
      31,
      2004Stockholders’
      equity - GAAP
    
    **$**
    **773,393**
    
    $
    774,401Condensed
      adjustments to reconcile GAAP equity to statutory surplus:Equity
      in non-insurance subsidiaries
    
    
    **12,450**
    
    
    8,082Net
      difference due to capital lease obligation
    
    
    **3,029**
    
    
    2,961Difference
      in net unrealized loss (gain) on investments
    
    
    **3,929**
    
    
    (21,709
    )Deferred
      policy acquisition costs
    
    
    **(67,395**
    **)**
    
    (58,759
    )Difference
      in net deferred tax assets
    
    
    **42,031**
    
    
    50,712Assets
      nonadmitted for statutory purposes
    
    
    **(150,118**
    **)**
    
    (140,795
    )Statutory
      surplus
    
    **$**
    **617,319**
    
    $
    614,893





*Transactions
with Related Parties.* Since
1995, we have entered into several transactions with AIG subsidiaries, including
various reinsurance agreements. At March 31, 2005, reinsurance recoverables, net
of payables, from AIG subsidiaries were $0.3 million, compared to $1.4 million
at December 31, 2004. Other transactions with AIG subsidiaries have resulted
from competitive bidding processes for certain corporate insurance coverages and
certain software and data processing services. In October 2003, as a result of a
competitive bidding process, we entered into an agreement with an AIG subsidiary
to provide investment management services to us. This agreement was approved by
the California Department of Insurance. ****





**Contractual
Obligations and Commitments**





There
were no material changes outside the ordinary course of our business in our
contractual obligations during the quarter ended March 31, 2005.







**Results
of Operations**





*Overall
Results.* We
reported net income of $19.4 million, or earnings **** per share
(basic and diluted) of $0.23, on direct premiums written of $352.1 million in
the quarter ended March 31, 2005, compared to a net income of $19.8 million, or
earnings per share (basic and diluted) of $0.23, on direct premiums written of
$340.6 million for the same quarter last year.





*Personal
Auto Lines Results.*  The
following table presents the components of our personal auto lines underwriting
profit and the components of the combined ratio:





*Three
      Months Ended**March
      31,**AMOUNTS
      IN THOUSANDS*
    
    **2005**
    2004Direct
      premiums written
    
    **$**
    **352,117**
    
    $
    340,592Net
      premiums written
    
    **$**
    **350,940**
    
    $
    339,404Net
      premiums earned
    
    **$**
    **336,361**
    
    $
    318,165Net
      loss and loss adjustment expenses
    
    
    **250,856**
    
    
    247,239Underwriting
      expenses incurred
    
    
    **71,681**
    
    
    60,090Personal
      auto lines underwriting profit
    
    **$**
    **13,824**
    
    $
    10,836Ratios:Loss
      and LAE ratio
    
    
    **74.6**%****
    ****
    
    77.7%Underwriting
      expense ratio
    
    
    **21.3**%****
    ****
    
    18.9%Combined
      ratio
    
    
    **95.9**%****
    ****
    
    96.6%




20
 *Table of Contents*





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





*Three
      Months Ended**March
      31,**AMOUNTS
      IN THOUSANDS*
    
    **2005**
    2004Personal
      auto lines underwriting profit
    
    **$**
    **13,824**
    
    $
    10,836Homeowner
      and earthquake lines in runoff, underwriting loss
    
    
    **(172**
    **)**
    
    (220
    )Net
      investment income
    
    
    **17,037**
    
    
    13,146Realized
      investment (losses) gains
    
    
    **(460**
    **)**
    
    7,646Interest
      and fees expense
    
    
    **(2,057**
    **)**
    
    (2,226
    )Provision
      for income taxes
    
    
    **(8,735**
    **)**
    
    (9,357
    )Net
      income
    
    **$**
    **19,437**
    
    $
    19,825





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





*Three
      Months Ended**March
      31,**AMOUNTS
      IN THOUSANDS*
    
    **2005**
    2004Direct
      premiums written
    
    **$**
    **352,117**
    
    $
    340,592Ceded
      premiums written
    
    
    **(1,177**
    **)**
    
    (1,188
    )Net
      premiums written
    
    **$**
    **350,940**
    
    $
    339,404Net
      change in unearned premiums
    
    
    **(14,579**
    **)**
    
    (21,239
    )Net
      premiums earned
    
    **$**
    **336,361**
    
    $
    318,615





Comments
relating to the underwriting results of the personal auto and the homeowner and
earthquake lines in runoff are presented below.







**Underwriting
Results**





*Personal
Auto.* Personal
automobile insurance is our primary line of business. Vehicles insured outside
of California accounted for 4.3% of our direct premiums written in the three
months ended March 31, 2004, but increased to 5.5% for our direct premiums
written for the three months ended March 31, 2005.





Direct
premiums written in the three months ended March 31, 2005, increased $11.5
million (3.4%) to $352.1 million compared to $340.6 million for the same period
in 2004. This increase was primarily due to a higher number of insured vehicles.





Net
premiums earned increased $18.2 million (5.7%) to $336.4 million for the three
months ended March 31, 2005, compared to $318.2 million for the same period a
year ago, attributable to the higher number of insured vehicles, as previously
mentioned.





California
auto retention was 92% for the quarter ended March 31, 2005, compared to 93% for
the quarter ended March 31, 2004. The decrease in 2005 is primarily due to an
increase in the new customer base, which typically has a lower retention rate
than long-time customers.





Net
losses and LAE incurred increased $3.7 million (1.5%) to $250.9 million for the
three months ended March 31, 2005, compared to $247.2 million for the same
period last year. The first quarter 2005 underwriting profit includes a $7.7
million release of reserves for prior accident years, compared to a $0.4 million
strengthening of reserves in the same period of 2004. The effect on the loss and
LAE ratios of changes in estimates relating to insured events of prior years
during the first quarter of 2005 was approximately 2.3%, compared to 0.0% in the
same quarter last year. In general, changes in estimates are recorded in the
period in which new information becomes available indicating that a change is
warranted, usually in conjunction with our monthly actuarial
review.





21
 *Table of Contents*





The
ratios of net underwriting expenses to net premiums earned were 21.3% and 18.9%
for the quarters ended March 31, 2005 and 2004, respectively. The increase was
primarily due to growth in advertising costs, additional sales workforce costs
and facility and support costs.





The
combined ratio was 95.9% for the quarter ended March 31, 2005, compared to 96.6%
for the same period a year ago. The improvement resulted mainly from the
decrease in net losses and LAE incurred, offset by increases in advertising,
sales and customer service costs.





*Homeowner
and Earthquake Lines in Runoff.* Underwriting
results of the homeowner and earthquake lines, which are in runoff, were losses
and LAE incurred of $0.2 million for the three months ended March 31, 2005,
unchanged from the same period a year ago. We have not written any earthquake
policies since 1994 and we exited the homeowners insurance business at the
beginning of 2002.





We have
executed various transactions to exit from our homeowner line. Under a January
1, 2002 agreement with Balboa Insurance Company (“Balboa”), a subsidiary of
Countrywide Financial Corporation (“Countrywide”), 100% of homeowner unearned
premium reserves and losses on or after that date were ceded to Balboa. Under
the terms of this agreement, we retain certain loss adjustment expenses. We
began non-renewing homeowner policies expiring on February 21, 2002, and
thereafter. Substantially all of these customers were offered homeowner coverage
through an affiliate of Countrywide. We have completed this process and no
longer have any homeowner policies in force.





**Investment
Income**





We
utilize a conservative investment philosophy. No derivatives or nontraditional
securities are held in our investment portfolio and only 3.0% of the portfolio
consists of equity securities. Substantially the entire fixed maturity portfolio
is investment grade. Net investment income was $17.0 million for the three
months ended March 31, 2005 compared to $13.1 million for the same quarter in
2004. The increase in net investment income is the result of higher average
investment balances and higher pre-tax yields.





At March
31, 2005, $288.0 million, or 21.6%, of our total fixed maturity investments at
fair value were invested in tax-exempt bonds with the remainder, representing
78.4% of the portfolio, invested in taxable securities, compared to 22.3% and
77.7%, respectively, at December 31, 2004. In the first quarter of 2004, we
decreased the percentage of total fixed maturity investments in tax-exempt
securities to accelerate our net operating loss utilization, improve cash flow
and shorten the duration of the portfolio.





The
average annual yields on invested assets for the three months ended March 31,
were as follows:





*Three Months Ended**March 31,***2005**
    
    2004Pre-tax
    
    
    **4.8**
    **%**
    
    4.2
    %After-tax
    
    
    **3.5**
    **%**
    
    3.3
    %





Net
realized losses on the sale of investments 1 were
$0.5 million in the first quarter of 2005 (realized gains of $1.3 million and
realized losses of $1.8 million) compared to a $7.6 million gain in the same
quarter in 2004 (realized gains of $8.9 million and realized losses of $1.3
million). Our policy is to investigate, on a quarterly basis, an investment for
possible “other-than-temporary” impairment in the event the fair value of the
security falls below its amortized cost, based on all relevant facts and
circumstances. No such impairments were recorded in the quarters or years ended
March 31, 2005 or 2004.





1
    Includes
      loss on disposal of fixed assets of $4,000 and $8,000 in 2005 and 2004,
      respectively.


22
 *Table of Contents*





**Critical
Accounting Estimates**





Our
financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America. The financial information
contained within those statements is, to a significant extent, financial
information that is based on approximate measures of the financial effects of
transactions and events that have already occurred. 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 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 loss adjustment expenses (“LAE”) include
the accumulation of estimates of losses for claims reported on or prior to the
balance sheet dates, estimates (based upon actuarial analysis of historical
data) of losses for claims incurred but not reported, the development of case
reserves to ultimate values and 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. Accordingly, short-tail claims,
such as property damage claims, tend to be more reasonably predictable than
relatively longer-tail liability claims. For our current mix of auto exposures,
which include both property and liability exposures, an average of approximately
80% of the ultimate losses are settled within twelve months of the date of loss.
Given the inherent variability in the estimates, management believes the
aggregate reserves are adequate. The methods of estimating losses and
establishing the resulting reserves are reviewed and updated monthly and any
resulting adjustments are reflected in current operations.





Changes
in these recorded reserves flow directly to the income statement 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.





*Property
and Equipment.* Accounting standards require a write-off to be recognized when an asset is
abandoned 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 2005 that would require a reassessment of any
asset group for impairment.





23
 *Table of Contents*





*Income
Taxes* .
Determining the consolidated provision for income tax expense, deferred tax
assets and liabilities and any related valuation allowance involves judgment.
Accounting principles generally accepted in the United States 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 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.





At March
31, 2005, our DTAs totaled $138.0 million and our DTLs totaled $75.5 million.
The net of those amounts, $62.5 million, represents the net deferred tax asset
reported in the condensed consolidated balance sheet.





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.





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**
    **SRLY****2****NOL
      of**
      **21st
      of the**
      **Southwest**
    **Consolidated**
      **NOL**2017
    
    $
    ―
    
    $
    1,744
    
    $
    1,7442018
    
    
    ―
    
    
    1,068
    
    
    1,0682019
    
    
    ―
    
    
    1,466
    
    
    1,4662020
    
    
    5,076
    
    
    3,172
    
    
    8,2482021
    
    
    134,647
    
    
    2,180
    
    
    136,8272022
    
    
    37,316
    
    
    ―
    
    
    37,316Totals
    
    $
    177,039
    
    $
    9,630
    
    $
    186,669





Our core
business has generated an underwriting profit for the past thirteen quarters.
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 our DTAs. If necessary, we believe we could implement
tax-planning strategies to generate sufficient future taxable income to utilize
the NOL carryforwards prior to their expiration. Accordingly, no valuation
allowance has been recognized as of March 31, 2005. 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 due to either SB 1899
matters or other causes were to occur, management might reach a different
conclusion about the realization of the DTAs and, if so, recognize a valuation
allowance at that time.





2
    “SRLY”
      stands for Separate Return Limitation Year. Under the Federal tax code,
      only future income generated by 21st of the Southwest (formerly 21st of
      Arizona) may be utilized against this portion of our
  NOL.


24
 *Table of Contents*





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
third quarter of 2004, California enacted AB 263, which allowed the Company to
file certain amended California tax returns and claim a dividends-received
deduction. As a result, the Company re-estimated its liability and reduced its
tax provision by approximately $4.9 million in the third quarter of 2004, which
reduced the effective tax rate for 2004. 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 has
reserved all its rights to file for refunds and appeal any adverse rulings the
FTB may make in the course of finalizing its audit.





*Deferred
Policy Acquisition Costs* .
Deferred policy acquisition costs (“DPAC”) include premium taxes 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 actuarially 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, no reduction in DPAC is required.





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.





*Investments* .
Unrealized investment gains and losses, net of applicable tax effects, are
included as an element of accumulated other comprehensive income (loss), which
is classified as a separate component of stockholders’ equity. 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, a charge is required to be reflected in income for the
difference between cost or amortized cost and the fair value. The determination
of whether a decline in market value is “other-than-temporary” is a matter of
subjective judgment. No such charges were recorded in the three months ended
March 31, 2005 and 2004. 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 because any unrealized losses are already
included in accumulated other comprehensive income.





25
 *Table of Contents*




The
following is a summary by issuer of non-investment grade fixed maturity
securities and unrated securities held at March 31, 2005 and December 31, 2004
(at fair value):
 
 **March
      31,**
    December
      31,*AMOUNTS
      IN THOUSANDS*
    
    **2005**
    2004Non-investment
      grade securities (i.e., rated below BBB):Cox
      Communications, Inc.
    
    **$**
    **2,180**
    
    $
    2,240Ford
      Motor Credit Company
    
    
    **4,464**
    
    
    4,615General
      Motors Acceptance Corp
    
    
    **5,002**
    
    
    5,643News
      America, Inc.
    
    
    **1,621**
    
    
    ―Xcel
      Energy, Inc.
    
    
    **1,448**
    
    
    ―Unrated
      securities:Impact
      Community Capital LLC3
    
    
    **2,023**
    
    
    2,023Impact
      C.I.L. Parent
    
    
    **5,097**
    
    
    5,111Total
      non-investment grade and unrated securities4
    
    **$**
    **21,835**
    
    $
    19,632
 
 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 March 31, 2005 and December 31,
2004:
 
 **March
      31, 2005**
    
    December
      31, 2004*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 for:Less
      than 6 months
    
    
    **59**
    
    **$**
    **502,392**
    
    **$**
    **12,821**
    
    
    7
    
    $
    88,258
    
    $
    1,0456-12
      months
    
    
    **20**
    
    
    **153,560**
    
    
    **5,903**
    
    
    15
    
    
    154,284
    
    
    3,415More
      than 1 year
    
    
    **5**
    
    
    **22,685**
    
    
    **1,039**
    
    
    2
    
    
    4,765
    
    
    326Less
      than $0.1 million
    
    
    **106**
    
    
    **203,970**
    
    
    **3,868**
    
    
    91
    
    
    306,984
    
    
    2,387Total
      fixed maturity securities
    
    
    **190**
    
    
    **882,607**
    
    
    **23,631**
    
    
    115
    
    
    554,291
    
    
    7,173Equity
      securities:Exceeding
      $0.1 million and for less than 6 months:
    
    
    **2**
    
    
    **1,266**
    
    
    **363**
    
    
    ―
    
    
    ―
    
    
    ―Less
      than $0.1 million
    
    
    **246**
    
    
    **3,284**
    
    
    **1,445**
    
    
    64
    
    
    15,479
    
    
    293Total
      equity securities
    
    
    **248**
    
    
    **4,550**
    
    
    **1,808**
    
    
    64
    
    
    15,479
    
    
    293Total
      investments with unrealized losses5
    
    
    **438**
    
    **$**
    **887,157**
    
    **$**
    **25,439**
    
    
    179
    
    $
    569,770
    
    $
    7,466
 
 3
    Impact
      Community Capital LLC, is a limited partnership that was established under
      California’s COIN program (California Organized Investment Network), a
      voluntary association of California insurers providing funding for low
      income communities.
4
    The
      total net unrealized (loss) gain for these securities as of March 31, 2005
      and December 31, 2004 was $(0.5) million and $0.4 million,
      respectively.
5
    Unrealized
      losses represent 2.9% and 1.3% of the total carrying value of investments
      with unrealized losses at March 31, 2005 and December 31, 2004,
      respectively.


26
 *Table of Contents*





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





**March
      31, 2005**
    December
      31, 2004*AMOUNTS
      IN THOUSANDS*
    
    ***Amortized***
      ***Cost***
    ***Carrying***
      ***Value***
    ***Unrealized***
      ***Loss***
    *Amortized*
      *Cost*
    *Carrying*
      *Value*
    *Unrealized*
      *Loss*Bond
      MaturitiesDue
      in one year or less
    
    **$**
    **8,262**
    
    **$**
    **8,224**
    
    **$**
    **38**
    
    $
    9,778
    
    $
    9,738
    
    $
    40Due
      after one year through five years
    
    
    **57,331**
    
    
    **55,991**
    
    
    **1,340**
    
    
    26,537
    
    
    26,073
    
    
    464Due
      after five years through ten years
    
    
    **543,560**
    
    
    **528,195**
    
    
    **15,365**
    
    
    318,644
    
    
    314,898
    
    
    3,746Due
      after ten years
    
    
    **297,085**
    
    
    **290,197**
    
    
    **6,888**
    
    
    206,505
    
    
    203,582
    
    
    2,923**$**
    **906,238**
    
    **$**
    **882,607**
    
    **$**
    **23,631**
    
    $
    561,464
    
    $
    554,291
    
    ****$
    ****7,173





*Stock-based
compensation* . Under
the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, *Accounting
for Stock-Based Compensation* , we have
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* .
Accordingly, we have not recognized in income any compensation expense for the
fair value of stock options awarded to employees. Companies electing to continue
to follow the intrinsic-value method must make pro-forma disclosures, as if the
fair value based method of accounting had been applied. A summary of the expense
that would have been recorded, together with the underlying assumptions, had
compensation cost for the Company’s stock-based compensation plans been
determined based on the fair value based method for of all awards, is included
in Note 1 of the Notes to Condensed Consolidated Financial
Statements.





**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;


·
    Regulatory
      approvals;


·
    Market
      position;


·
    Financial
      results;


·
    Dividend
      policy; and


·
    Reserves.





27
 *Table of Contents*




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. 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;


·
    Adverse
      underwriting and claims experience, including as a result of revived
      earthquake claims under SB 1899;


·
    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 Woodland Hills, California;


·
    Information
      system problems, including failures to implement information technology
      projects on time and within budget;


·
    Internal
      control failures;


·
    Adverse
      developments in financial markets or interest rates;


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




28
 *Table of Contents*




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 our financial instruments, 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 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 are 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. As a result, it has been unnecessary for us to
employ elaborate market risk management techniques involving complicated asset
and liability duration matching or hedging strategies. Accordingly, the Company
primarily invests in fixed maturity investments, which at March 31, 2005,
comprised 97% of the fair value of the Company’s total investments. The
remainder of the Company’s investments, representing approximately 3% of total
investments at market value, is held in equity securities.





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, and cash flow.





Since
fixed maturity investments with longer remaining terms to maturity tend to
realize higher yields, the Company’s investment philosophy typically resulted in
a portfolio with an effective duration of over 6 years (almost 7 years as of
December 31, 2001). Due to the current interest rate environment, management, in
consultation with the Investment Committee, targeted 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 5.4 years as of December 31, 2004 to
5.3 years at March 31, 2005.





The
Company has also obtained long-term fixed rate financing as a means of
increasing the statutory surplus of the Company’s largest insurance
subsidiary.





The
following table shows the financial statement carrying values of our fixed
maturity investments, which are reported at fair value, and our debt, which is
reported at historical value. The table also presents estimated carrying values
at adjusted market rates assuming a 100 basis point increase in market interest
rates, given the effective duration noted above, for the fixed maturity
investment portfolio and a 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*
      *March
      31, 2005*
    
    *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
    
    $
    1,332.2
    
    $
    1,261.7
    
    
    (5.29
    %)Debt
    
    
    135.3
    
    
    143.3
    
    
    5.91




29
 *Table of Contents*





The
common equity portfolio, which represents approximately 3% of total investments
at market value, consists primarily of financial services, industrial, and
miscellaneous stocks. Beta is a measure of a security’s systematic
(non-diversifiable) risk, which is the percentage change in an individual
security’s return for a 1% change in the return of the market. The average Beta
for the Company’s common stock holdings was 0.57.





The
following table presents the financial statement carrying value of our equity
portfolio and the effect of a hypothetical 20% reduction in the overall value of
the stock market using the Beta noted above and accordingly summarizes only the
exposure to equity price risk for the Company’s equity securities:





*DOLLAR
      AMOUNTS IN MILLIONS*
      *March
      31, 2005*
    
    *Carrying*
      *Value*
    *Estimated
      Carrying*
      *Value
      at Hypothetical*
      *20%
      Reduction in*
      *Overall
      Value of*
      *Stock
      Market*
    *Change
      in*
      *Value
      as a*
      *Percentage
      of*
      *Carrying
      Value*Equity
      securities available for sale
    
    $
    41.1
    
    $
    36.4
    
    
    (11.5
    %)





The
discussion above provides only a limited, point-in-time view of the market risk
sensitivity of our financial instruments. The actual impact of market interest
rate and price changes on the financial instruments may differ significantly
from those shown.





**ITEM 4.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 March 31, 2005, the Chief
Executive Officer and Chief 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.





The
Company intends to review and evaluate the design and effectiveness of its
disclosure controls and procedures on an ongoing basis and to improve its
controls and procedures over time and to correct any deficiencies that may be
discovered in the future in order to ensure that senior management has timely
access to all material financial and non-financial information concerning the
Company’s business. While the present design of the Company’s disclosure
controls and procedures is effective to achieve these results, future events
affecting the Company’s business may cause management to modify its disclosure
controls and procedures.





30
 *Table of Contents*





**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 3 of the Notes to Condensed Consolidated
Financial Statements.





**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**





Exhibits





31.1
    Certification
      of President and Chief Executive Officer Pursuant to Exchange Act Rule
      13a-14(a).


31.2
    Certification
      of Chief 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.





31
 *Table of Contents*





**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:
    April
      21, 2005
    
    /s/
      Bruce W. MarlowBRUCE
      W. MARLOWPresident
      and Chief Executive OfficerDate:
    April
      21, 2005
    
    /s/
      Lawrence P. BascomLAWRENCE
      P. BASCOMSr.
      Vice President and Chief Financial Officer


32
 *Table of Contents*


**EXHIBIT INDEX**





Exhibit
      No.
    Description31.1
    Certification
      of President and Chief Executive Officer Pursuant to Exchange Act Rule
      13a-14(a).31.2
    Certification
      of Chief 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.




33