**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 September 30, 2006




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


**SECURITIES
      EXCHANGE ACT OF 1934**





For
      the
      transition period from  to





Commission
      File Number 0-6964








(Exact
      name of registrant as specified in its charter)






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








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





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




Large
                accelerated filer ̈
            Accelerated
                filerx
            Non-accelerated
                filer ̈





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


Yes  ̈ No x





The
      number of shares outstanding of the issuer’s common stock as of October 23, 2006
      was 86,377,135.













**TABLE
      OF CONTENTS**





Description
            Page
                Number**PART
                I - FINANCIAL INFORMATION**Item
                1.
            Financial
                Statements (unaudited)
            2Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition andResults
                of Operations
            19Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            36Item
                4.
            Controls
                and Procedures
            37**PART
                II - OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            38Item
                1A.
            Risk
                Factors
            38Item
                6.
            Exhibits
            38**SIGNATURES**
            39**EXHIBIT
                INDEX**
            4031.1
            Certification
                of principal executive officer pursuant to Rule 13a-14(a)
                under the Securities Exchange Act of 193431.2
            Certification
                of principal financial officer pursuant to Rule 13a-14(a) under the
                Securities Exchange Act of 193432
            Certification
                Pursuant to 18 U.S.C. Section 1350




1
 *Table
            of Contents*





**PART
      I - FINANCIAL INFORMATION**





**ITEM
      1. FINANCIAL STATEMENTS**





**21ST
                CENTURY INSURANCE GROUP****CONDENSED
                CONSOLIDATED BALANCE SHEETS**Unaudited*AMOUNTS
                IN THOUSANDS, EXCEPT SHARE DATA*
            
            **September
                30,**
              **2006**
            December
                31,
              2005**Assets**Investments
                available for saleFixed
                maturity securities, at fair value (amortized cost: $1,487,873 and
                $1,365,948)
            
            **$**
            **1,470,385**
            
            $
            1,354,707Equity
                securities, at fair value (cost: $0 and $49,210)
            
            
            **—**
            
            
            47,367Other
                long-term investments, equity method
            
            
            **9,443**
            
            
            —Total
                investments
            
            
            **1,479,828**
            
            
            1,402,074Cash
                and cash equivalents
            
            
            **19,497**
            
            
            68,668Accrued
                investment income
            
            
            **17,006**
            
            
            16,585Premiums
                receivable
            
            
            **115,513**
            
            
            100,900Reinsurance
                receivables and recoverables
            
            
            **6,550**
            
            
            6,539Prepaid
                reinsurance premiums
            
            
            **2,141**
            
            
            1,946Deferred
                income taxes
            
            
            **42,566**
            
            
            56,209Deferred
                policy acquisition costs
            
            
            **67,592**
            
            
            59,939Leased
                property under capital leases, net of deferred gain of $1,203 and
                $1,534
                and net of accumulated amortization of $40,853 and $36,995
            
            
            **19,998**
            
            
            22,651Property
                and equipment, at cost less accumulated depreciation of $105,780
                and
                $89,595
            
            
            **152,480**
            
            
            145,811Other
                assets
            
            
            **40,277**
            
            
            38,907Total
                assets
            
            **$**
            **1,963,448**
            
            $
            1,920,229**Liabilities
                and stockholders’ equity**Unpaid
                losses and loss adjustment expenses
            
            **$**
            **484,258**
            
            $
            523,835Unearned
                premiums
            
            
            **329,719**
            
            
            319,676Debt
            
            
            **118,853**
            
            
            127,972Claims
                checks payable
            
            
            **39,697**
            
            
            42,681Reinsurance
                payable
            
            
            **769**
            
            
            643Other
                liabilities
            
            
            **92,529**
            
            
            75,450Total
                liabilities
            
            
            **1,065,825**
            
            
            1,090,257Commitments
                and contingenciesStockholders’
                equity:Common
                stock, par value $0.001 per share; 110,000,000 shares authorized;
                shares
                issued 86,381,472 and 85,939,889
            
            
            **86**
            
            
            86Additional
                paid-in capital
            
            
            **438,618**
            
            
            425,454Treasury
                stock; at cost shares: 8,804 and 5,929
            
            
            **(106**
            **)**
            
            (84
            )Retained
                earnings
            
            
            **472,271**
            
            
            414,898Accumulated
                other comprehensive loss
            
            
            **(13,246**
            **)**
            
            (10,382
            )Total
                stockholders’ equity
            
            
            **897,623**
            
            
            829,972Total
                liabilities and stockholders’ equity
            
            **$**
            **1,963,448**
            
            $
            1,920,229




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





2
 *Table
            of Contents*





**21ST
                CENTURY INSURANCE GROUP****CONDENSED
                CONSOLIDATED STATEMENTS OF OPERATIONS**
              Unaudited*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS, EXCEPT SHARE DATA*
            
            **2006**
            2005
            **2006**
            2005**Revenues**Net
                premiums earned
            
            **$**
            **327,325**
            
            $
            344,102
            
            **$**
            **978,661**
            
            $
            1,017,311Net
                investment income
            
            
            **16,897**
            
            
            17,042
            
            
            **51,827**
            
            
            51,085Other
                income (loss)
            
            
            **58**
            
            
            (3
            )
            
            **68**
            
            
            364Net
                realized investment gains (losses)
            
            
            **159**
            
            
            (939
            )
            
            **(878**
            **)**
            
            (2,666
            )Total
                revenues
            
            
            **344,439**
            
            
            360,202
            
            
            **1,029,678**
            
            
            1,066,094**Losses
                and expenses**Net
                losses and loss adjustment expenses
            
            
            **222,550**
            
            
            258,105
            
            
            **682,140**
            
            
            757,420Policy
                acquisition costs
            
            
            **64,803**
            
            
            60,852
            
            
            **189,022**
            
            
            188,931Other
                underwriting expenses
            
            
            **12,715**
            
            
            8,786
            
            
            **34,819**
            
            
            24,908Other
                expense
            
            
            **—**
            
            
            —
            
            
            **924**
            
            
            **—**Interest
                and fees expense
            
            
            **1,820**
            
            
            1,988
            
            
            **5,572**
            
            
            6,076Total
                losses and expenses
            
            
            **301,888**
            
            
            329,731
            
            
            **912,477**
            
            
            977,335Income
                before provision for income taxes
            
            
            **42,551**
            
            
            30,471
            
            
            **117,201**
            
            
            88,759Provision
                for income taxes
            
            
            **14,144**
            
            
            9,369
            
            
            **39,155**
            
            
            27,725Net
                income
            
            **$**
            **28,407**
            
            $
            21,102
            
            **$**
            **78,046**
            
            $
            61,034**Earnings
                per share:**Basic
            
            **$**
            **0.33**
            
            $
            0.25
            
            **$**
            **0.91**
            
            $
            0.71Diluted
            
            **$**
            **0.33**
            
            $
            0.24
            
            **$**
            **0.90**
            
            $
            0.71**Cash
                dividends declared per share**
            
            **$**
            **0.08**
            
            $
            0.04
            
            **$**
            **0.24**
            
            $
            0.12**Weighted-average
                shares outstanding:**Basic
            
            
            **86,192,395**
            
            
            85,793,904
            
            
            **86,010,994**
            
            
            85,672,993Additional
                common shares assumed issued under treasury stock method
            
            
            **262,114**
            
            
            411,695
            
            
            **390,035**
            
            
            264,823Diluted
            
            
            **86,454,509**
            
            
            86,205,599
            
            
            **86,401,029**
            
            
            85,937,816




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





3
 *Table
            of Contents*




**21ST
                  CENTURY INSURANCE GROUP****CONDENSED
                  CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**Unaudited*Common
                  Stock**$0.001
                  par*
                *value**AMOUNTS
                  IN THOUSANDS,*
                *EXCEPT
                  SHARE DATA*
              
              *Issued*
                *Shares*
              *Amount*
              *Additional*
                *Paid-in*
                *Capital*
              *Treasury*
                *Stock*
              *Retained*
                *Earnings*
              *Accumulated*
                *Other*
                *Comprehensive*
                *Loss*
              *Total*Balance
                  - January 1, 2006
              
              
              85,939,889
              
              $
              86
              
              $
              425,454
              
              $
              (84
              )
              $
              414,898
              
              $
              (10,382
              )
              $
              829,972Comprehensive
                  income (loss)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              78,046
              (1)
              
              (2,864
              )(2)
              
              75,182Cash
                  dividends declared on common stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (20,673
              )
              
              
              
              
              (20,673
              )Exercise
                  of stock options
              
              
              325,033
              
              
              
              
              
              4,250
              
              
              
              
              
              
              
              
              
              
              
              4,250Issuance
                  of restricted stock
              
              
              116,550
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              —Forfeiture
                  of 2,875 shares of restricted stock
              
              
              
              
              
              
              
              
              22
              
              
              (22
              )
              
              
              
              
              
              
              
              —Stock-based
                  compensation cost
              
              
              
              
              
              
              
              
              8,752
              
              
              
              
              
              
              
              
              
              
              
              8,752Excess
                  tax benefits of stock-based compensation
              
              
              
              
              
              
              
              
              140
              
              
              
              
              
              
              
              
              
              
              
              140Balance
                  - September 30, 2006
              
              
              86,381,472
              
              $
              86
              
              $
              438,618
              
              $
              (106
              )
              $
              472,271
              
              $
              (13,246
              )
              $
              897,623





(1)
            Net
                income for the nine months ended September 30,
                2006.




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




*Nine
                  Months Ended*
                *September
                  30, 2006*Unrealized
                  holding losses arising during the period, net of tax benefit of
                  $1,844
              
              $
              (3,423
              )Reclassification
                  adjustment for investment losses included in net income, net of
                  tax
                  benefit of $301
              
              
              559Total
              
              $
              (2,864
              )




*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**Nine
                Months Ended September 30,*
            
            **2006**
            2005**Operating
                activities**Net
                income
            
            **$**
            **78,046**
            
            $
            61,034Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            **20,393**
            
            
            24,502Net
                amortization of investment premiums and discounts
            
            
            **7,318**
            
            
            7,205Stock-based
                compensation cost
            
            
            **8,752**
            
            
            238Provision
                for deferred income taxes
            
            
            **15,185**
            
            
            10,687Net
                realized investment losses
            
            
            **878**
            
            
            2,779Changes
                in assets and liabilitiesPremiums
                receivable
            
            
            **(14,613**
            **)**
            
            (11,166
            )Deferred
                policy acquisition costs
            
            
            **(7,653**
            **)**
            
            (5,001
            )Reinsurance
                receivables and recoverables
            
            
            **(80**
            **)**
            
            1,193Federal
                income taxes
            
            
            **(5,540**
            **)**
            
            (1,088
            )Other
                assets
            
            
            **1,531**
            
            
            6,723Unpaid
                losses and loss adjustment expenses
            
            
            **(39,577**
            **)**
            
            22,072Unearned
                premiums
            
            
            **10,043**
            
            
            9,019Claims
                checks payable
            
            
            **(2,984**
            **)**
            
            1,974Other
                liabilities
            
            
            **12,551**
            
            
            (7,802
            )Net
                cash provided by operating activities
            
            
            **84,250**
            
            
            122,369**Investing
                activities**Purchases
                of:Fixed
                maturity securities available-for-sale
            
            
            **(228,027**
            **)**
            
            (94,020
            )Equity
                securities available-for-sale
            
            
            **(35,627**
            **)**
            
            (239,493
            )Other
                long-term investments, equity method
            
            
            **(9,123**
            **)**
            
            —Property
                and equipment
            
            
            **(23,315**
            **)**
            
            (32,539
            )Maturities
                and calls of fixed maturity securitites available-for-sale
            
            
            **23,726**
            
            
            24,461Sales
                of:Fixed
                maturity securities available-for-sale
            
            
            **73,765**
            
            
            28,943Equity
                securities available-for-sale
            
            
            **84,836**
            
            
            233,884Net
                cash used in investing activities
            
            
            **(113,765**
            **)**
            
            (78,764
            )**Financing
                activities**Repayment
                of debt
            
            
            **(10,283**
            **)**
            
            (9,343
            )Dividends
                paid (per share: $0.16 and $0.08)
            
            
            **(13,763**
            **)**
            
            (6,850
            )Proceeds
                from the exercise of stock options
            
            
            **4,250**
            
            
            3,155Excess
                tax benefit from stock-based compensation
            
            
            **198**
            
            
            —Excess
                tax liability from stock-based compensation
            
            
            **(58**
            **)**
            
            —Net
                cash used in financing activities
            
            
            **(19,656**
            **)**
            
            (13,038
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            **(49,171**
            **)**
            
            30,567Cash
                and cash equivalents, beginning of period
            
            
            **68,668**
            
            
            34,697Cash
                and cash equivalents, end of period
            
            **$**
            **19,497**
            
            $
            65,264**Supplemental
                information:**Income
                taxes paid
            
            **$**
            **29,580**
            
            $
            19,281Interest
                paid
            
            
            **3,991**
            
            
            4,495




*See
      accompanying Notes to Condensed Consolidated Financial
      Statements.*





5
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





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





***General***





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




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





***Other
      long-term investments, equity method***





The
      Company started investing in limited partnerships and limited liability
      corporations during the third quarter of 2006, as further discussed in Note
      9 of
      the *Notes
      to Condensed Consolidated Financial Statements* .
      Since
      our share of a partnership’s or corporation’s capital is greater than 3%, but
      less than 50%, we account for these investments on the equity method, and the
      carrying values of our investments are adjusted to reflect our share of the
      underlying equity of the partnerships or corporations, as applicable.





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





The
      numerator for the calculation of both basic and diluted EPS is equal to net
      income reported for that period. The difference between basic and diluted EPS
      denominators is due to dilutive common stock equivalents (stock options and
      restricted stock). Basic EPS excludes dilution and reflects net income divided
      by the weighted-average shares of common stock outstanding during the periods
      presented. Diluted EPS is based upon the weighted-average shares of common
      stock
      and dilutive common stock equivalents outstanding during the periods presented.
      Common stock equivalents arising from dilutive stock options and restricted
      common stock were computed using the treasury stock method.





The
      following shares attributable to outstanding stock options and restricted shares
      were excluded from the calculation of diluted earnings per share because their
      inclusion would have been anti-dilutive (i.e., their inclusion under the
      treasury stock method would have increased EPS):




*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,***2006**
            2005
            **2006**
            2005Common
                stock equivalents excluded from calculation of diluted EPS
            
            
            **6,149,111**
            
            
            4,501,547
            
            
            **5,625,501**
            
            
            6,395,088




6
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





***Stock-Based
      Compensation***





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





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




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





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




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





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





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





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





7
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





***Recent
      Accounting Pronouncements***





In
      September 2006, Financial
      Accounting Standards Board (“FASB”) issued
      FAS  158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans - an
      Amendment of FASB Statements No. 87, 88, 106 and* ** *132(R)* ("FAS
      158"). FAS 158 requires an employer that is a business entity and sponsors
      one
      or more single employer benefit plans to (1) recognize the  funded
      status of the benefit in its statement of financial position, (2) recognize
      as a
      component of other comprehensive income, net of tax, the gains  or
      losses
      and prior service costs or credits that arise during the period, but are not
      recognized as components of net periodic benefit cost, (3) measure  defined
      benefit plan assets and obligations as of the date of the employer's fiscal
      year
      end statement of financial position and (4) disclose in the notes  to
      financial statements additional information about certain effects on net
      periodic benefit cost for the next fiscal year that arise from
      delayed  recognition
      of the gains or losses, prior service costs on credits, and transition asset
      or
      obligations. Under
      FAS
      158, the Company will be required to recognize the funded status of its defined
      benefit plans and to provide the required disclosures as of December 31,
      2006 . However,
      had we been required to adopt the provisions of FAS 158 as of September 30,
      2006, the estimated cumulative impact on the Company’s condensed consolidated
      financial statements as a result of the adoption of this standard would have
      resulted in an approximate $17million net after-tax reduction in equity with a corresponding reduction
      of $7.8 million in total assets, and an increase of $9.3 million in total
      liabilities. Because our net pension liabilities are **** dependent
      upon future events and circumstances, the impact at the time of adoption of
      FAS
      158 may differ from these amounts. Adoption of FAS 158 will **** not
      have
      any effect on the Company's compliance with its financial
      covenants.





In
      September 2006, the FASB issued FAS 157, *Fair
      Value Measurements* (“FAS
      157”). FAS 157 clarifies the principle that fair value should be based on the
      assumptions market participants would use when pricing an asset or liability
      and
      establishes a fair value hierarchy that prioritizes the information used to
      develop those assumptions. Under the standard, fair value measurements would
      be
      separately disclosed by level within the fair value hierarchy. FAS 157 is
      effective for financial statements issued for fiscal years beginning
      after November 15, 2007 and interim periods within those fiscal years, with
      early adoption permitted. The Company has not yet determined the effect, if
      any,
      that the implementation of FAS 157 will have on our results of operations or
      financial condition.





In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* (“SAB
      108”). SAB 108 provides interpretive guidance on how the effects of the
      carryover or reversal of prior year misstatements should be considered in
      quantifying a current year misstatement. The SEC staff believes that registrants
      should quantify errors using both a balance sheet and an income statement
      approach and evaluate whether either approach results in quantifying a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. SAB 108 is effective for the Company’s fiscal year
      ending December 31, 2006. We do not expect SAB 108 to have a material impact
      on
      our consolidated financial statements.





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





Statement
      of Position 05-1 *,
      Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
      with Modifications or Exchanges of Insurance Contracts* (“SOP
      05-1”) *,* becomes
      effective January ** 1,
      2007.
      SOP 05-1 provides guidance on accounting for deferred acquisition costs on
      internal replacements of insurance and investment contracts other than those
      specifically described in FAS No. 97, *Accounting
      and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
      and
      for Realized Gains and Losses from the Sale of Investments* .
      The SOP
      defines an internal replacement as a modification in product benefits, features,
      rights, or coverage that occurs by the exchange of a contract for a new
      contract, or by amendment, endorsement, or rider to a contract, or by the
      election of a feature or coverage within a contract. The Company is currently
      assessing the effect of implementing this guidance.





8
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





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





***2006
      Stock-Based Compensation Summary***





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





*Three
                Months Ended*
              *September
                30, 2006*
            
            *Nine
                Months Ended*
              *September
                30, 2006**AMOUNTS
                IN THOUSANDS, EXCEPT PER SHARE DATA*
            
            *Without*
              *FAS
                123R*
            *FAS
                123R*
              *Impact*
            *With
                FAS*
              *123R*
            
            *Without*
              *FAS
                123R*
            *FAS
                123R*
              *Impact*
            *With
                FAS*
              *123R*Total
                revenues
            
            $
            344,439
            
            $
            —
            
            $
            344,439
            
            
            $
            1,029,678
            
            $
            —
            
            $
            1,029,678Losses
                and expensesNet
                losses and loss adjustment expenses
            
            
            221,767
            
            
            783
            
            
            222,550
            
            
            
            679,464
            
            
            2,676
            
            
            682,140Policy
                acquisition costs
            
            
            63,893
            
            
            910
            
            
            64,803
            
            
            
            187,177
            
            
            1,845
            
            
            189,022Other
                underwriting expenses
            
            
            12,184
            
            
            531
            
            
            12,715
            
            
            
            32,019
            
            
            2,800
            
            
            34,819Other
                expense
            
            
            —
            
            
            —
            
            
            —
            
            
            
            924
            
            
            —
            
            
            924Interest
                and fees expense
            
            
            1,820
            
            
            —
            
            
            1,820
            
            
            
            5,572
            
            
            —
            
            
            5,572Total
                losses and expenses
            
            
            299,664
            
            
            2,224
            
            
            301,888
            
            
            
            905,156
            
            
            7,321
            
            
            912,477Income
                before provision for income taxes
            
            
            44,775
            
            
            (2,224
            )
            
            42,551
            
            
            
            124,522
            
            
            (7,321
            )
            
            117,201Provision
                for income taxes
            
            
            14,876
            
            
            (732
            )
            
            14,144
            
            
            
            40,932
            
            
            (1,777
            )
            
            39,155Net
                income
            
            $
            29,899
            1
            $
            (1,492
            )
            $
            28,407
            
            
            $
            83,590
            1
            $
            (5,544
            )
            $
            78,046Basic
                earnings per share2
            
            $
            0.35
            
            $
            (0.02
            )
            $
            0.33
            
            
            $
            0.97
            
            $
            (0.06
            )
            $
            0.91Diluted
                earnings per share2
            
            $
            0.35
            
            $
            (0.02
            )
            $
            0.33
            
            
            $
            0.97
            
            $
            (0.06
            )
            $
            0.90





The
      nine
      months ended September 30, 2006 results include $0.7 million of accelerated
      costs incurred during the first quarter to recognize the effect of retirement
      eligibility in accordance with the non-substantive vesting period approach
      and
      $1.4 million of actual vesting in accordance with an executive retention
      agreement. As compensation costs for certain employees are included in deferred
      policy acquisition costs, pre-tax compensation cost related to stock-based
      compensation of $0.8 million was deferred, for the nine months ended September
      30, 2006. The remaining unrecognized compensation cost related to unvested
      awards as of September 30,
      2006,
      was $11.3 million and the weighted-average period over which this cost will
      be
      recognized is 1.9 years. Results for the nine-month period ended September
      30,
      2006 included $140 thousand of excess tax benefits as a financing cash inflow
      and an increase of additional paid-in capital.





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





Had
      compensation cost for the Company’s stock-based compensation plans been
      determined in the prior year based on the fair-value based method for all
      awards, net income would have been reduced by $1.2 million and $3.7
      million  for
      the
      three and nine months ended September 30, 2005, respectively. The Company
      followed the nominal vesting period approach, which recognizes compensation
      cost
      over the vesting period unless the employee retired before the end of the
      vesting period at which time the Company recognizes any remaining unrecognized
      compensation cost at the date of retirement. The Company did not determine
      the
      amount of stock-based compensation cost that would have been deferred as policy
      acquisition costs in its pro forma footnotes under FAS 123.




1
            Includes
                $0.2 million and $0.7 million stock-based compensation related to
                restricted shares and $0.1 million and $0.2 million associated tax,
                as the
                previousaccounting
                under APB 25 was consistent with that of FAS 123, for the three months
                and
                nine months ended September 30, 2006,
                respectively.


2
            Earnings
                per share figuresmay
                not total due to rounding.





9
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





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




*AMOUNTS
                  IN THOUSANDS, EXCEPT SHARE DATA*
              
              *Three
                  Months Ended*
                *September
                  30, 2005*
              *Nine
                  Months Ended*
                *September
                  30, 2005***Net
                  income, as reported**
              
              $
              21,102
              
              $
              61,034*Add:*Stock-based employee compensation expense included in reported
                  net income,
                  net of related tax effects
              
              
              65
              
              
              155*Deduct:*Total stock-based employee compensation expense determined under
                  fair-value based method for all awards, net of related tax
                  effects
              
              
              (1,278
              )
              
              (3,844
              )**Net
                  income, pro forma**
              
              $
              19,889
              
              $
              57,345**Basic
                  earnings per share:**As
                  reported
              
              $
              0.25
              
              $
              0.71Pro
                  forma
              
              $
              0.23
              
              $
              0.67**Diluted
                  earnings per share:**As
                  reported
              
              $
              0.24
              
              $
              0.71Pro
                  forma
              
              $
              0.23
              
              $
              0.67





***Stock
      Option Plans***





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





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





*Issuable
      and Issued Securities*





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




*AMOUNTS
                IN THOUSANDS*
            
            *1995
                Stock*
              *Option
                Plan*
            *2004
                Stock*
              *Option
                Plan*Total
                number of securities authorized
            
            
            10,000
            
            
            4,000Number
                of securities issued
            
            
            (1,001
            )
            
            (210
            )Number
                of securities issuable upon the exercise of all outstanding
                options
            
            
            (6,683
            )
            
            (3,545
            )Number
                of securities forfeited
            
            
            (2,601
            )
            
            (151
            )Number
                of forfeited securities returned to plan
            
            
            2,601
            
            
            151Unused
                options assumed by 2004 Stock Option Plan
            
            
            (2,316
            )
            
            2,316Number
                of securities available for future grants under each plan
            
            
            —
            
            
            2,561




10
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





*Current
      Activity*





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




*AMOUNTS
                IN THOUSANDS, EXCEPT PRICE DATA*
            
            *Number
                of*
              *Options*
            *Weighted-*
              *Average*
              *Exercise
                Price*Options
                outstanding December 31, 2005
            
            
            8,869
            
            $
            16.22Granted
                in 2006
            
            
            2,012
            
            
            16.54Exercised
                in 2006
            
            
            (325
            )
            
            13.08Forfeited
                in 2006
            
            
            (88
            )
            
            14.38Canceled
                in 2006
            
            
            (240
            )
            
            19.49Options
                outstanding September 30, 2006
            
            
            10,228
            
            
            16.32





A
      summary
      of the Company’s stock option activity and related information for the nine
      months ended September 30, follows:




*AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005Fair
                value of stock options granted
            
            **$**
            **10,040**
            
            $
            8,186Intrinsic
                value of options exercised
            
            
            **566**
            
            
            590Grant
                date fair value of options vested
            
            
            **7,428**
            
            
            5,288Proceeds
                from exercise of stock options
            
            
            **4,250**
            
            
            3,155Tax
                benefit realized as a result of stock option exercises
            
            
            **198**
            
            
            247




*Black-Scholes
      Fair Values*





The
      weighted-average fair value per option granted during the nine months ended
      September 30, 2006 and 2005, was $4.99 and $4.75, respectively. The fair value
      of each option grant was estimated on the date of grant using the Black-Scholes
      option-pricing model with the following assumptions:




*Nine
                Months Ended September 30,*
            
            **2006**
            2005
              Pro
                FormaRisk-free
                interest rate:Minimum
            
            
            **4.5**
            **%**
            
            3.7
            %Maximum
            
            
            **5.0**
            **%**
            
            4.3
            %Dividend
                yield
            
            
            **1.9**
            **%**
            
            1.1
            %Volatility
                factor of the expected market price of the Company’s common
                stock:Minimum
            
            
            **0.29**
            
            
            0.29Maximum
            
            
            **0.29**
            
            
            0.32Expected
                option term
            
            
            **6
                years**
            
            
            6
                years





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





11
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





*Outstanding
      Options*





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





*Outstanding*
            
            *Exercisable**Range
                of*
              *Exercise
                Prices*
            
            *Number
                of*
              *Options*
            *Weighted-*
              *Average*
              *Remaining*
              *Contractual*
              *Term*
            *Weighted-*
              *Average*
              *Exercise*
              *Price*
            *Aggregate*
              *Intrinsic*
              *Value*
            
            *Number
                of*
              *Options*
            *Weighted-*
              *Average*
              *Remaining*
              *Contractual*
              *Term*
            *Weighted-*
              *Average*
              *Exercise*
              *Price*
            *Aggregate*
              *Intrinsic*
              *Value*$
                11.68 - 13.00
            
            
            1,240
            
            
            6.5
                Years
            
            $
            11.73
            
            $
            3,991
            
            
            
            1,235
            
            
            6.5
                Years
            
            $
            11.73
            
            $
            3,98013.01
                - 15.00
            
            
            2,839
            
            
            7.5
                Years
            
            
            14.28
            
            
            1,894
            
            
            
            1,409
            
            
            7.5
                Years
            
            
            14.31
            
            
            90715.01
                - 17.00
            
            
            3,349
            
            
            7.8
                Years
            
            
            16.38
            
            
            —
            
            
            
            1,489
            
            
            6.1
                Years
            
            
            16.18
            
            
            —17.01
                - 19.00
            
            
            1,776
            
            
            4.0
                Years
            
            
            18.05
            
            
            —
            
            
            
            1,776
            
            
            4.0
                Years
            
            
            18.05
            
            
            —19.01
                - 22.00
            
            
            131
            
            
            1.5
                Years
            
            
            19.65
            
            
            —
            
            
            
            131
            
            
            1.5
                Years
            
            
            19.65
            
            
            —22.01
                - 29.25
            
            
            893
            
            
            1.9
                Years
            
            
            24.99
            
            
            —
            
            
            
            893
            
            
            1.9
                Years
            
            
            24.99
            
            
            —$
                11.68 - 29.25
            
            
            10,228
            
            
            6.3
                Years
            
            
            16.32
            
            $
            5,885
            
            
            
            6,933
            
            
            5.3
                Years
            
            
            16.69
            
            $
            4,887





The
      aggregate intrinsic value in the preceding table represents the pre-tax amount
      that would have been received by the option holders had all option holders
      exercised their options as of September 30, 2006. Vested and expected-to-vest
      options as of September 30, 2006, included in the table above, totaled
      10,147,276 with a weighted-average exercise price of $16.33, a weighted-average
      contractual life of 6.2 years and an aggregate intrinsic value of $5.9
      million.





***Restricted
      Shares Plan***





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





Total
      compensation expense relating to the Restricted Shares Plan was $0.2 million
      and
      $0.7 million for the three and nine months ended September 30, 2006,
      respectively, and $0.1 million and $0.2 million for the three and nine months
      ended September 30, 2005. Unrecognized compensation cost in connection with
      restricted stock grants totaled $1.9 million at September 30, 2006. The cost
      is
      expected to be recognized over a weighted-average period of 2.2
      years.





*Restricted
      Shares Issuable and Issued*





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





*AMOUNTS
                IN THOUSANDS*
            
            *Restricted*
              *Shares
                Plan*Total
                number of securities authorized
            
            
            1,422Number
                of securities issued
            
            
            (1,260
            )Number
                of forfeited securities returned to plan
            
            
            164Number
                of securities remaining available for future grants under the
                plan
            
            
            326




12
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





*Current
      Restricted Shares Activity*





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





*AMOUNTS
                IN THOUSANDS, EXCEPT PRICE DATA*
            
            *Number
                of*
              *Shares*
            *Weighted-Average*
              *Market
                Price Per*
              *Share*
              *on
                Date of Grant*Non-vested,
                December 31, 2005
            
            
            87
            
            $
            14.08Vested
                in 2006
            
            
            (33
            )
            
            14.38Granted
                in 2006
            
            
            117
            
            
            15.83Forfeited
                in 2006
            
            
            (3
            )
            
            15.65Non-vested,
                September 30, 2006
            
            
            168
            
            
            15.22





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




*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            **2006**
            2005Fair
                value of restricted stock awards granted
            
            **$**
            **121**
            
            $
            **—**
            
            **$**
            **1,845**
            
            $
            1,267Fair
                value of restricted stock awards vested
            
            
            **—**
            
            
            29
            
            
            **475**
            
            
            212





*SHARE
                DATA*Weighted-average
                fair value per share for restricted shares granted
            
            **$**
            **15.11**
            
            $
            **—**
            
            **$**
            **15.83**
            
            $
            14.09








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




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





Losses
      and LAE incurred for the homeowner and earthquake lines in runoff were $0.2
      million and $0.5 million for the three and nine months ended September 30,
      2006,
      compared to $0.6 million and $1.0 million for the same periods in 2005,
      respectively.








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





***Legal
      Proceedings***





In
      the
      normal course of business, the Company is named as a defendant in lawsuits
      related to its insurance operations and 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 the possibility of 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.





13
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





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





*Poss
      v. 21st Century Insurance Company* ** was
      filed
      on June 13, 2003, in Los Angeles Superior Court and *Axen
      v. 21st Century Insurance Company* was
      filed on April 14, 2004 in Alameda County Superior Court. Both complaints seek
      injunctive and unspecified restitutionary relief against the Company under
      Business and Professions Code (“B&P”) Sec. 17200 for alleged unfair business
      practices in violation of California Insurance Code Sec. 1861.02(c) relating
      to
      Company rating practices. The court in the *Poss* case
      granted the Company’s motion to dismiss the complaint, based on California’s
      Proposition 64, but allowed the addition of a second plaintiff, Leacy. Discovery
      has been stayed in both cases and, because these matters are in the pleading
      stages, and no discovery has taken place, no estimate of the range of potential
      losses in the event of a negative outcome can be made at this time.




*Cecelia
      Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia
      Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th
      Century Insurance* was
      filed on July 3, 1997, in Los Angeles Superior Court. Plaintiffs allege bad
      faith, emotional distress, and estoppel involving the Company’s (the Company was
      formerly named 20th Century Insurance) handling of a 1994 homeowner’s claim. On
      March 1, 1994, Ramon Aguilera, a homeowner policyholder, shot and killed Mr.
      Gonzalez (the minor children’s father) and was later sued by Ms. Encarnacion for
      wrongful death. On August 30, 1996, judgment was entered against Ramon Aguilera
      for $5.6 million. The Company paid for Aguilera’s defense costs through the
      civil trial; however, the homeowner’s policy did not provide indemnity coverage
      for the incident, and the Company refused to pay the judgment. After the trial,
      Aguilera assigned a portion of his action against the Company to Encarnacion
      and
      the minor children. Aguilera and the Encarnacion family then sued the Company
      alleging that the Company had promised to pay its bodily injury policy limit
      if
      Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial
      court held a bench trial on the limited issues of promissory and equitable
      estoppel, and policy forfeiture. On September 26, 2003, the trial court issued
      a
      ruling that the Company cannot invoke any policy exclusions as a defense to
      coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs’ motion
      for summary adjudication, ordering that the Company must pay the full amount
      of
      the underlying judgment of $5.6 million, plus interest, for a total of $10.5
      million. The Company disagrees with this ruling as it appears inconsistent
      with
      the court’s simultaneous ruling denying the Company’s motion for summary
      judgment on grounds that there are triable issues of material fact as to whether
      plaintiffs are precluded from recovering damages as a consequence of Aguilera’s
      inequitable conduct. The Company also believes that the court’s decision was not
      supported by the evidence in the case, demonstrating that no promise to settle
      was ever made. The Company has appealed the judgment as to the Encarnacions.
      The
      trial as to Aguilera concluded on December 9, 2005, on his claims for bad faith,
      emotional distress, punitive damages and attorney fees. A jury found he
      sustained no damages as to these claims. The Company’s exposure in this case
      includes the aforementioned $10.5 million judgment plus post-judgment interest,
      which currently totals $2.1  million.
      This matter is now subject to three separate appeals by the parties. The Company
      moved to consolidate the three appeals on October 18, 2006.





*Insurance
      Company cases (Ramona Goldenburg)* was
      originally filed as *Bryan
      Speck, individually, and on behalf of others similarly situated v. 21st Century
      Insurance Company, 21st Century Casualty Company, and 21st Century Insurance
      Group* .
      The
      original action was filed on June 20, 2002, in Los Angeles Superior Court.
      Plaintiff seeks California class action certification, injunctive relief, and
      unspecified actual and punitive damages. The complaint contended that the
      Company uses “biased” software in determining the value of total-loss
      automobiles. Specifically, Plaintiff alleged that database providers use
      improper methodology to establish comparable auto values and populate their
      databases with biased figures and that the Company and other carriers allegedly
      subscribe to the programs to unfairly reduce claims costs. This case is
      consolidated with similar actions against other insurers for discovery and
      pre-trial motions. A court-ordered appraisal of Speck’s vehicle was favorable to
      the Company and Ramona Goldenberg was substituted as a Plaintiff, replacing
      Speck, and a new appraisal was ordered. On October 13, 2006, Plaintiff’s counsel
      offered to dismiss this case, with prejudice, in exchange for the Company
      waiving its costs. The Company has accepted Plaintiff’s counsel’s offer to
      dismiss the matter and will support a motion, containing the agreed terms,
      for
      the court to dismiss the action.





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





14
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





*Silvia
      Quintana, on her own behalf and on behalf of all others similarly situated
      v.
      21st Century Insurance Company* was
      filed on November 16, 2005 .
      This
      purported class action, filed in San Diego, names the Company in four causes
      of
      action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust
      enrichment and, 4) declaratory relief. Silvia Quintana alleges that the
      Company’s demand for reimbursement of the medical payments it made to her
      pursuant to her insurance contract violates the “made-whole rule.” The Company
      anticipates that if the matter survives the initial pleading stage, it will
      be
      consolidated, for discovery and pre-trial motions, with actions alleging similar
      facts against other insurers. This matter is in the pleading stage and no
      reasonable estimate of potential losses in the event of a negative outcome
      can
      be made at this time. In July 2006, the trial court denied the Company’s
      demurrer and motion to strike and the Company has filed a writ to the Court
      of
      Appeal for review of this decision.




*Ronald
      A.Katz Technology Licensing, L.P. vs. American International Group, Inc. et
      al* ** was
      filed
      on September 1, 2006, in the United States District Court for the District
      of
      Delaware. The defendants include American International Group, Inc., its
      subsidiaries and affiliates, including 21st Century Insurance Group, 21st
      Century Insurance Company, and 21st Century Casualty Company. The complaint
      alleges infringement of various patents relating to automated call processing
      applications. The matter is in the initial pleading stage and no reasonable
      estimate of potential losses in the event of a negative outcome can be made
      at
      this time.







**NOTE
      5. ACCUMULATED OTHER COMPREHENSIVE LOSS**





Accumulated
      other comprehensive loss is a component of stockholders’ equity and includes all
      after-tax changes in unrealized gains and losses and changes in minimum pension
      liability in excess of unamortized prior service cost.





A
      summary
      of accumulated other comprehensive loss follows:




**September
                30,**
              **2006**
            December
                31,
              2005Net
                unrealized losses on available-for-sale investments, net of deferred
                income taxes of $6,120 and $4,579
            
            **$**
            **(11,368**
            **)**
            $
            (8,504
            )Minimum
                pension liability in excess of unamortized prior service cost, net
                of
                deferred income taxes of $1,011 and $1,011
            
            
            **(1,878**
            **)**
            
            (1,878
            )Total
                accumulated other comprehensive loss
            
            **$**
            **(13,246**
            **)**
            $
            (10,382
            )





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





The
      Company has a qualified defined benefit pension plan, which covers essentially
      all employees who have completed at least one year of service. The pension
      benefits under the qualified plan are based on employees’ compensation during
      all years of service. The Company’s funding policy for the qualified plan is to
      make annual contributions as required by applicable regulations; employees
      may
      not make contributions to this plan. 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.





***Components
      of Net Periodic Cost***





Net
      pension costs for all plans were as follows:




*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,***2006**
            2005
            **2006**
            2005Service
                cost
            
            **$**
            **1,782**
            
            $
            1,620
            
            **$**
            **5,347**
            
            $
            5,145Interest
                cost
            
            
            **1,935**
            
            
            1,763
            
            
            **5,804**
            
            
            5,473Expected
                return on plan assets
            
            
            **(2,110**
            **)**
            
            (1,827
            )
            
            **(6,330**
            **)**
            
            (5,487
            )Amortization
                of prior service cost
            
            
            **36**
            
            
            78
            
            
            **109**
            
            
            131Amortization
                of net loss
            
            
            **653**
            
            
            428
            
            
            **1,959**
            
            
            1,442Total
            
            **$**
            **2,296**
            
            $
            2,062
            
            **$**
            **6,889**
            
            $
            6,704




15
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





***Pension
      Plan Contributions***





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





Contributions
      to our non-qualified defined benefit pension plan generally are limited to
      amounts needed to make benefit payments to retirees, which are expected to
      total
      approximately $1.1 million in 2006.




***Defined
      Contribution Plans***





The
      Company sponsors a qualified 401(k) contributory savings and security plan
      for
      eligible employees and officers. The Company provides matching contributions
      equal to 75% of the lesser of 6% of an employee’s eligible compensation or the
      amount contributed by the employee up to the maximum allowable under Internal
      Revenue Service regulations. The plan offers a variety of investments among
      which employees exercise complete discretion as to choice and investment
      duration. The Company also sponsors a 401(k) supplemental plan to provide
      specified benefits to a select group of management and highly compensated
      employees. The charges to expenses equal to Company contributions to both plans
      were $1.5 million and $4.6 million for the three and nine months ended September
      30, 2006, respectively, and $1.4 million and $3.7 million for the same periods
      in 2005, respectively.








**NOTE
      7. SEGMENT INFORMATION**





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





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





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





16
 *Table
            of Contents*




**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





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




*Personal
                Auto Lines*
            *Homeowner
                and Earthquake Lines in Runoff**3*
            *Total**Three
                Months Ended September 30, 2006*Net
                premiums earned
            
            **$**
            **327,325**
            
            **$**
            **—**
            
            **$**
            **327,325**Depreciation
                and amortization expense
            
            
            **7,088**
            
            
            **1**
            
            
            **7,089**Segment
                profit (loss)
            
            
            **27,447**
            
            
            **(190**
            **)**
            
            **27,257***Three
                Months Ended September 30, 2005*Net
                premiums earned
            
            $
            344,099
            
            $
            3
            
            $
            344,102Depreciation
                and amortization expense
            
            
            9,504
            
            
            3
            
            
            9,507Segment
                profit (loss)
            
            
            16,972
            
            
            (613
            )
            
            16,359*Nine
                Months Ended September 30, 2006*Net
                premiums earned
            
            **$**
            **978,661**
            
            **$**
            **—**
            
            **$**
            **978,661**Depreciation
                and amortization expense
            
            
            **20,389**
            
            
            **4**
            
            
            **20,393**Segment
                profit (loss)
            
            
            **73,213**
            
            
            **(533**
            **)**
            
            **72,680***Nine
                Months Ended September 30, 2005*Net
                premiums earned
            
            $
            1,017,302
            
            $
            9
            
            $
            1,017,311Depreciation
                and amortization expense
            
            
            24,495
            
            
            7
            
            
            24,502Segment
                profit (loss)
            
            
            47,035
            
            
            (983
            )
            
            46,052





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





*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,***2006**
            2005
            **2006**
            2005Segment
                profit
            
            **$**
            **27,257**
            
            $
            16,359
            
            **$**
            **72,680**
            
            $
            46,052Net
                investment income
            
            
            **16,897**
            
            
            17,042
            
            
            **51,827**
            
            
            51,085Other
                income
            
            
            **58**
            
            
            (3
            )
            
            **68**
            
            
            364Net
                realized investment gains (losses)
            
            
            **159**
            
            
            (939
            )
            
            **(878**
            **)**
            
            (2,666
            )Other
                expense
            
            
            **—**
            
            
            —
            
            
            **(924**
            **)**
            
            —Interest
                and fees expense
            
            
            **(1,820**
            **)**
            
            (1,988
            )
            
            **(5,572**
            **)**
            
            (6,076
            )Income
                before provision for income taxes
            
            **$**
            **42,551**
            
            $
            30,471
            
            **$**
            **117,201**
            
            $
            88,759




3
              2005
                  revenue for the homeowner and earthquake lines in runoff segment
                  represents premium earned as a result of the Company’s participation in
                  theCalifornia
                  FAIR Plan.
  17
 *Table
              of Contents*


**21ST
      CENTURY INSURANCE GROUP**


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


**Unaudited**


**TABULAR
      DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA**


**September
      30, 2006**





**NOTE
      8. VARIABLE INTEREST ENTITIES**





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





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





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





The
      Company is not the primary beneficiary of any of the VIEs as the Company has
      voting rights, beneficiary rights, obligations, and ownership in proportion
      to
      each of its Impact related investments.





In
      addition to the above, the Company held $8.5 million and $6.2 million in other
      Impact related fixed-income investments as of September 30, 2006 and December
      31, 2005, respectively. The Company also held $0.3 million in other Impact
      related private equity investments reclassified as other long-term investments
      as of September 30, 2006. Total Impact related investment income was $0.2
      million and $0.7 million for the three and nine months ended September 30,
      2006,
      respectively, and $0.1 million and $0.5 million for the same periods in 2005,
      respectively.




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








**NOTE
      9. TRANSACTIONS WITH RELATED PARTIES**





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





18
 *Table
            of Contents*





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





**OVERVIEW**





***General***





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





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





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





***National
      Expansion***





The
      Company is implementing a multi-year strategy for national expansion and has
      previously announced plans to operate in additional states during the fourth
      quarter of 2006. The entry into New Jersey in October 2006 is the latest step
      of
      this strategy. 21st entered the Midwest in 2004, Texas in 2005, and three
      Eastern states - Florida, Georgia and Pennsylvania - during the second quarter
      of 2006. During the first 10 months of 2006, the Company has increased the
      percentage of the U.S. personal auto market in which it operates from 34 percent
      to 53 percent. Growth in direct premiums written in non-California markets
      in
      the third quarter of 2006 was 79.6% and we wrote 12.3% of the third quarter’s
      direct premium outside of California, versus 6.6% for the same period in 2005.
      Implementation of our growth strategy could be affected by a number of factors
      beyond our control, such as increased competition, judicial, regulatory, or
      legislative developments, general economic conditions or increased operating
      costs, and we cannot assure you that we will be able to maintain previously
      announced timetables. The ultimate benefits of the national expansion should
      include economies of scale, lower unit marketing costs due to the cost
      efficiency of buying advertising on a national basis, less dependency on any
      single market and the operating flexibility to focus resources on attractive
      markets and deemphasize less attractive markets.





***Highlights***





Financial
      highlights for the third quarters ended September 30, 2006 and
      2005:




·
            Total
                direct premiums written decreased 3.4% to $337.2million
                in 2006, from $349.1 million for same period in
                2005.




·
            California
                direct premiums written decreased 9.3% to $295.8 million in 2006,
                compared
                to $326.0 million for the same period in 2005.




·
            Non-California
                direct premiums written increased 79.6% to $41.4 million in 2006,
                compared
                to $23.1 million for the same period in 2005.




·
            2006
                consolidated combined ratio was 91.7%, versus 95.2% for the third
                quarter
                of 2005. 2006 was favorably impacted by 4.4 points of prior accident
                year
                loss and loss adjustment expenses (“LAE”) reserve development in 2006,
                while 2005 was favorably impacted by 0.3 points of prior accident
                year
                development.





Financial
      highlights for the nine months ended September 30, 2006 and 2005:




·
            Total
                direct premiums written decreased 3.6% to $992.6million
                in 2006, from $1,029.9 million for the same period in
                2005.




·
            California
                direct premiums written decreased 7.5% to $895.0 million in 2006,
                compared
                to $967.8 million for the same period in
                2005.




·
            Non-California
                direct premiums written increased 57.2% to $97.6 million in 2006,
                compared
                to $62.1 million for the same period in
                2005.




·
            2006
                consolidated combined ratio was 92.6%, versus 95.5% for the same
                period in
                2005. 2006 was favorably impacted by 4.0 points of prior accident
                year
                loss and LAE reserve development in 2006, while 2005 was favorably
                impacted by 2.0 points of prior accident year
                development.




19
 *Table
            of Contents*





For
      the
      three months and nine months ended September 30, 2006, 21st’s insurance
      subsidiaries achieved underwriting profitability, but total direct premiums
      written declined. In recent quarters, the California market, which represented
      87.7% of our total direct premiums written during the third quarter, has seen
      stable to declining rates from competitors and a reduced level of shopping
      behavior by consumers. Both of these factors reduced our opportunities for
      profitable growth in this state.




In
      July
      2006, the California Department of Insurance (the “CDI”) obtained approval for
      changes to regulations (the “Auto Rating Factor Regulations”) relating to
      automobile insurance rating factors, particularly concerning territorial rating.
      Because the new Auto Rating Factor Regulations require every personal auto
      insurance company operating in California to make a class plan and rate filing
      in the third quarter of 2006, competitive rate levels may change and consumer
      shopping behavior may increase in the future. As of this date, the Company
      has
      filed for an overall rate decrease in California of approximately 5% of premium.
      Most of the Company’s main competitors have also filed for overall rate
      decreases of varying amounts, while others have not substantially changed
      overall rate levels while attempting to comply with the new regulations. It
      is
      not possible at this time to predict the ultimate timing or impact of these
      changes, which could have either a materially favorable or materially adverse
      impact on the Company. All rate changes and class plan filings must be approved
      by the California Department of Insurance. See further discussion in *Part
      II -* *Item
      1A. Risk Factors.*





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





Net
      income increased 34.6% to $28.4  million
      for the three months ended September 30, 2006, or $0.33  per
      basic
      share, compared to $21.1 million, or $0.25 per basic share, for the same period
      in 2005. The third quarter 2006 results include prior year favorable reserve
      development totaling $14.4 million, versus $1.2 million in the third quarter
      of
      2005. Net income increased 27.9% to $78.0  million,
      or $0.91  per
      basic
      share, for the nine months ended September 30, 2006, compared to $61.0 million,
      or $0.71 per basic share, for the same nine-month period in 2005. The nine
      months ended September 30, 2006 include favorable prior year reserve development
      totaling $39.5 million, versus $20.8 million for the same period in
      2005.





The
      underwriting expense to net premiums earned ratio increased to 23.7% for the
      three months ended September 30, 2006 from 20.2% for the same period in 2005.
      For the nine months ended September 30, 2006, the underwriting expense to net
      premiums earned ratio increased to 22.9% from 21.0% for the same period in
      2005.
      These underwriting expense ratio increases are primarily the result of expenses
      associated with the Company’s national expansion efforts and the 2006 recognition of stock-based
      compensation, which were partially offset by deferred policy acquisition costs.
      Underwriting expenses during the nine months ended September 30, 2006, were
      also
      impacted by severance costs and corporate litigation incurred during the first
      quarter.




The
      recognition of stock-based compensation resulted from our adoption of Statement
      of Financial Accounting Standards No. 123 (revised 2004), *Share-Based
      Payment* (“FAS
      123R”). FAS 123R requires the recognition of compensation expense in the
      Condensed Consolidated Statements of Operations based on the estimated fair
      value of the employee share-based options. See *Critical
      Accounting Estimates - Stock-Based Compensation Cost* for
      further discussion. Stock-based compensation classified as underwriting expense
      for the three and nine months ended September 30, 2006, was $ 1.4 million
      and $ 4.6 million,
      respectively.





***Non-GAAP
      Measures***





Information
      concerning premiums written, underwriting profit 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. We use premiums written as a measure of the underlying growth of our
      insurance business from period to period. The most directly comparable GAAP
      measure, premiums earned, represents the portion of premiums written that is
      recognized as income on a pro rata basis over the terms of the policies.





Underwriting
      profit (loss) consists of net premiums earned less losses from claims, loss
      adjustment expenses and underwriting expenses. 21st believes that underwriting
      profit (loss) provides investors with financial information that is not only
      meaningful, but critically important to understanding the results of property
      and casualty insurance operations. The results of operations of a property
      and
      casualty insurance company includes three components: underwriting profit
      (loss), net investment income and realized capital gains (losses). Without
      disclosure of underwriting profit (loss), it is difficult to determine how
      successful an insurance company is in its core business activity of assessing
      and underwriting risk, as including investment income and realized capital
      gains
      (losses) in the results of operations without disclosing underwriting profit
      (loss) can mask underwriting losses.





20
 *Table
            of Contents*





Statutory
      surplus represents equity as of the end of a fiscal period for the Company’s
      insurance subsidiaries, determined in accordance with statutory accounting
      principles prescribed by insurance regulatory authorities. Stockholders’ equity
      is the most directly comparable GAAP measure to statutory surplus. **





The
      reconciliations of these financial measures to the most directly comparable
      GAAP
      measures are located in *Results
      of Operations* and *Liquidity
      and Capital Resources* ,
      respectively. These financial measures are not intended to replace, and should
      be read in conjunction with the GAAP financial measures.





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





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




·
            Results
                of Operations




·
            Financial
                Condition




·
            Liquidity
                and Capital Resources




·
            Transactions
                with Related Parties




·
            Contractual
                Obligations and Commitments




·
            Critical
                Accounting Estimates




·
            Recent
                Accounting Pronouncements




·
            Forward-Looking
                Statements




**RESULTS
      OF OPERATIONS**





***Consolidated
      Results***





The
      following table summarizes our condensed consolidated results of operations
      and
      reconciles personal auto lines underwriting profit to net income:





*Three
                Months Ended*
              *September
                30,*
            
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS,*
              *EXCEPT
                SHARE DATA*
            
            **2006**
            2005
            
            *Increase/*
              *(Decrease)*
            
            **2006**
            2005
            
            *Increase/*
              *(Decrease)*Personal
                auto lines underwriting profit
            
            **$**
            **27,447**
            
            $
            16,972
            
            
            
            61.7
            %
            
            **$**
            **73,213**
            
            $
            47,035
            
            
            
            55.7
            %Homeowner
                and earthquake lines in runoff underwriting loss
            
            
            **(190**
            **)**
            
            (613
            )
            
            
            (69.0
            )
            
            
            **(533**
            **)**
            
            (983
            )
            
            
            (45.8
            )Net
                investment income
            
            
            **16,897**
            
            
            17,042
            
            
            
            (0.9
            )
            
            
            **51,827**
            
            
            51,085
            
            
            
            1.5Other
                income (loss)
            
            
            **58**
            
            
            (3
            )
            
            
            N/M
            1
            
            
            **68**
            
            
            364
            
            
            
            N/M
            1Net
                realized investment gain (losses)
            
            
            **159**
            
            
            (939
            )
            
            
            N/M
            1
            
            
            **(878**
            **)**
            
            (2,666
            )
            
            
            (67.1
            )Other
                expense
            
            
            —
            
            
            —
            
            
            
            —
            
            
            
            **(924**
            **)**
            
            —
            
            
            
            —Interest
                and fees expense
            
            
            **(1,820**
            **)**
            
            (1,988
            )
            
            
            (8.5
            )
            
            
            **(5,572**
            **)**
            
            (6,076
            )
            
            
            (8.3
            )Provision
                for income taxes
            
            
            **(14,144**
            **)**
            
            (9,369
            )
            
            
            51.0
            
            
            
            **(39,155**
            **)**
            
            (27,725
            )
            
            
            41.2Net
                income
            
            **$**
            **28,407**
            
            $
            21,102
            
            
            
            34.6
            
            
            **$**
            **78,046**
            
            $
            61,034
            
            
            
            27.9Basic
                earnings per share
            
            
            **0.33**
            
            
            0.25
            
            
            
            32.0
            
            
            
            **0.91**
            
            
            0.71
            
            
            
            28.2Diluted
                earnings per share
            
            
            **0.33**
            
            
            0.24
            
            
            
            37.5
            
            
            
            **0.90**
            
            
            0.71
            
            
            
            26.8




1
              Ratio
                  is not meaningful.




21
 *Table
            of Contents*





Underwriting
      results above include the effect of prior years’ reserve redundancy recorded in
      the current year. The following table summarizes losses and LAE incurred, net
      of
      applicable reinsurance, for the periods indicated:





*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            **2006**
            2005Net
                losses and LAE incurred related to insured events in:Current
                accident year personal auto lines
            
            **$**
            **236,942**
            
            $
            259,301
            
            **$**
            **721,668**
            
            $
            778,203Prior
                accident years:Personal
                auto lines
            
            
            **(14,582**
            **)**
            
            (1,811
            )
            
            **(40,061**
            **)**
            
            (21,774
            )Homeowner
                and earthquake lines in runoff
            
            
            **190**
            
            
            615
            
            
            **533**
            
            
            991Total
                prior years’ redundancy recorded in current year
            
            
            **(14,392**
            **)**
            
            (1,196
            )
            
            **(39,528**
            **)**
            
            (20,783
            )Total
                net losses and LAE incurred
            
            **$**
            **222,550**
            
            $
            258,105
            
            **$**
            **682,140**
            
            $
            757,420





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





***Personal
      Auto Lines Underwriting Results***





Personal
      automobile insurance is our primary line of business. Non-California vehicles
      accounted for 12.3% of our direct premiums written for the three months ended
      September 30, 2006, compared to 6.6% for the same period in 2005. For the nine
      months ended September 30, 2006, non-California vehicles accounted for 9.8%
      of
      our direct premiums written, compared to 6.0% for the same period in 2005.
      This
      increase is due to our ongoing national expansion program, which includes
      marketing in non-California states. Prior to September 30, 2006, 21st sold
      policies in 12 states. The Company entered New Jersey in October 2006 and plans
      to expand into additional states during the fourth quarter of 2006 as part
      of
      its national expansion strategy. The following table presents the components
      of
      our personal auto lines underwriting profit and the components of the combined
      ratio:




*Three
                Months Ended*
              *September
                30,*
            
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN**T**HOUSANDS*
            
            **2006**
            2005
            
            *Increase/*
              *(Decrease)*
            
            **2006**
            2005
            
            *Increase/*
              *(Decrease)*Direct
                premiums written
            
            **$**
            **337,217**
            
            $
            349,119
            
            
            
            (3.4
            )%
            
            **$**
            **992,623**
            
            $
            1,029,905
            
            
            
            (3.6
            )%Net
                premiums written
            
            **$**
            **335,809**
            
            $
            347,827
            
            
            
            (3.5
            )
            
            **$**
            **988,509**
            
            $
            1,026,247
            
            
            
            (3.7
            )Net
                premiums earned
            
            **$**
            **327,325**
            
            $
            344,099
            
            
            
            (4.9
            )
            
            **$**
            **978,661**
            
            $
            1,017,302
            
            
            
            (3.8
            )Net
                losses and LAE
            
            
            **(222,360**
            **)**
            
            (257,489
            )
            
            
            (13.6
            )
            
            
            **(681,607**
            **)**
            
            (756,428
            )
            
            
            (9.9
            )Underwriting
                expenses
            
            
            **(77,518**
            **)**
            
            (69,638
            )
            
            
            11.3
            
            
            
            **(223,841**
            **)**
            
            (213,839
            )
            
            
            4.7Underwriting
                profit
            
            **$**
            **27,447**
            
            $
            16,972
            
            
            
            61.7
            
            
            **$**
            **73,213**
            
            $
            47,035
            
            
            
            55.7Ratios:Loss
                and LAE ratio
            
            
            **67.9**
            **%**
            
            74.8
            %
            
            
            (6.9
            )
            
            
            **69.6**
            **%**
            
            74.4
            %
            
            
            (4.8
            )Underwriting
                expense ratio
            
            
            **23.7**
            
            
            20.3
            
            
            
            3.4
            
            
            
            **22.9**
            
            
            21.0
            
            
            
            1.9Combined
                ratio
            
            
            **91.6**
            **%**
            
            95.1
            %
            
            
            (3.5
            )
            
            
            **92.5**
            **%**
            
            95.4
            %
            
            
            (2.9
            )





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




*Three
                Months Ended*
              *September
                30,*
            
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Direct
                premiums written
            
            **$**
            **337,217**
            
            $
            349,119
            
            
            **$**
            **992,623**
            
            $
            1,029,905Ceded
                premiums written
            
            
            **(1,408**
            **)**
            
            (1,292
            )
            
            
            **(4,114**
            **)**
            
            (3,658
            )Net
                premiums written
            
            
            **335,809**
            
            
            347,827
            
            
            
            **988,509**
            
            
            1,026,247Net
                change in unearned premiums
            
            
            **(8,484**
            **)**
            
            (3,728
            )
            
            
            **(9,848**
            **)**
            
            (8,945
            )Net
                premiums earned
            
            **$**
            **327,325**
            
            $
            344,099
            
            
            **$**
            **978,661**
            
            $
            1,017,302




22
 *Table
            of Contents*





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





As
      the
      Company proceeds with its national expansion, we believe that achieving our
      long-term growth goal will steadily depend less on the California marketplace.
      The Company’s national expansion efforts will provide us with flexibility to use
      combinations of local and national marketing media, as appropriate, and the
      ability to focus our marketing expenditures and Company resources on attractive
      markets, while minimizing costs in less attractive markets.





The
      declines in the loss and LAE ratios for the three months and nine months ended
      September 30, 2006 of 6.9 points and 4.8 points, respectively, are primarily
      due
      to the effect of favorable development related to prior accident years and
      lower
      accident frequency. The loss and LAE ratios for the three months ended September
      30, 2006, included 4.5 points ($14.6 million) of favorable development compared
      to 0.5 points ($1.8 million) in the same period of 2005. For the nine months
      ended September 30, 2006 loss and LAE ratio included 4.1 points ($40.1 million)
      of favorable reserve development compared to 2.1 points ($21.8 million) in
      the
      same period of 2005. Changes in estimates are recorded in the period in which
      new information becomes available indicating that a change is warranted. The
      remaining decrease in the loss and LAE ratios for both of the 2006 periods
      was
      primarily attributable to the decline in frequency.





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





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





We
      have
      not written any earthquake policies since 1994 and exited the voluntary
      homeowner insurance business in 2002. Underwriting results of the homeowner
      and
      earthquake lines, which are in runoff, include losses and LAE incurred of $0.2
      million for the three months ended September 30, 2006, compared to $0.6 million
      for the same period in 2005. For the nine months ended September 30, 2006 and
      2005, losses and LAE for those same lines were $0.5 million and $1.0 million,
      respectively, of which the earthquake lines accounted for $0.1 million in loss
      and LAE during the three months and nine months ended September 30,
      2006.





***Net
      Investment Income***





We
      utilize a conservative investment philosophy. No derivatives are held in our
      investment portfolio and there were no equity securities at September 30, 2006.
      The Company had previously held publicly traded equities, but exited the asset
      class in the first quarter of 2006. Substantially the entire fixed maturity
      portfolio is investment grade, having a weighted average Standard & Poor’s
      credit quality of “AA”. The components of net investment income were as
      follows:





*Three
                Months Ended*
              *September
                30,*
            
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            
            **2006**
            2005Fixed
                maturity securities available-for-sale
            
            **$**
            **16,597**
            
            $
            15,471
            
            
            **$**
            **50,095**
            
            $
            46,145Equity
                securities available-for-sale
            
            
            **—**
            
            
            1,188
            
            
            
            **811**
            
            
            4,164Cash
                and cash equivalents
            
            
            **300**
            
            
            383
            
            
            
            **921**
            
            
            776Net
                investment income
            
            **$**
            **16,897**
            
            $
            17,042
            
            
            **$**
            **51,827**
            
            $
            51,085




The
      fixed
      maturity portfolio comprised 99% and 95% of the total investment portfolio
      at
      September 30, 2006 and December 31, 2005, respectively. The average annual
      yields on fixed income assets were as follows:





*Three
                Months Ended*
              *September
                30,*
            
            *Nine
                Months Ended*
              *September
                30,***2006**
            2005
            
            **2006**
            2005Pre-tax
                - fixed maturity securities
            
            
            **4.5**
            **%**
            
            4.6
            %
            
            
            **4.6**
            **%**
            
            4.6
            %After-tax
                - fixed maturity securities
            
            
            **3.3**
            **%**
            
            3.3
            %
            
            
            **3.3**
            **%**
            
            3.3
            %




23
 *Table
            of Contents*





The
      yield
      declined slightly due to the reinvestment of funds from sales of equity
      securities and maturities of fixed-income securities into lower yielding fixed
      maturity securities during the first and second quarters of 2006.





At
      September 30, 2006, $408.4 million, or 27.8%, of our total fixed maturity
      investments at fair value were invested in tax-exempt bonds with the remainder,
      representing 72.2% of the portfolio, invested in taxable securities, compared
      to
      23.1% and 76.9%, respectively, at December 31, 2005 and 22.5% and 77.5%,
      respectively, at September 30, 2005. As of September 30, 2006, no investments
      were rated below investment grade.





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


*Three
                Months Ended*
              *September
                30,*
            *Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            **2006**
            2005Gross
                realized gains2
            
            **$**
            **172**
            
            $
            1,292
            
            **$**
            **1,722**
            
            $
            4,587Gross
                realized losses3
            
            
            **(13**
            **)**
            
            (2,231
            )
            
            **(2,600**
            **)**
            
            (7,253
            )Net
                realized gains (losses) on investments
            
            **$**
            **159**
            
            $
            (939
            )
            **$**
            **(878**
            **)**
            $
            (2,666
            )





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





***Other
      Income and Expense***





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





**FINANCIAL
      CONDITION**





Investments
      and cash were $1.5 billion at September 30, 2006 and December 31, 2005. The
      Company initiated the sale of its equity securities during the first quarter
      of
      2006 and did not hold any equity securities as of September 30, 2006. Applicable
      funds realized from the sale of equity securities were primarily reinvested
      in
      fixed maturity investments. However, we executed a $35 million funding
      commitment for a private equity investment program during the second quarter
      of
      2006, as described in Note 9 of the *Notes
      to Condensed Consolidated Financial Statements* .
      The
      Company funded $9.1 million of the commitment in the third quarter of 2006.





The
      Company also has unrated, community investments representing 1.0% of total
      investments. These investments have been made in an effort to provide housing
      and other services to economically disadvantaged communities. See Note 8 of
      the *Notes
      to Condensed Consolidated Financial Statements* for
      additional information.




Increased
      advertising, sales and customer service costs in the third quarter of 2006
      contributed to an increase in deferred policy acquisition costs (“DPAC”) of
      $7.7  million
      to $67.6  million,
      compared to $59.9 million at December 31, 2005. Our DPAC is estimated to be
      fully recoverable (see *Critical
      Accounting Estimates - Deferred Policy Acquisition Costs* ).





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





**September
                30, 2006**
            
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            **Gross**
            **Net**
            
            Gross
            NetUnpaid
                losses and LAEPersonal
                auto lines
            
            **$**
            **482,871**
            
            **$**
            **478,039**
            
            
            $
            521,528
            
            $
            516,849Homeowner
                and earthquake lines in runoff
            
            
            **1,387**
            
            
            **688**
            
            
            
            2,307
            
            
            1,368Total
            
            **$**
            **484,258**
            
            **$**
            **478,727**
            
            
            $
            523,835
            
            $
            518,217




2
              Gross
                  realized gains during the three months ended September 30, 2005
                  include
                  $1.2 million from the sale of equity securities. Gross realized
                  gains
                  during the nine months ended September 30, 2006 and 2005 include
                  $1.2
                  million and $4.4 million from the sale of equity securities,
                  respectively.
 3
              Gross
                  realized losses during the three months ended September 30, 2005
                  include
                  $2.2 million from the sale of equity securities. Gross realized
                  losses
                  during the nine months ended September 30, 2006 and 2005 include
                  $2.6
                  million and $ 5.9 million from the sale of equity securities,
                  respectively.





24
 *Table
            of Contents*





At
      September 30, 2006, gross unpaid losses and LAE decreased $39.6 million,
      primarily due to a reserve decrease of $38.7 million in the personal auto lines
      as a result of $40.1 million of favorable loss development related to prior
      accident years recorded during the nine months ended September 30, 2006 and
      a
      decline in the number of insured vehicles. The gross unpaid losses and LAE
      in
      the homeowner and earthquake lines decreased $0.9 million as the result of
      continued runoff activity (see *Critical
      Accounting Estimates - Losses and Loss Adjustment Expenses* for
      a
      description of the Company’s reserving process).




Debt
      of
      $118.9 million consists of $19.0 million of capital lease obligations and $99.9
      million of Senior Notes, net of discount. The decrease in debt of $9.0 million
      during the nine months ended September 30, 2006 is primarily attributable to
      principal payments on the capital leases.





Stockholders’
      equity and book value per share increased to $897.6 million and $10.39,
      respectively, at September 30, 2006, compared to $830.0 million and $9.66 at
      December 31, 2005, respectively. The increase in stockholders’ equity for the
      nine months ended September 30, 2006 was primarily due to net income of $78.0
      million, stock-based compensation cost of $8.9 million, and $4.3 million from
      the exercise of stock options. This was partially offset by dividends to
      stockholders of $20.7 million and an increase in accumulated other comprehensive
      loss of $2.9 million, which resulted from a $4.5 million increase in net
      unrealized losses on the investment portfolio due to rising market interest
      rates.





**LIQUIDITY
      AND CAPITAL RESOURCES**





***Holding
      Company***




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




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




On
      November 30, 2005, the CDI approved an amendment to a term loan line that
      increased the available amount from $40 million to $150 million that our
      insurance subsidiary, 21st Century Insurance Company, can loan to our holding
      company. The outstanding balance of the term loan line as of September 30,
      2006,
      was $86.0 million.




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




·
            Ongoing
                costs to enhance our computer
                software;




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




·
            The
                repayment of $86.0 million principal on the term loan line to the
                insurance subsidiary (scheduled payments include $18.0 million, $40.0
                million, and $28.0 million in 2007, 2008,and 2009, respectively);
                and




·
            Related
                interest on the obligations above.





We
      expect
      to be able to meet those obligations from sources of cash currently available
      (i.e., cash and investments at the holding company, which totaled $24.1 million
      at September 30, 2006, payments received from the intercompany lease, and
      borrowing from our insurance subsidiary), additional funds that may be
      obtainable from the capital markets or dividends received from our insurance
      subsidiaries. The effective 2006 California state income tax rate applicable
      to
      any such dividends paid from our subsidiaries, if taxable, is approximately
      1.8%, or 1.2% net of federal benefit.




***Insurance
      Subsidiaries***




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




25
 *Table
            of Contents*





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




At
      September 30, 2006, our insurance subsidiaries had a combined statutory surplus
      of $781.6 million compared to $704.7 million at December 31, 2005. The increase
      in statutory surplus was primarily due to statutory net income of $96.1 million
      and an increase in net unrealized investment gains of $1.2 million, partially
      offset by a $13.2 million decrease in the deferred income tax asset and an
      increase in nonadmitted assets of $7.8 million. The net premiums written to
      statutory surplus ratio, which is required to be below 3.0 by the insurance
      regulators, was 1.6 at September 30, 2006, compared to 1.9 at December 31,
      2005.





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





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




*AMOUNTS
                IN THOUSANDS*
            
            **September
                30,**
              **2006**
            December
                31,
              2005Stockholders’
                equity - GAAP
            
            **$**
            **897,623**
            
            $
            829,972Condensed
                adjustments to reconcile GAAP shareholders’ equity to statutory
                surplus:Net
                book value of fixed assets under capital leases
            
            
            **(21,200**
            **)**
            
            (24,185
            )Deferred
                gain under capital lease transactions
            
            
            **(288**
            **)**
            
            (914
            )Capital
                lease obligation
            
            
            **18,946**
            
            
            28,074Nonadmitted
                net deferred tax assets
            
            
            **(16,018**
            **)**
            
            (34,936
            )Net
                deferred tax assets related to items nonadmitted under SAP
            
            
            **32,641**
            
            
            38,544Intercompany
                receivables
            
            
            **(85,683**
            **)**
            
            (57,683
            )Fixed
                assets
            
            
            **(22,801**
            **)**
            
            (22,492
            )Equity
                in non-insurance entities
            
            
            **54,827**
            
            
            26,798Net
                unrealized losses on investments
            
            
            **16,956**
            
            
            10,788Deferred
                policy acquisition costs
            
            
            **(67,592**
            **)**
            
            (59,939
            )Prepaid
                pension costs and intangible pension asset
            
            
            **(17,249**
            **)**
            
            (21,309
            )Other
                prepaid expenses
            
            
            **(13,680**
            **)**
            
            (11,049
            )Other,
                net
            
            
            **5,151**
            
            
            3,002Statutory
                surplus
            
            **$**
            **781,633**
            
            $
            704,671








***Operating
      Cash Flows***





Our
      operating cash flows were as follows:




*Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Decrease*Net
                cash provided by operating activities
            
            **$**
            **84,250**
            
            $
            122,369
            
            $
            38,119





Net
      cash
      provided by operating activities decreased primarily due to a decline in direct
      premiums collected resulting from the decline in premiums written and an
      increase in taxes paid as a result of the utilization of the carryforward of
      net
      operating losses during 2006. This was partially offset by decreases in loss
      and
      LAE payments. Also, while underwriting expenses and deferred policy acquisition
      costs increased since the prior year, cash paid for underwriting expenses
      decreased slightly due to the increase in other liabilities of $17.0 million,
      primarily as a result of expenditures incurred in connection with our national
      expansion efforts.





***Investing
      Activities***





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





26
 *Table
            of Contents*





Our
      cash
      flows from investing activities were as follows:





*Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Increase*Net
                cash used in investing activities
            
            **$**
            **113,765**
            
            $
            78,764
            
            $
            35,001





Net
      cash
      used in investing activities increased due to a $44.2 million increase in net
      acquisitions (purchases, net of maturities, calls and sales) of investments
      primarily as a result of the redeployment of cash equivalents, partially offset
      by a $9.2 million decrease in purchases of property and equipment.





***Financing
      Activities***





Our
      cash
      flows from financing activities were as follows:





*Nine
                Months Ended*
              *September
                30,**AMOUNTS
                IN THOUSANDS*
            
            **2006**
            2005
            *Increase*Net
                cash used in financing activities
            
            **$**
            **19,656**
            
            $
            13,038
            
            $
            6,618





Net
      cash
      used in financing activities increased due to the doubling of the quarterly
      dividend since the prior year from $0.04 per share to $0.08 per share, partially
      offset by a $1.1 million increase in cash receipts provided by stock option
      exercises.





**TRANSACTIONS
      WITH RELATED PARTIES**





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




***Reinsurance
      Agreements***




The
      Company has a catastrophe reinsurance agreement for the comprehensive portion
      of
      its auto physical damage lines that is provided by three participating entities,
      two of which are AIG subsidiaries. Together they reinsure any covered event
      up
      to $45.0 million in excess of $20.0 million. This coverage was renewed effective
      January 1, 2005 and 2006. Total premiums ceded to AIG subsidiaries were $0.3
      million and $0.8 million for the three and nine months ended September 30,
      2006,
      respectively, and $0.2 million and $0.7 million for the three and nine months
      ended September 30, 2005, respectively. Total reinsurance recoverables, net
      of
      payables, from AIG subsidiaries were $0.4 million and $0.6 million at September
      30, 2006 and December 31, 2005, respectively.





***Corporate
      Insurance Coverage***





We
      have
      obtained the following corporate insurance policies from AIG
      subsidiaries:





·
            Workers’
                compensation insurance




·
            General
                liability insurance




·
            Property
                insurance




·
            Umbrella
                excess insurance




·
            Fiduciary
                liability insurance




·
            Fidelity
                insurance




·
            Auto
                insurance




·
            Employment
                practices liability insurance




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





Insurance
      expense attributable to AIG corporate insurance coverages was $0.7 million
      and
      $2.8 million for the three and nine months ended September 30, 2006,
      respectively, and $1.1 million and $3.3 million for the three and nine months
      ended September 30, 2005, respectively.





27
 *Table
            of Contents*





***Investment
      Management and Investment Accounting***





In
      October 2003, as a result of a competitive bidding process, we entered into
      an
      agreement with AIG Global Investment Corp. (“AIGGIC”) to provide investment
      management and investment accounting services. The fees are determined as a
      percentage of the average invested asset balance and are classified with net
      investment income. This agreement was approved by the CDI. Investment management
      and accounting expense was $0.2 million and $0.7 million for the three and
      nine
      months ended September 30, respectively, for both 2006 and 2005.





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





**CONTRACTUAL
      OBLIGATIONS AND COMMITMENTS**





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





**CRITICAL
      ACCOUNTING ESTIMATES**





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





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





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





***Losses
      and Loss Adjustment Expenses***




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





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





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





28
 *Table
            of Contents*





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





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





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





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





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




The
      Company has experienced changes in the mix of business and policy limits. We
      believe that the assumption with the highest likelihood of change that could
      materially affect carried unpaid losses and LAE is the estimate of the frequency
      of unpaid bodily injury claims. The Company has experienced approximately 14%
      lower bodily injury claim frequency over the past three years in California.
      A
      5% change in the estimate of the frequency of unpaid bodily injury claims for
      accident year 2005 would result in an approximate increase or decrease in
      total  unpaid
      losses and LAE of 1.0%, or $4.8 million, at September 30, 2006.




***Investments***




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





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





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





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





29
 *Table
            of Contents*





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





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





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





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





**September
                30, 2006**
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            ***#
                issues***
            ***Fair
                Value***
            *#
                issues*
            *Fair
                Value*AAA
            
            
            **324**
            
            **$**
            **737,497**
            
            
            286
            
            $
            604,812AA
            
            
            **112**
            
            
            **183,576**
            
            
            116
            
            
            169,708A
            
            
            **115**
            
            
            **429,433**
            
            
            118
            
            
            486,338BBB
            
            
            **44**
            
            
            **114,702**
            
            
            44
            
            
            88,918BB
            
            
            **—**
            
            
            **—**
            
            
            3
            
            
            2,495Unrated
            
            
            **6**
            
            
            **5,177**
            
            
            2
            
            
            2,436Total
                fixed maturity securities
            
            
            **601**
            
            **$**
            **1,470,385**
            
            
            569
            
            $
            1,354,707





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





*AMOUNTS
                IN THOUSANDS*
            
            **September
                30,**
              **2006**
            December
                31,
              2005Non-investment
                grade investments:AmerUs
                Group Co.4
            
            **$**
            **—**
            
            $
            864Ford
                Motor Credit Company5
            
            
            **—**
            
            
            2,495Total
                non-investment grade investments
            
            
            **—**
            
            
            3,359Unrated
                fixed maturity securities:Impact
                Community Capital, LLC6
            
            
            **1,999**
            
            
            2,023Impact
                Healthcare, LLC6
            
            
            **413**
            
            
            413Impact
                Childcare, LLC6
            
            
            **330**
            
            
            —Impact
                Commercial Opportunities, LLC6
            
            
            **1,858**
            
            
            —Impact
                Childcare 2, LLC6
            
            
            **480**
            
            
            —Impact
                Healthcare 2, LLC6
            
            
            **97**
            
            
            —Total
                unrated fixed maturity securities
            
            
            **5,177**
            
            
            2,436Unrated
                other long-term investmentsImpact
                Workforce, LLC6
            
            
            **320**
            
            
            —AIG
                PEP7
            
            
            **9,123**
            
            
            —Total
                unrated other long-term investments
            
            
            **9,443**
            
            
            —Total
                non-investment grade and unrated investments
            
            **$**
            **14,620**
            
            $
            5,795Percentage
                of total investments, at fair value
            
            
            **1.0**
            **%**
            
            0.4
            %




4
              The
                  AmerUs Group Co. was a preferred stock holding that had an unrealized
                  gain
                  as of December 31, 2005.
 5
              The
                  Ford Motor Credit Company security matured in the first quarter
                  of 2006
                  and the Company received all amounts due, thereby incurring no
                  loss.
 6
              Impact
                  Community Capital is a limited partnership that was voluntarily
                  established by a group of California insurers to make loans and
                  otherinvestments
                  that provide housing and other services to economically disadvantaged
                  communities. See further discussion in Note 8 of the*Notes
                  to the**Condensed
                  Consolidated Financial
                  Statements.*
 7
              AIG
                  PEP is a private equity investment program managed by AIGGIC.See further discussion in Note 9 of the*Notes
                  to the Condensed Consolidated Financial**Statements.*





30
 *Table
            of Contents*





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 September 30, 2006 and December 31,
      2005:





**September
                30, 2006**
            December
                31, 2005*AMOUNTS
                IN THOUSANDS,*
              *EXCEPT
                NUMBER OF ISSUES*
            
            ***#***
              ***issues***
            ***Fair
                Value***
            ***Unrealized***
              ***Loss***
            *#*
              *issues*
            *Fair
                Value*
            *Unrealized*
              *Loss*Investments
                with unrealized losses:Fixed
                maturity securities:Exceeding
                $0.1 million and in a loss position for:Less
                than 6 months
            
            
            **1**
            
            **$**
            **9,771**
            
            **$**
            **228**
            
            
            16
            
            $
            141,034
            
            $
            3,0746-12
                months
            
            
            **29**
            
            
            **232,850**
            
            
            **7,297**
            
            
            16
            
            
            129,044
            
            
            4,072More
                than 1 year
            
            
            **61**
            
            
            **475,781**
            
            
            **19,530**
            
            
            56
            
            
            433,368
            
            
            16,896Less
                than $0.1 million
            
            
            **127**
            
            
            **264,782**
            
            
            **4,758**
            
            
            113
            
            
            204,724
            
            
            4,347Total
                fixed maturity securities with unrealized losses
            
            
            **218**
            
            
            **983,184**
            
            
            **31,813**
            
            
            201
            
            
            908,170
            
            
            28,389Equity
                securities:Exceeding
                $0.1 million
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            2
            
            
            578
            
            
            305Less
                than $0.1 million
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            245
            
            
            35,672
            
            
            1,873Total
                equity securities with unrealized losses
            
            
            **—**
            
            
            **—**
            
            
            **—**
            
            
            247
            
            
            36,250
            
            
            2,178Total
                investments with unrealized losses8
            
            
            **218**
            
            **$**
            **983,184**
            
            **$**
            **31,813**
            
            
            448
            
            $
            944,420
            
            $
            30,567





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





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





**September
                30, 2006**
            December
                31, 2005*AMOUNTS
                IN THOUSANDS*
            
            ***Amortized***
              ***Cost***
            ***Fair
                Value***
            ***Unrealized***
              ***Loss***
            *Amortized*
              *Cost*
            *Fair
                Value*
            *Unrealized*
              *Loss*Fixed
                maturity securities:Due
                in one year or less
            
            **$**
            **3,037**
            
            **$**
            **3,005**
            
            **$**
            **32**
            
            $
            5,562
            
            $
            5,512
            
            $
            50Due
                after one year through five years
            
            
            **466,042**
            
            
            **451,858**
            
            
            **14,184**
            
            
            205,363
            
            
            200,075
            
            
            5,288Due
                after five years through ten years
            
            
            **212,214**
            
            
            **205,040**
            
            
            **7,174**
            
            
            415,417
            
            
            401,533
            
            
            13,884Due
                after ten years
            
            
            **333,704**
            
            
            **323,281**
            
            
            **10,423**
            
            
            310,216
            
            
            301,050
            
            
            9,167Total
                fixed maturity securities with unrealized losses
            
            **$**
            **1,014,997**
            
            **$**
            **983,184**
            
            **$**
            **31,813**
            
            $
            936,558
            
            $
            908,170
            
            $
            28,389




***Income
      Taxes***




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




At
      September 30, 2006, our DTAs were $111.2 million and our DTLs were $68.6
      million, for a net DTA of $42.6 million.  At
      December 31, 2005, our DTAs were $128.5 million and our DTLs were $72.3 million,
      for a net DTA of $56.2 million. The net DTAs are classified as an asset,
“Deferred income taxes”, in the condensed consolidated balance
      sheets.




8
              Unrealized
                  losses represent approximately 3.2% of the total fair value of
                  investments
                  with unrealized losses at both September 30, 2006 and December
                  31,2005.




31
 *Table
            of Contents*




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




The
      Company’s net deferred tax assets include a net operating loss (“NOL”)
      carryforward for regular federal corporate tax purposes of approximately $9.3
      million, representing an unrealized tax benefit of $3.3 million at September
      30,
      2006, compared to $33.6 million at December 31, 2005. The steady decline in
      the
      unrealized tax benefit of the NOL since 2002 resulted from the generation of
      taxable underwriting and investment income in the nine months ended September
      30, 2006.





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




**Year
                of Expiration**
            
            **SRLY 9****NOL
                of 21st of**
              **the
                Southwest**2017
            
            $
            1,4562018
            
            
            1,0682019
            
            
            1,4662020
            
            
            3,1722021
            
            
            2,1802022
            
            
            **—**Total
            
            $
            9,342





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





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




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




***Deferred
      Policy Acquisition Costs***




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





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




9
              ”SRLY”
                  stands for Separate Return Limitation Year. Under the Federal tax
                  code,
                  only future income generated by 21st of the Southwest may be utilized
                  against this portion of our
                  NOL.





32
 *Table
            of Contents*





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 it
      is
      a reasonable assumption, actual results could differ materially from such
      estimates.




***Property
      and Equipment***




At
      September 30, 2006, property and equipment included $129.1 million in software.
      Accounting standards require a write-off to be recognized when an asset is
      vacated or an asset group’s carrying value exceeds its fair value. For purposes
      of recognition and measurement of an impairment loss, a long-lived asset or
      assets are grouped with other assets and liabilities at the lowest level for
      which identifiable cash flows are largely independent of the cash flows of
      other
      assets and liabilities. Accounting standards require asset groups to be tested
      for possible impairment under certain conditions. There have been no events
      or
      circumstances in the third quarter of 2006 that would require a reassessment
      of
      any asset group for impairment.




***Stock-Based
      Compensation Cost***





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





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





The
      adoption of FAS 123R in the first quarter of 2006 resulted in additional
      stock-based compensation cost of $2.1 million and $8.1 million in the three
      and
      nine months ended September 30, 2006, respectively, which previously would
      have
      been only presented in a pro forma footnote disclosure. We expect this cost
      to
      approximate $10.0 million for fiscal year 2006. FAS 123R also requires the
      Company to estimate forfeitures in calculating the expense relating to
      stock-based compensation, as opposed to recognizing these forfeitures and
      corresponding reduction in expense as they occur. No cumulative adjustment
      was
      necessary for prior year forfeitures as these were estimated in the Company’s
      prior year pro forma financial statements. In addition, FAS 123R requires us
      to
      reflect the cash savings resulting from excess tax benefits (i.e., the benefit
      of the tax deduction for a share-based payment that exceeds the recognized
      compensation cost for that award) in its consolidated financial statements
      as a
      financing cash flow, rather than as an operating cash flow as in prior periods.
      Basic earnings per share for the three and nine months ended September 30,
      2006
      would have been $0.35 and $0.97, respectively, if the Company had not adopted
      FAS 123R, compared to reported basic earnings per share of $0.33 and $0.91,
      respectively.





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





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





33
 *Table
            of Contents*





**RECENT
      ACCOUNTING PRONOUNCEMENTS**





In
      September 2006, Financial
      Accounting Standards Board (“FASB”) issued
      FAS  158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans - an
      Amendment of FASB Statements No. 87, 88, 106 and* ** *132(R)* ("FAS
      158"). FAS 158 requires an employer that is a business entity and sponsors
      one
      or more single employer benefit plans to (1) recognize the  funded
      status of the benefit in its statement of financial position, (2) recognize
      as a
      component of other comprehensive income, net of tax, the gains  or
      losses
      and prior service costs or credits that arise during the period, but are not
      recognized as components of net periodic benefit cost, (3) measure  defined
      benefit plan assets and obligations as of the date of the employer's fiscal
      year
      end statement of financial position and (4) disclose in the notes  to
      financial statements additional information about certain effects on net
      periodic benefit cost for the next fiscal year that arise from
      delayed  recognition
      of the gains or losses, prior service costs on credits, and transition asset
      or
      obligations. Under
      FAS
      158, the Company will be required to recognize the funded status of its defined
      benefit plans and to provide the required disclosures as of December 31,
      2006 . However,
      had we been required to adopt the provisions of FAS 158 as of September 30,
      2006, the estimated cumulative impact on the Company’s condensed consolidated
      financial statements as a result of the adoption of this standard would have
      resulted in an approximate $17 million net after-tax reduction in equity with
      a
      corresponding reduction of $7.8 million in total assets, and an increase of
      $9.3
      million in total liabilities. Because our net pension liabilities
      are **** dependent
      upon future events and circumstances, the impact at the time of adoption of
      FAS
      158 may differ from these amounts. Adoption of FAS 158 will **** not
      have
      any effect on the Company's compliance with its financial
      covenants.





In
      September 2006, the FASB issued FAS 157, *Fair
      Value Measurements* (“FAS
      157”). FAS 157 clarifies the principle that fair value should be based on the
      assumptions market participants would use when pricing an asset or liability
      and
      establishes a fair value hierarchy that prioritizes the information used to
      develop those assumptions. Under the standard, fair value measurements would
      be
      separately disclosed by level within the fair value hierarchy. FAS 157 is
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007 and interim periods within those fiscal years, with early
      adoption permitted. We have not yet determined the effect, if any, that the
      implementation of FAS 157 will have on our results of operations or financial
      condition.





In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* (“SAB
      108”). SAB 108 provides interpretive guidance on how the effects of the
      carryover or reversal of prior year misstatements should be considered in
      quantifying a current year misstatement. The SEC staff believes that registrants
      should quantify errors using both a balance sheet and an income statement
      approach and evaluate whether either approach results in quantifying a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. SAB 108 is effective for the Company’s fiscal year
      ending December 31, 2006. We do not expect SAB 108 to have a material impact
      on
      our consolidated financial statements.





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





Statement
      of Position 05-1 *,
      Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
      with Modifications or Exchanges of Insurance Contracts* (“SOP
      05-1”) *,* becomes
      effective January ** 1,
      2007.
      SOP 05-1 provides guidance on accounting for deferred acquisition costs on
      internal replacements of insurance and investment contracts other than those
      specifically described in FAS No. 97, *Accounting
      and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
      and
      for Realized Gains and Losses from the Sale of Investments* .
      The SOP
      defines an internal replacement as a modification in product benefits, features,
      rights, or coverage that occurs by the exchange of a contract for a new
      contract, or by amendment, endorsement, or rider to a contract, or by the
      election of a feature or coverage within a contract. We are currently assessing
      the effect of implementing this guidance.





34
 *Table
            of Contents*





**FORWARD-LOOKING
      STATEMENTS**





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





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





·
            Our
                strategy for growth;




·
            Underwriting
                results;




·
            Our
                expected combined ratio and growth of written
                premiums;




·
            Product
                development;




·
            Computer
                systems;




·
            Litigation,
                regulatory environment and
                approvals;




·
            Market
                position;




·
            Financial
                results;




·
            Dividend
                policy; and




·
            Reserves.





It
      is
      possible that our actual results, actions and financial condition may differ,
      possibly materially, from the anticipated results, actions and financial
      condition indicated in these forward-looking statements. Other important factors
      that could cause our actual results and actions to differ, possibly materially,
      from those in the specific forward-looking statements include those discussed
      in
      this MD&A as well as:





·
            The
                effects of competition and competitors’ pricing
                actions;




·
            Changes
                in consumer preferences or buying
                habits;




·
            Adverse
                underwriting and claims experience;




·
            Customer
                service problems;




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




·
            Information
                system problems;




·
            Control
                environment failures;




·
            Adverse
                developments in financial markets or interest rates;




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




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




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





35
 *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 the financial instruments in which we
      invest, the underlying insurance risk related to our core business and the
      exposure of the personal lines insurance business, as a regulated industry,
      to
      legal, legislative, judicial, political and regulatory action. Financial
      instruments are not used for trading purposes. The Company also obtained
      long-term fixed rate financing as a means of increasing the statutory surplus
      of
      the Company’s largest insurance subsidiary in 2002 and 2003. The following
      disclosure reflects estimated changes in value that may result from selected
      hypothetical changes in market rates and prices. Actual results may
      differ.




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




***Fixed
      maturity financial instruments***




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




Since
      fixed maturity securities with longer remaining terms to maturity usually tend
      to realize higher yields, the Company’s investment philosophy through 2003
      typically resulted in a portfolio with an effective duration of over 6 years.
      Due to the changing interest rate environment in 2004, management, in
      consultation with the Investment Committee, began targeting a lower duration
      for
      the Company’s fixed maturity security portfolio to reduce the negative impact of
      potential increases in interest rates.  As
      a
      result, the effective duration of the fixed maturity portfolio declined from
      4.7
      years as of December 31, 2005 to 4.0 years at September 30, 2006.




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




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




*DOLLAR
                  AMOUNTS IN MILLIONS*
                *September
                  30, 2006*
              
              *Carrying*
                *Value*
              *Estimated*
                *Carrying
                  Value at*
                *Adjusted
                  Market*
                *Rates/Prices*
                *Indicated
                  Above*
              *Change
                  in*
                *Value
                  as a*
                *Percentage
                  of*
                *Carrying
                  Value*Fixed
                  maturity securities available-for-sale, at fair value
              
              $
              1,470.4
              
              $
              1,411.1
              
              
              (4.0
              %)Debt,
                  at amortized cost
              
              
              118.9
              
              
              125.3
              
              
              5.5
              %





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





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





36
 *Table
            of Contents*





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





The
      following summarizes the effective duration distribution of our fixed maturity
      securities portfolio.





*Effective
                Duration Ranges (in years)**September
                30, 2006*
            
            Below
                1
            1
                to 3
            3
                to 5
            5
                to 7
            7
                to 10
            10
                to 20Fair
                value percentage of fixed maturity security portfolio
            
            
            1.2
            %
            
            16.2
            %
            
            43.6
            %
            
            33.9
            %
            
            4.1
            %
            
            1.0
            %





**ITEM
      4. CONTROLS AND PROCEDURES**





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





The
      Company has established disclosure controls and procedures designed 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.





As
      required by Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange
      Act”), our management, including our Principal Executive Officer and Principal
      Financial Officer, has evaluated the effectiveness of our disclosure controls
      and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based
      on
      that evaluation the Principal Executive Officer and Principal Financial Officer
      have concluded that such disclosure controls and procedures are effective as
      of
      the end of the period covered by this report in providing reasonable level
      of
      assurance that information we are required to disclose in reports that we file
      or submit under the Exchange Act is recorded, processed, summarized and reported
      within the time periods specified in Securities and Exchange Commission rules
      and forms, and a reasonable level of assurance that information required to
      be
      disclosed by us in such reports is accumulated and communicated to our
      management, including our Principal Executive Officer and Principal Financial
      Officer, as appropriate to allow timely decisions regarding required
      disclosure.




***Changes
      in Internal Control Over Financial Reporting***





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




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





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





37
 *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 its insurance operations and business practices. Information
      regarding reportable legal proceedings is contained in *Part
      I, Item 3. Legal Proceedings* in our
      Annual Report on Form 10-K, as updated in our subsequent Quarterly Reports
      on
      Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006, respectively.
      A current description of the reportable legal proceedings to which the Company
      and its subsidiaries are a party is contained in Note 4 of the *Notes
      to Condensed Consolidated Financial Statements* ,
      and is
      incorporated herein by reference. The description identifies legal proceedings,
      if any, that become reportable during the quarter ended September 30, 2006,
      and
      amends and restates descriptions of previously reported legal proceedings in
      which there have been material developments during such quarter or which are
      otherwise updated due to other developments.








**ITEM
      1A. RISK FACTORS**





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




***We
      write a substantial portion of our business in California, and therefore recent
      changes in California insurance regulations could have a material impact on
      the
      Company.***




In
      July
      of 2006, the California Department of Insurance (the “CDI”) issued changes to
      regulations relating to automobile insurance rating factors, particularly
      concerning territorial rating (the “Auto Rating Factor Regulations”).
      Theprevious regulation had been validated by a court decision. The new
      rules require automobile insurance companies to make a class plan and rate
      filing during the third quarter to bring their automobile insurance rates in
      California into compliance with the Auto Rating Factor Regulations. Litigation
      to primarily enjoin the implementation of the Auto Rating Factor Regulations
      and
      have them declared in violation of California law has been unsuccessful. As
      a
      result, the Company has submitted class plan and rate filings to the CDI for
      its
      review. The Company’s rate filing proposes an overall rate decrease of 5% of
      premium. The CDI may or may not approve the Company’s class plan and rate
      filings. If not approved, further administrative and legal proceedings related
      specifically to the Company may be required to resolve any dispute. As a result
      of such proceedings, the Company could ultimately be required to make changes
      in
      the structure of its rating plans and/or the level of its overall rates that
      it
      believes are actuarially unsound. In addition, because the new Auto Rating
      Factor Regulations require every company to make a rate filing, competitive
      rate
      levels may change and consumer shopping behavior may increase in the future.
      As
      of this date, most of the Company’s main competitors have also filed for overall
      rate decreases of varying amounts, while others have not substantially changed
      overall rate levels while attempting to comply with the new regulations. It
      is
      not possible at this time to predict the ultimate timing or impact of these
      proceedings and changes, which could have either a materially favorable or
      materially adverse impact on the Company.





Also
      in
      July 2006, the CDI proposed new amended rate approval regulations (the “Rate
      Approval Regulations”) that would determine how insurance rates for personal
      auto and most other lines of personal and commercial property and casualty
      lines
      of business are established in California. In October 2006, the CDI issued
      additional amendments to the Rate Approval Regulations. Multiple changes from
      the current regulations include capping the maximum permitted after-tax rate
      of
      return on derived capital at a floating rate equal to a “risk free” rate of
      return plus 6% for all affected lines of insurance. The proposed amended Rate
      Approval Regulations provide for several “variances” from the rates specified by
      the formula. The Company is reviewing the current version of the proposal in
      its
      entirety to determine its impact, but the proposed Rate Approval Regulations,
      if
      approved without modification, could have a materially adverse impact on the
      Company’s results.




**ITEM
      6. EXHIBITS**





See
      accompanying exhibit index.





38
 *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:
            November
                2, 2006
            
            /s/
                Bruce W. MarlowBRUCE
                W. MARLOWPresident
                and Chief Executive Officer(Principal
                Executive Officer)Date:
            November
                2, 2006
            
            /s/
                Steven P. ErwinSTEVEN
                P. ERWINSenior
                Vice President and Chief Financial Officer(Principal
                Financial Officer)




39
 *Table
            of Contents*




**EXHIBIT
      INDEX**







Exhibit
              No.
            Description
                of Exhibit
            
            Location10.1
            Employment
                Letter between Steven P. Erwin and the Company, dated May 5,
                2006
            
            Current
                Report on Form 8-K (filed with SEC on May 11, 2006; Exhibit 10.1
                therein).31.1
            Certification
                of principal executive officer pursuant to Rule 13a-14(a) under the
                Securities Exchange Act of 1934
            
            Filed
                herewith31.2
            Certification
                of principal financial officer pursuant to Rule 13a-14(a) under the
                Securities Exchange Act of 1934
            
            Filed
                herewith32.1
            Certification
                Pursuant to 18 U.S.C. Section 1350
            
            Filed
                herewith




40