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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
  FORM 10-Q (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from to. 000-50641
(Commission File Number) 
 PROCENTURY CORPORATION    Ohio
(State or other jurisdiction of
incorporation or organization)
    
    31-1718622
(I.R.S. Employer Identification No.)465 Cleveland Avenue
Westerville, Ohio
(Address of principal executive offices)
    
    43082
(Zip Code)
 (614) 895-2000
(Registrants telephone number, including area code) 
 Indicate by check mark whether 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 report(s)), and (2) has been subject to
such filing requirements for the past 90 days. YES o NO x Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES o NO x As of June 4, 2004, the registrant had 13,101,195 outstanding Common
Shares, without par value.




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PROCENTURY CORPORATION QUARTERLY REPORT ON FORM 10-Q
For the Quarterly Period Ended March 31, 2004 INDEX PagePART I: FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    3Consolidated Condensed Balance Sheets-
March 31, 2004 and December 31, 2003
    
    
    3Consolidated Condensed Statements of Operations-
Three Months Ended March 31, 2004 and 2003
    
    
    4Consolidated Condensed Statements of Shareholders Equity and
Comprehensive Income-Three Months Ended March 31, 2004 and 2003
    
    
    5Consolidated Condensed Statements of Cash Flow-
Three Months Ended March 31, 2004 and 2003
    
    
    6Notes to Consolidated Condensed Financial Statements- March 31, 2004
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4. Controls and Procedures
    
    
    25PART II: OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    26Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
    
    
    26Item 3. Defaults Upon Senior Securities
    
    
    26Item 4. Submission of Matters to a Vote of Security Holders
    
    
    26Item 5. Other Information
    
    
    26Item 6. Exhibits and Reports on Form 8-K
    
    
    26SIGNATURE
    
    
    28Exhibit 3.1Exhibit 3.2Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
 2




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PART I: FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation) 
 Consolidated Condensed Balance Sheets March 31, 2004
    
    December 31, 2003(Unaudited)AssetsInvestments:Fixed maturities:Available-for-sale, at fair value (amortized cost 2004, $203,049,212, 2003, $167,970,330)
    
    $
    206,452,856
    
    
    
    169,104,006Held-to-maturity, at amortized cost (fair value 2004, $4,435,565; 2003, $4,216,670)
    
    
    4,350,280
    
    
    
    4,153,091Equities (available-for-sale):Equity securities, at fair value (cost 2004, $17,735,118; 2003, $16,040,725)
    
    
    18,406,759
    
    
    
    16,393,880Bond mutual funds, at fair value (cost 2004, $8,662,442; 2003, $10,821,670)
    
    
    8,748,910
    
    
    
    10,839,175Short-term investments, at amortized cost
    
    
    1,995,744
    
    
    
    26,251,830Total investments
    
    
    239,954,549
    
    
    
    226,741,982Cash
    
    
    8,744,463
    
    
    
    7,300,597Premiums in course of collection, net
    
    
    11,209,602
    
    
    
    11,337,253Deferred policy acquisition costs
    
    
    16,118,397
    
    
    
    14,642,308Prepaid reinsurance premiums
    
    
    16,291,567
    
    
    
    14,926,467Reinsurance recoverable on paid and unpaid losses, net
    
    
    48,586,913
    
    
    
    48,320,544Deferred federal income tax asset
    
    
    1,730,642
    
    
    
    2,760,166Other assets
    
    
    6,219,590
    
    
    
    6,083,209Total assets
    
    $
    348,855,723
    
    
    
    332,112,526Liabilities and Shareholders EquityLoss and loss expense reserves
    
    $
    144,837,569
    
    
    
    136,982,225Unearned premiums
    
    
    79,621,198
    
    
    
    74,734,166Long term debt
    
    
    33,898,352
    
    
    
    34,132,833Accrued expenses and other liabilities
    
    
    9,287,643
    
    
    
    9,219,095Reinsurance balances payable
    
    
    6,748,825
    
    
    
    7,328,388Collateral held
    
    
    4,386,459
    
    
    
    6,270,009Federal income taxes payable
    
    
    3,186,890
    
    
    
    1,728,131Total liabilities
    
    
    281,966,936
    
    
    
    270,394,847Minority interest
    
    
    26,340,107
    
    
    
    25,320,242Shareholders equity:Capital stock, without par value:Class A
shares  Authorized 7,500,000 shares; issued and outstanding 5,000,000 shares
    
    
    
    
    
    
    Class B shares  Authorized 5,000 shares; issued and outstanding 531.68 shares
    
    
    
    
    
    
    Class C shares  Authorized 10,000 shares; issued and outstanding 0 shares
    
    
    
    
    
    
    Additional paid-in capital
    
    
    26,866,634
    
    
    
    26,866,634Retained earnings
    
    
    11,184,650
    
    
    
    8,296,776Accumulated other comprehensive income, net of minority interest and taxes
    
    
    2,497,396
    
    
    
    1,234,027Total shareholders equity
    
    
    40,548,680
    
    
    
    36,397,437Total liabilities and shareholders equity
    
    $
    348,855,723
    
    
    
    332,112,526
 See accompanying notes to the unaudited consolidated condensed financial
statements. 3




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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation) 
 Consolidated Condensed Statements of Operations (Unaudited) For the Three Months EndedMarch 31,2004
    
    2003Premiums earned
    
    $
    34,510,056
    
    
    
    24,592,293Net investment income
    
    
    2,314,140
    
    
    
    1,587,310Net realized investment gains
    
    
    160,770
    
    
    
    82,050Total revenues
    
    
    36,984,966
    
    
    
    26,261,653Losses and loss expenses
    
    
    18,674,975
    
    
    
    13,898,874Amortization of deferred policy acquisition costs
    
    
    8,784,768
    
    
    
    5,796,666Other operating expenses
    
    
    4,102,115
    
    
    
    4,273,654Interest expense
    
    
    415,212
    
    
    
    317,787Total expenses
    
    
    31,977,070
    
    
    
    24,286,981Income before gain on sale of minority interest in subsidiary, net
    
    
    5,007,896
    
    
    
    1,974,672Gain on sale of minority interest in subsidiary, net of transaction fees
    
    
    
    
    
    
    97,499Income before minority interest and income tax expense
    
    
    5,007,896
    
    
    
    2,072,171Minority interest
    
    
    564,124
    
    
    
    490,311Income tax expense
    
    
    1,555,898
    
    
    
    734,333Net income
    
    $
    2,887,874
    
    
    
    847,527Basic and diluted net income per share:Net income
    
    $
    0.58
    
    
    
    0.17Weighted average of shares outstanding
    
    
    5,000,532
    
    
    
    5,000,532
 See accompanying notes to the unaudited consolidated condensed financial
statements. 4




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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation) 
 Consolidated Condensed Statements of Shareholders Equity
and Comprehensive Income (Unaudited) Three Months Ended March 31,2004
    
    2003Shareholders EquityCapital stock:Beginning of year
    
    $
    
    
    
    
    Stock issued
    
    
    
    
    
    
    End of year
    
    
    
    
    
    
    Additional paid-in capital:Beginning of year
    
    
    26,866,634
    
    
    
    26,460,000Issuance of common shares
    
    
    
    
    
    
    End of year
    
    
    26,866,634
    
    
    
    26,460,000Retained earnings:Beginning of year
    
    
    8,296,776
    
    
    
    7,983,259Net income
    
    
    2,887,874
    
    
    
    847,527End of year
    
    
    11,184,650
    
    
    
    8,830,786Accumulated other comprehensive income, net of taxes:Beginning of year
    
    
    1,234,027
    
    
    
    1,952,659Unrealized holding gains arising during the period, net of
reclassification adjustment
    
    
    1,263,369
    
    
    
    390,430End of year
    
    
    2,497,396
    
    
    
    2,343,089Total shareholders equity
    
    $
    40,548,680
    
    
    
    37,633,875Comprehensive IncomeNet income
    
    $
    2,887,874
    
    
    
    847,527Other comprehensive income:Unrealized gains on securities:Unrealized holding gains arising during the period:Gross
    
    
    2,755,995
    
    
    
    785,955Adjustment to minority interest
    
    
    (455,740
    )
    
    
    (117,631
    )Related federal income tax expense
    
    
    (932,385
    )
    
    
    (224,561
    )Net unrealized gains
    
    
    1,367,870
    
    
    
    443,763Reclassification adjustment for gains included in net incomeGross
    
    
    160,770
    
    
    
    82,050Related federal income tax expense
    
    
    (56,269
    )
    
    
    (28,718
    )Net reclassification adjustment
    
    
    104,501
    
    
    
    53,332Other comprehensive income
    
    
    1,263,369
    
    
    
    390,431Total comprehensive income
    
    $
    4,151,243
    
    
    
    1,237,958
 See accompanying notes to the unaudited consolidated condensed financial
statements. 5




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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation) 
 Consolidated Condensed Statements of Cash Flows
(Unaudited) For the Three Months EndedMarch 31,2004
    
    2003Cash flows provided by (used in) operating activities:Net income
    
    $
    2,887,874
    
    
    
    847,527Adjustments:Deferred retroactive reinsurance gain
    
    
    
    
    
    
    (198,315
    )Minority interest
    
    
    564,124
    
    
    
    490,311Net realized investment gains
    
    
    (160,770
    )
    
    
    (82,050
    )Gain on the sale of minority interest in subsidiary
    
    
    
    
    
    
    (312,499
    )Deferred federal income tax (benefit) expense
    
    
    97,140
    
    
    
    (508,156
    )Changes in assets and liabilities:Premiums in course of collection, net
    
    
    127,651
    
    
    
    (2,130,220
    )Deferred policy acquisition costs
    
    
    (1,476,089
    )
    
    
    (1,611,719
    )Prepaid reinsurance premiums
    
    
    (1,365,100
    )
    
    
    (661,249
    )Reinsurance recoverable on paid and unpaid losses, and retroactive, net
    
    
    (266,369
    )
    
    
    (2,303,357
    )Federal income taxes payable
    
    
    1,458,759
    
    
    
    242,490Loss and loss expense reserves
    
    
    7,855,344
    
    
    
    4,953,736Unearned premiums
    
    
    4,887,032
    
    
    
    6,409,658Funds held under retroactive reinsurance contract
    
    
    
    
    
    
    220,851Reinsurance balances payable
    
    
    (579,563
    )
    
    
    (2,781,156
    )Collateral held
    
    
    (1,883,550
    )
    
    
    (144,810
    )Receivable from sale of minority interest in subsidiary
    
    
    
    
    
    
    (5,300,000
    )Other, net
    
    
    251,431
    
    
    
    149,701Net cash provided by (used in) operating activities
    
    
    12,397,914
    
    
    
    (2,719,257
    )Cash flows (used in) provided by investing activities:Purchases of equity securities
    
    
    (25,415,041
    )
    
    
    (50,962,019
    )Purchase of fixed maturity securities available-for-sale
    
    
    (58,996,791
    )
    
    
    (63,617,432
    )Purchase of fixed maturity securities held-to-maturity
    
    
    (209,696
    )
    
    
    Proceeds from sales of equity securities
    
    
    25,868,866
    
    
    
    51,272,649Proceeds from sales and maturities of fixed maturities available-for-sale
    
    
    23,777,283
    
    
    
    48,824,860Proceeds from maturities of fixed maturities held-to-maturity
    
    
    
    
    
    
    250,000Proceeds from sale of minority interest in subsidiary
    
    
    
    
    
    
    2,800,000Short-term investments, net
    
    
    24,256,086
    
    
    
    13,501,760Net cash (used in) provided by investing activities
    
    
    (10,719,566
    )
    
    
    2,069,818Cash flows (used in) provided by financing activities:Issuance of Class C shares by subsidiary
    
    
    
    
    
    
    2,500,000Principal payment on long term debt
    
    
    (234,482
    )
    
    
    (228,213
    )Net cash (used in) provided by financing activities
    
    
    (234,482
    )
    
    
    2,271,787Increase in cash and cash equivalents
    
    
    1,443,866
    
    
    

    1,622,348Cash and equivalents at beginning of year
    
    
    7,300,597
    
    
    
    8,723,777Cash and equivalents at end of year
    
    $
    8,744,463
    
    
    
    10,346,125Supplemental disclosure of cash flow information:Interest paid
    
    $
    434,958
    
    
    
    322,391Federal income taxes paid
    
    $
    
    
    
    
    1,000,000
 See accompanying notes to the unaudited consolidated condensed financial
statements. 6




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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation) 
 Notes to Consolidated Condensed Financial Statements March 31, 2004 (Unaudited)  (1)
    
    Basis of PresentationThe accompanying interim unaudited consolidated condensed financial
statements and notes include the accounts of ProCentury Corporation,
formerly ProFinance Holdings Corporation, (the Company or ProCentury)
and its wholly owned and controlled insurance subsidiaries, Century Surety
Company (Century), Evergreen National Indemnity Company (Evergreen), and
Continental Heritage Insurance Company (Continental). The financial
statements have been prepared in accordance with accounting principles
generally accepted in the United States of America (GAAP) for interim
financial information and with the instructions to Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and notes
required by GAAP for complete financial statements. In the opinion of
management, all adjustments (consisting of normal and recurring adjustments)
considered necessary for a fair presentation of results for the interim
periods have been included. These interim unaudited consolidated condensed
financial statements and related notes should be read in conjunction with
the consolidated financial statements and related notes in the Companys
audited consolidated financial statements, included in the Companys final
prospectus filed with the Securities and Exchange Commission pursuant to
Rule 424 of the Securities Act of 1933, as amended, (the Prospectus) (File
No. 333-111294). The Companys results of operations for interim periods are
not necessarily indicative of the results to be expected for the entire
year.In preparing the interim unaudited consolidated condensed financial
statements, management was required to make certain estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the
interim unaudited consolidated condensed financial statements, and the
reported amounts of revenue and expenses for the reporting period. Actual
results could differ significantly from those estimates.Material estimates that are particularly susceptible to significant change
in the near-term relate to the determination of loss and loss expense
reserves, the recoverability of deferred policy acquisition costs and
deferred tax assets, the net realizable value of reinsurance recoverables,
and the determination of other-than-temporary declines in the fair value of
investments. Although considerable variability is inherent in these
estimates, management believes that the amounts provided are adequate. These
estimates are continually reviewed and adjusted as necessary. Such
adjustments are generally reflected in current operations.These financial statements should be read in conjunction with the following
notes and with the Notes to Consolidated Financial Statements as of and for
the year ended December 31, 2003, included in the Companys Prospectus.On April 26, 2004, the Company issued 8,000,000 common shares in an initial
public offering (the IPO) and received net proceeds (before expenses) of
$78.1 million, based on an initial public offering price of $10.50. As this
transaction did not occur during the period covered by this Form 10-Q, the
accompanying interim unaudited consolidated condensed financial statements
are on a historical basis and do not reflect the following transactions that
occurred in connection with the IPO:  
    
    The spin-off of Evergreen and Continental and related specialty surety lines;
    
    The issuance of common shares and related proceeds from the IPO;
    
    Repayment of the $8.9 million bank indebtedness outstanding at the closing of the IPO; and
    
    Redemption of the $5.0 million Class B common shares and related interest expense of $513,000. All significant intercompany balances and transactions have been eliminated. 7




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(2)
    
    InvestmentsThe Company invests primarily in investment-grade fixed maturities. The
amortized cost, gross unrealized gains and losses and estimated fair value
of fixed maturity securities classified as held-to-maturity were as follows: March 31, 2004Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    valueU.S. Treasury
securities and
obligations of U.S.
government
corporations and
agencies
    
    $
    4,350,280
    
    
    
    86,416
    
    
    
    (1,131
    )
    
    
    4,435,565Total
    
    $
    4,350,280
    
    
    
    86,416
    
    
    
    (1,131
    )
    
    
    4,435,565
 December 31, 2003Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    valueU.S. Treasury
securities and
obligations of U.S.
government
corporations and
agencies
    
    $
    4,153,091
    
    
    
    64,462
    
    
    
    (883
    )
    
    
    4,216,670Total
    
    $
    4,153,091
    
    
    
    64,462
    
    
    
    (883
    )
    
    
    4,216,670
 The amortized cost, gross unrealized gains and losses, and estimated fair
value of fixed maturity and equity securities classified as
available-for-sale were as follows: March 31, 2004Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    valueFixed maturity securities:U.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    35,145,312
    
    
    
    1,008,448
    
    
    
    (19,943
    )
    
    
    36,133,817Obligations of states and
political subdivisions
    
    
    33,373,330
    
    
    
    236,143
    
    
    
    (310,023
    )
    
    
    33,299,450Corporate securities
    
    
    49,707,615
    
    
    
    1,152,361
    
    
    
    (9,668
    )
    
    
    50,850,308Mortgage-backed securities
    
    
    40,651,405
    
    
    
    687,784
    
    
    
    (13,780
    )
    
    
    41,325,409Collateralized mortgage
obligations
    
    
    12,650,838
    
    
    
    118,810
    
    
    
    (34,973
    )
    
    
    12,734,675Asset-backed securities
    
    
    31,520,712
    
    
    
    637,151
    
    
    
    (48,666
    )
    
    
    32,109,197Total fixed maturity securities
    
    
    203,049,212
    
    
    
    3,840,697
    
    
    
    (437,053
    )
    
    
    206,452,856Equities:Equity securities
    
    
    17,735,118
    
    
    
    737,239
    
    
    
    (65,598
    )
    
    
    18,406,759Bond mutual funds
    
    
    8,662,442
    
    
    
    86,468
    
    
    
    
    
    
    

    8,748,910Total equities
    
    
    26,397,560
    
    
    
    823,707
    
    
    
    (65,598
    )
    
    
    27,155,669Total
    
    $
    229,446,772
    
    
    
    4,664,404
    
    
    
    (502,651
    )
    
    
    233,608,525
 8




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December 31, 2003Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    valueFixed maturity securities:U.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    33,341,914
    
    
    
    601,194
    
    
    
    (140,747
    )
    
    
    33,802,361Obligations of states and
political subdivisions
    
    
    10,897,900
    
    
    
    22,993
    
    
    
    (168,844
    )
    
    
    10,752,049Corporate securities
    
    
    46,947,779
    
    
    
    436,715
    
    
    
    (166,788
    )
    
    
    47,217,706Mortgage-backed securities
    
    
    35,577,632
    
    
    
    444,465
    
    
    
    (33,789
    )
    
    
    35,988,308Collateralized mortgage
obligations
    
    
    11,044,873
    
    
    
    54,080
    
    
    
    (77,670
    )
    
    
    11,021,283Asset-backed securities
    
    
    30,160,232
    
    
    
    286,995
    
    
    
    (124,928
    )
    
    
    30,322,299Total fixed maturity securities
    
    
    167,970,330
    
    
    
    1,846,442
    
    
    
    (712,766
    )
    
    
    169,104,006Equities:Equity securities
    
    
    16,040,725
    
    
    
    428,462
    
    
    
    (75,307
    )
    
    
    16,393,880Bond mutual funds
    
    
    10,821,670
    
    
    
    23,401
    
    
    
    (5,896
    )
    
    
    10,839,175Total equities
    
    
    26,862,395
    
    
    
    451,863
    
    
    
    (81,203
    )
    
    
    27,233,055Total
    
    $
    194,832,725
    
    
    
    2,298,305
    
    
    
    (793,969
    )
    
    
    196,337,061
  The Company considers four factors in determining if an other-than-temporary
decline in fair value exists: length of time and extent that a security has
been in an unrealized loss position; the existence of an event that would
impair the issuers future earnings potential; the near-term prospects for
recovery of the fair value of a security; and the intent and ability of the
Company to hold the security until the fair value recovers. Realized losses,
including any provision for other-than-temporary declines in value, are
included in the consolidated statements of operations. No
other-than-temporary declines were realized in the three month periods ended
March 31, 2004 or 2003.  The estimated fair value, related gross unrealized losses, and the length of
time that the securities have been impaired for held-to-maturity securities
that are considered temporarily impaired are as follows: March 31, 2004Less than 12 months
    
    12 months or longer
    
    TotalEstimated
    
    Gross
    
    Estimated
    
    Gross
    
    Estimated
    
    Grossfair
    
    unrealized
    
    fair
    
    unrealized
    
    fair
    
    unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    lossesFixed maturity securities:U.S. Treasury
securities and
obligations of U.S.
government corporations
and agencies
    
    $
    208,566
    
    
    
    (1,131
    )
    
    
    
    
    
    
    
    
    
    
    208,566
    
    
    
    (1,131
    )Total
    
    $
    208,566
    
    
    
    (1,131
    )
    
    
    
    
    
    
    
    
    
    
    208,566
    
    
    
    (1,131
    )
 9




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##### Table of Contents



The estimated fair value, related gross unrealized losses, and the length of
time that the securities have been impaired for available-for-sale
securities that are considered temporarily impaired are as follows: March 31, 2004Less than 12 months
    
    12 months or longer
    
    TotalEstimated
    
    Gross
    
    Estimated
    
    Gross
    
    Estimated
    
    Grossfair
    
    unrealized
    
    fair
    
    unrealized
    
    fair
    
    unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    lossesFixed maturity securities:U.S. Treasury
securities and
obligations of U.S.
government corporations
and agencies
    
    $
    2,729,824
    
    
    
    (19,943
    )
    
    
    
    
    
    
    
    
    
    
    2,729,824
    
    
    
    (19,943
    )Obligations of states
and political
subdivisions
    
    
    21,272,916
    
    
    
    (310,023
    )
    
    
    
    
    
    
    
    
    
    
    21,272,916
    
    
    
    (310,023
    )Corporate securities
    
    
    1,285,505
    
    
    
    (9,662
    )
    
    
    90,225
    
    
    
    (6
    )
    
    
    1,375,730
    
    
    
    (9,668
    )Mortgage-backed
securities
    
    
    2,091,337
    
    
    
    (13,780
    )
    
    
    
    
    
    
    
    
    
    
    2,091,337
    
    
    
    (13,780
    )Collateralized mortgage
obligations
    
    
    2,877,036
    
    
    
    (34,265
    )
    
    
    123,772
    
    
    
    (708
    )
    
    
    3,000,808
    
    
    
    (34,973
    )Asset-backed securities
    
    
    4,441,758
    
    
    
    (25,641
    )
    
    
    943,508
    
    
    
    (23,025
    )
    
    
    5,385,266
    
    
    
    (48,666
    )Total fixed maturity
securities
    
    
    34,698,376
    
    
    
    (413,314
    )
    
    
    1,157,505
    
    
    
    (23,739
    )
    
    
    35,855,881
    
    
    
    (437,053
    )Equities:Equity securities
    
    
    3,302,180
    
    
    
    (44,910
    )
    
    
    202,473
    
    
    
    (20,688
    )
    
    
    3,504,653
    
    
    
    (65,598
    )Bond mutual funds
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total equities
    
    
    3,302,180
    
    
    
    (44,910
    )
    
    
    202,473
    
    
    
    (20,688
    )
    
    
    3,504,653
    
    
    
    (65,598
    )Total
    
    $
    38,000,556
    
    
    
    (458,224
    )
    
    
    1,359,978
    
    
    
    (44,427
    )
    
    
    39,360,534
    
    
    
    (502,651
    )
  At March 31, 2004, there were six securities (five fixed-maturity and one
common stock) that have been in an unrealized loss position for one year or
longer. The one common stock security that was in an unrealized loss
position for 12 months or longer had a fair value that was 90% of book
value at March 31, 2004. Of the five fixed-maturity securities, all but one
security was rated AA or better, and the remaining four only represented
$5,444 of an aggregate unrealized loss. The one fixed-maturity security
that was not rated AA or better, that was in an unrealized loss position for
12 months or longer, had a fair value that was 89% of book value at
March 31, 2004. Management believes that the declines are temporary and are
not indicative of other-than-temporary impairments with these securities.(3)
    
    Loss and Loss Expense ReservesThe liability for losses and loss expenses represent the Companys best
estimate of the ultimate amounts needed to pay both reported and unreported
claims. These estimates are based on quarterly internal actuarial studies
and annually on an independent actuarial study. The Company continually
reviews these estimates and, based on new developments and information, the
Company includes adjustments of the probable ultimate liability in the
operating results for the periods in which the adjustments are made.In the first quarter of 2004 the Company recorded $16.4 million of incurred
losses and loss expenses attributable to the 2004 accident year and $2.2
million attributable to events of prior years.A significant portion of the 2004 prior year increases resulted principally
from construction defect claims in the other liability line in the property
and casualty segment. During the first quarter of 2004, new construction
defect claim counts exceeded expectations. Based on the claim count
experience that has emerged, the Companys actuaries revised the factors
used in the estimation of ultimate construction defect claim counts. This
re-estimation of claim count projection factors produced an increase in the
estimated ultimate cost of construction defect claims. The prior year
development recognized during the quarter for construction defect is
substantially due to adverse claim count experience. The claim severities
for the quarter were in line with the Companys recent experience and
expectations. Additionally, during the quarter, development on pending
claims was favorable and the amount of claims closed continued to exceed the
amount of new claims reported. As of March 31, 2004, we had 572 open claims
relating to construction defect compared to 597 open claims as of December
31, 2003. During the first three months of 2004, 262 new claims were
reported and 287 existing claims were settled or 10




---



##### Table of Contents



dismissed. Our net loss and loss expense reserves for construction defect
claims as of March 31, 2004 were $17.9 million.During the first quarter of 2004, the Company observed increases in paid and
incurred losses and loss expenses on seven commercial auto liability claims.
The net incurred increases on these claims totaled $778,000. The
increases were related to one significant, unanticipated new claim
($155,000), reserve increases related to coverage disputes on three claims
($297,000), and unfavorable changes in conditions relating to three other
claims ($326,000).Due to the development during the quarter, the Company is conducting further
analysis of the nature and impact of the commercial automobile activity. In
addition to its current methods for assessing the overall reserve needs on
this run-off business, the Companys actuaries have undertaken a project
with claims management to assess the range of potential costs on the 51
remaining pending claims.As of March 31, 2004, we had 51 open claims relating to commercial
automobile compared to 63 open claims as of December 31, 2003. During the
first three months of 2004, 4 new claims were reported and 16 existing
claims were settled or dismissed. Our net loss and loss expense reserves for
commercial automobile as of March 31, 2004 were $3.8 million.In the first quarter of 2003, the Company recorded $2.8 million of incurred
losses and loss expenses attributable to events of prior years. During this
period, the Company experienced increases in claims and claim severity above
expectations in the property line that caused changes to the selected
development patterns primarily for the 2002 accident year that caused a
reestimation of reserves on the property line of $2.2 million.(4)
    
    ReinsuranceIn the normal course of business, the Company has entered into various
reinsurance contracts with unrelated reinsurers. The Company participates
in such agreements for the purpose of limiting loss exposure and
diversifying business. Reinsurance contracts do not relieve the Company
from its obligations to policyholders. There have been no significant
changes in the Companys reinsurance program except that the Company is now
retaining the first $500,000 ($300,000 in 2003) of individual property and
casualty losses in our excess of loss contracts effective January 1, 2004.The effects of assumed and ceded reinsurance on premiums written, premiums
earned and loss and loss expenses incurred were as follows: Three Months Ended March 31,2004
    
    2003Premiums written:Direct
    
    $
    50,715,964
    
    
    
    38,643,359Assumed
    
    
    (1,351,835
    )
    
    
    1,281,885Ceded
    
    
    (11,332,141
    )
    
    
    (9,574,722
    )Net premiums written
    
    $
    38,031,988
    
    
    
    30,350,522Premiums earned:Direct
    
    $
    44,493,299
    
    
    
    32,523,762Assumed
    
    
    (16,202
    )
    
    
    982,005Ceded
    
    
    (9,967,041
    )
    
    
    (8,913,474
    )Net premiums earned
    
    $
    34,510,056
    
    
    
    24,592,293Loss and loss expenses incurred:Direct
    
    $
    25,275,179
    
    
    
    19,057,462Assumed
    
    
    (432,088
    )
    
    
    354,884Ceded
    
    
    (6,168,116
    )
    
    
    (5,513,472
    )Net losses and loss expenses incurred
    
    $
    18,674,975
    
    
    
    13,898,874
 11




---



##### Table of Contents





|(5) |  | Deferred Policy Acquisition Costs
|--- |  | ---------------------------------



| |  | The following reflects the amounts of policy acquisitions costs deferred
and amortized:
| |  | ---------------------------------------------------------------------------------------

Three Months Ended March 31,2004
    
    2003Balance at beginning of period
    
    $
    14,642,308
    
    
    
    8,347,246Policy acquisition costs deferred
    
    
    10,260,857
    
    
    
    7,408,393Amortization of deferred policy
acquisition costs
    
    
    (8,784,768
    )
    
    
    (5,796,666
    )Balance at end of period
    
    $
    16,118,397
    
    
    
    9,958,973




|(6) |  | Federal Income Taxes
|--- |  | --------------------



| |  | The income tax expense differed from the amounts computed by applying the
U.S. federal income tax rate of 35% to income before minority interest and
income taxes as a result of the following:
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

For the Three MonthsEnded March 31,2004
    
    2003Federal income tax expense at statutory rate
    
    
    35.00
    %
    
    
    35.00Increase (decrease) attributable to:Nontaxable interest income
    
    
    (0.26
    )
    
    
    (1.03
    )Dividend received deduction net of proration
    
    
    (1.62
    )
    
    
    Tax benefit on the sale of Continental
    
    
    (2.94
    )
    
    
    Tax expense
on the sale of Evergreen
    
    
    
    
    
    
    5.20Other
    
    
    0.89
    
    
    
    (3.73
    )Total
    
    
    31.07
    %
    
    
    35.44




|(7) |  | Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|    |  | The Company is a defendant in various lawsuits. In the opinion of
management, the effects, if any, of such lawsuits are not expected to be
material to the Companys consolidated financial position or results from
operations.                                                                                                                                                                                                                                                                                                                                                     
|   
|(8) |  | Segment Reporting Disclosures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   
|    |  | The Company operates in two segments of the specialty insurance market: the
Property and Casualty Lines (P/C) (including general liability,
multi-peril, and commercial property) and Surety Lines (including specialty
bonds, landfill bonds and bail bonds).                                                                                                                                                                                                                                                                                                                       
|   
|    |  | All investment activities are included in the Investing operating segment.
Exited programs (including workers compensation and commercial auto) are
included in Other (Including Exited Lines) for purposes of segment
reporting.                                                                                                                                                                                                                                                                                                                                                   
|   
|    |  | The Company considers many factors, including economic similarity, the
nature of the underwriting units insurance products, production sources,
distribution strategies and regulatory environment in determining how to
aggregate operating segments.                                                                                                                                                                                                                                                                                                                              
|   
|    |  | Segment profit or loss for each of the Companys operating segments is
measured by underwriting profit or loss. The property and casualty
insurance industry commonly defines underwriting profit or loss as earned
premium net of loss and loss expenses and underwriting, acquisition and
insurance expenses. Underwriting profit or loss does not replace operating
income or net income computed in accordance with GAAP as a measure of
profitability. Segment profit for the Investing operating segment is
measured by net investment income and net realized gains or losses.
|   
|    |  | The Company does not allocate assets to the P/C and Surety operating
segments for management reporting purposes. The total investment portfolio
and cash are allocated to the Investment operating segment.                                                                                                                                                                                                                                                                                                                                                                          

12



---



##### Table of Contents



The following is a summary of segment disclosures: Three Months Ended March 31,2004
    
    2003Segment revenue:P/C
    
    $
    32,052,466
    
    
    
    22,444,835Surety
    
    
    2,711,350
    
    
    
    1,647,579Investing
    
    
    2,474,910
    
    
    
    1,669,360Other (including exited lines)
    
    
    (253,760
    )
    
    
    499,879Segment revenue
    
    $
    36,984,966
    
    
    
    26,261,653Segment profit (loss):P/C
    
    $
    2,686,126
    
    
    
    1,725,848Surety
    
    
    961,533
    
    
    
    472,937Investing
    
    
    2,474,910
    
    
    
    1,669,360Other (including exited lines)
    
    
    (606,756
    )
    
    
    (740,621
    )Segment profit
    
    $
    5,515,813
    
    
    
    3,127,524Segment assets:Investing
    
    $
    239,954,549
    
    
    
    166,087,384Assets not allocated
    
    
    108,901,174
    
    
    
    108,004,399Total consolidated assets
    
    $
    348,855,723
    
    
    
    274,091,783
  The following summary reconciles significant segment items to the
Companys consolidated financial statements: Three Months Ended March 31,2004
    
    2003Income before minority interest and income taxes:Segment profit
    
    $
    5,515,813
    
    
    
    3,127,524Unallocated amounts:Corporate expenses
    
    
    (92,705
    )
    
    
    (835,065
    )Gain on sale of minority interest in subsidiary, net
    
    
    
    
    
    
    97,499Interest expense
    
    
    (415,212
    )
    
    
    (317,787
    )Income before minority interest and income taxes
    
    $
    5,007,896
    
    
    
    2,072,171
  The following is a summary of segment earned premium by group of products: Property
    
    Casualty
    
    Surety
    
    Other
    
    ConsolidatedThree Months ended March 31, 2004:P/C
    
    $
    13,255,024
    
    
    
    18,797,442
    
    
    
    
    
    
    
    
    
    
    
    32,052,466Surety
    
    
    
    
    
    
    
    
    
    
    2,711,350
    
    
    
    
    
    
    
    2,711,350Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (253,760
    )
    
    
    (253,760
    )Earned premiums
    
    $
    13,255,024
    
    
    
    18,797,442
    
    
    
    2,711,350
    
    
    
    (253,760
    )
    
    
    34,510,056Three Months ended March 31, 2003:P/C
    
    $
    9,529,360
    
    
    
    12,915,475
    
    
    
    
    
    
    
    
    
    
    
    22,444,835Surety
    
    
    
    
    
    
    
    
    
    
    1,647,579
    
    
    
    
    
    
    
    1,647,579Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    499,879
    
    
    
    499,879Earned premiums
    
    $
    9,529,360
    
    
    
    12,915,475
    
    
    
    1,647,579
    
    
    
    499,879
    
    
    
    24,592,293
  The Company does not manage property and casualty products at this level
of detail. 13




---



##### Table of Contents



(9)
    
    Initial Public Offering  On April 26, 2004, ProCentury issued 8,000,000 common shares in the IPO and
received net proceeds (before expenses) of $78.1 million. In connection
with the IPO, each outstanding common share was converted into 500
common shares. After the IPO the total number of shares outstanding is
13,101,195. The following transactions were completed in connection with
the IPO:  (a)
    
    Termination of the Intercompany Pooling AgreementEffective January 1, 2004, the intercompany pooling agreement among
ProCentury and its insurance subsidiaries was terminated. As a result of
the termination, the loss and loss expense reserves and unearned premiums
were reallocated with an equal amount of cash and investments to each
insurance subsidiary based on the insurance business it produced as an
individual company. This transaction did not have any impact on the
consolidated financial position or results of operations of the Company.Simultaneously with the termination, pursuant to reinsurance agreements,
all specialty surety business of Century, ProCenturys primary insurance
subsidiary, was transferred to Evergreen and all property and casualty
business and discontinued lines of Evergreen and Continental were
transferred to Century. The initial transfer of this business did not
have any impact on the consolidated financial position or results of
operations of the Company.(b)
    
    Sale of ContinentalOn February 19, 2004, Evergreen bought 100% of the outstanding shares of
Centurys subsidiary Continental for GAAP book value. No gain or loss
resulted from this transaction. However, a net tax benefit of $147,000
resulted from this transaction.(c)
    
    Transfer of Ownership of EvergreenOn April 26, 2004, Century distributed to ProCentury all Class A and B
common shares of Evergreen owned by Century. ProCentury then
distributed these shares on a pro rata basis to Class A shareholders of
ProCentury in the form of a $7.5 million stock dividend. The dividend
was approved by the Ohio Department of Insurance.(d)
    
    Contribution of SurplusOn April 26, 2004, ProCentury used a portion of the proceeds from the
IPO to make a $55.0 million cash capital contribution to Century to
support Centurys ongoing insurance operations.(e)
    
    Redemption of Class B sharesOn April 26, 2004, ProCentury used a portion of the proceeds from the
IPO to redeem all outstanding Class B common shares for $5.0 million.
This transaction resulted in $513,000 of interest expense that was
recorded in April of 2004.(f)
    
    Repayment of Bank DebtOn April 27, 2004, ProCentury used a portion of the proceeds from the
IPO to repay all of its bank debt, which had a balance at March 31, 2004
of $8.9 million. With the repayment of the bank debt, the
outstanding common shares of Century were released as collateral. 14




---



##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following discussion of our financial condition and results of operations
should be read in conjunction with our consolidated financial statements and
the notes to those statements included in this Form 10-Q. The discussion and
analysis below includes certain forward-looking statements that are subject to
risks, uncertainties and other factors described in Cautionary Statement
Regarding Forward-Looking Statementsthat could cause our actual growth,
results of operations, performance and business prospects and opportunities in
2004 and beyond to differ materially from those expressed in, or implied by,
those forward-looking statements. Overview ProCentury is a holding company that underwrites selected property and
casualty and surety insurance through its subsidiaries. On April 26, 2004, we
issued 8,000,000 common shares in the IPO. Immediately prior to the closing of
the IPO we disposed of our subsidiaries, Evergreen and Continental and the
related surety segment. However, the following managements discussion and
analysis covers the financial results of ProCentury prior to the issuance of
the common shares and the disposition of Evergreen and Continental and,
therefore, includes the results of Evergreen and Continental and the related
surety segment. As a niche company, we offer specialty insurance products designed to
meet specific insurance needs of targeted insured groups. The excess and
surplus lines market provides an alternative market for customers with
hard-to-place risks and risks that insurance companies licensed by the state in
which the insurance policy is sold, which are also referred to as admitted
insurers, specifically refuse to write. When we underwrite within the excess
and surplus lines market, we are selective in the lines of business and types
of risks we choose to write. Typically, the development of these specialty
insurance products is generated through proposals brought to us by an agent or
broker seeking coverage for a specific group of clients. We evaluate our insurance operations by monitoring key measures of growth
and profitability. We measure our growth by examining our gross written
premiums. We generally measure our operating results by examining our net
income, return on equity and loss, expense and combined ratios. The following
provides further explanation of the key measures that we use to evaluate our
results: Gross Written Premiums.Gross written premiums is the sum of direct
written premiums and assumed written premiums. We use gross written premiums,
which excludes the impact of premiums ceded to reinsurers, as a measure of the
underlying growth of our insurance business from period to period. Net Written Premiums.Net written premiums is the sum of direct written
premiums and assumed written premiums less ceded written premiums. We use net
written premiums, primarily in relation to gross written premiums, to measure
the amount of business retained after cessions to reinsurers. Loss Ratio.Loss ratio is the ratio (expressed as a percentage) of losses
and loss expenses incurred to premiums earned. Loss ratio generally is measured
on both a gross (direct and assumed) and net (gross less ceded) basis. We use
the gross loss ratio as a measure of the overall underwriting profitability of
the insurance business we write and to assess the adequacy of our pricing. Our
net loss ratio is meaningful in evaluating our financial results, which are net
of ceded reinsurance, as reflected in the accompanying unaudited consolidated
condensed financial statements Expense Ratio.Expense ratio is the ratio (expressed as a percentage) of
net operating expenses to premiums earned and measures a companys operational
efficiency in producing, underwriting and administering its insurance business.
We reduce our operating expenses by ancillary income (excluding net investment
income and realized gains (losses) on securities) to calculate our net
operating expenses. Due to our historically high levels of reinsurance, we
calculate our expense ratio on both a gross basis (before the effect of ceded
reinsurance) and a net basis (after the effect of ceded reinsurance). Although
the net basis is meaningful in evaluating our financial results that are net of
ceded reinsurance, as reflected in the accompanying unaudited consolidated
condensed financial statements, we believe that the gross expense ratio better
reflects the operational efficiency of the underlying business and is a better
measure of future trends. Interest expense is not included in the calculation
of the expense ratio. Combined Ratio.Combined ratio is the sum of the loss ratio and the
expense ratio and measures a companys overall underwriting profit. If the
combined ratio is at or above 100, an insurance company cannot be profitable
without investment income (and may not be profitable if investment income is
insufficient). We use the GAAP combined ratio in evaluating our overall
underwriting profitability and as a measure for comparing our profitability
relative to the profitability of our competitors. 15




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##### Table of Contents



Critical Accounting Policies It is important to understand our accounting policies in order to
understand our financial statements. Management considers certain of these
policies to be critical to the presentation of our financial results, since
they require management to make estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets, liabilities, revenues,
expenses and related disclosures at the financial reporting date and throughout
the period being reported upon. Certain of the estimates result from judgments
that can be subjective and complex, and consequently actual results may differ
from these estimates, which would be reflected in future periods. Our most critical accounting policies involve the reporting of loss and
loss expense reserves (including losses that have occurred but were not
reported to us by the financial reporting date (IBNR)), reinsurance
recoverables, the impairment of invested assets, deferred policy acquisition
costs and deferred taxes. Loss and Loss Expense Reserves.Loss and loss expense reserves represent
an estimate of the expected cost of the ultimate settlement and administration
of losses, based on facts and circumstances then known. We use actuarial
methodologies to assist us in establishing these estimates, including judgments
relative to estimates of future claims severity and frequency, length of time
to develop to ultimate resolution, judicial theories of liability and other
third-party factors that are often beyond our control. Due to the inherent
uncertainty associated with the cost of unsettled and unreported claims, the
ultimate liability may be different from the original estimate. Such estimates
are regularly reviewed and updated and any resulting adjustments are included
in the current periods results. See Note 3 to our unaudited consolidated
condensed financial statements included in this Form 10-Q. Reinsurance Recoverables.Reinsurance recoverables on paid and unpaid
losses, net, are established for the portion of our loss and loss expense
reserves that are ceded to reinsurers. Reinsurance recoverables are determined
based in part on the terms and conditions of reinsurance contracts which could
be subject to interpretations that differ from our own based on judicial
theories of liability. In addition, we bear credit risk with respect to our
reinsurers which can be significant considering that certain of the reserves
remain outstanding for an extended period of time. We are required to pay
losses even if a reinsurer fails to meet its obligations under the applicable
reinsurance agreement. See Note 4 to our unaudited consolidated condensed
financial statements included in this Form 10-Q. Impairment of Invested Assets.Impairment of investment securities results
in a charge to operations when a market decline below cost is deemed to be
other-than-temporary. We regularly review our fixed maturity and equity
securities portfolios to evaluate the necessity of recording impairment losses
for other-than-temporary declines in the fair value of investments. A number of
criteria are considered during this process including, but not limited to: the
current fair value as compared to amortized cost or cost, as appropriate, of
the security; the length of time the securitys fair value has been below
amortized cost or cost and specific credit issues related to the issuer and
current economic conditions. In general, we focus our attention on those
securities whose fair value was less than 80% of their amortized cost or cost,
as appropriate, for six or more consecutive months. In evaluating potential
impairment, we also consider the current fair value compared to amortized cost
or cost, as appropriate, our intent and ability to retain the investment for a
period of time sufficient to allow for an anticipated recovery in value,
specific credit issues related to the issuer and current economic conditions.
Other-than-temporary impairment losses result in a permanent reduction of the
cost basis of the underlying investment. Significant changes in the factors we
consider when evaluating investments for impairment losses could result in a
significant change in impairment losses reported in the unaudited consolidated
condensed financial statements. See Note 2 to our unaudited consolidated
financial statements including in this Form 10-Q. Deferred Policy Acquisition Costs.We defer commissions, premium taxes and
certain other costs that vary with and are primarily related to the acquisition
of insurance contracts. These costs are capitalized and charged to expense in
proportion to premium revenue recognized. The method followed in computing
deferred policy acquisition costs limits the amount of such deferred costs to
their estimated realizable value, which gives effect to the premium to be
earned, related investment income, anticipated losses and settlement expenses
and certain other costs expected to be incurred as the premium is earned.
Judgments as to ultimate recoverability of such deferred costs are highly
dependent upon estimated future loss costs associated with the written
premiums. See Note 5 to our unaudited consolidated condensed financial
statements included in this Form 10-Q. Deferred Taxes.We utilize the asset and liability method of accounting
for income tax. Under this method, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and operating loss and tax credit carry-forwards.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date. Valuation allowances are established
when necessary to reduce the deferred tax assets to the amounts more likely
than not to be realized. 16




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##### Table of Contents



Results of Operations The table below summarizes certain operating results and key measures we
use in monitoring and evaluating our operations. The information is intended to
summarize and supplement information contained in our unaudited consolidated
condensed financial statements and to assist the reader in gaining a better
understanding of our results of operations. Three Months Ended March 31,2004
    
    2003(dollars in thousands)Selected Financial Data:Gross written premiums
    
    $
    49,364
    
    
    
    39,925Net premiums earned
    
    
    34,510
    
    
    
    24,592Net investment income
    
    
    2,314
    
    
    
    1,587Net realized investment gains
    
    
    161
    
    
    
    82Total revenues
    
    
    36,985
    
    
    
    26,261Total expenses
    
    
    31,977
    
    
    
    24,287Other transactions:Gain on sale of minority interest in subsidiary, net
    
    
    
    
    
    
    97Net income
    
    
    2,888
    
    
    
    848Key Financial Ratios:Loss and loss expense ratio
    
    
    54.11
    %
    
    
    56.52Expense ratio
    
    
    37.34
    
    
    
    40.95Combined ratio
    
    
    91.45
    %
    
    
    97.47
 Overview of Operating Results Net income increased to $2.8 million for the three months ended March 31,
2004, compared to net income of $848,000 for the same period in 2003. The
increase in net income was primarily attributable to improved underwriting
results from decreasing current accident year loss and expense ratios, an
increase in premium volume that provided additional underwriting margins, and
an increase in net investment income, including $79,000 increase in net
realized investment gains. Revenues Premiums Premiums include insurance premiums underwritten by our insurance
subsidiaries (which we refer to as direct premiums) and insurance premiums
assumed from other insurers generally in states where we do not currently have
a licensed insurance subsidiary (which we refer to as assumed premiums). We
refer to direct and assumed premiums together as gross premiums. Written premiums refers to the total amount of premiums billed to the
policyholder less the amount of premiums returned, generally as a result of
cancellations, during a given period. Written premiums become premiums earned
as the policy ages. Barring premium changes, if an insurance company writes the
same mix of business each year, written premiums and premiums earned will be
equal, and the unearned premium reserve will remain constant. During periods of
growth, the unearned premium reserve will increase, causing premiums earned to
be less than written premiums. Conversely, during periods of decline, the
unearned premium reserve will decrease, causing premiums earned to be greater
than written premiums. We have historically relied on quota share, excess of loss, and
catastrophe reinsurance primarily to manage our regulatory capital requirements
and also to limit our exposure to loss. Our underwriting business can be divided into three primary segments:  
    
    property/casualty;
    
    surety; and
    
    other (including exited lines). Our property/casualty segment primarily includes general liability,
commercial property and multi-peril insurance for small and mid-sized
businesses. Our surety segment includes landfill, specialty surety and bail
bonds. The other (including exited lines) segment includes workers
compensation, which we exited in January 2002, and commercial auto, which was
exited in May 2000. 17




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##### Table of Contents



The following table presents our gross written premiums in our primary
segments and provides a summary of gross, ceded and net written premiums and
net premiums earned for the periods indicated. Three Months Ended March 31,2004
    
    2003(dollars in thousands)Gross written premiums:Property/casualty
    
    $
    42,865
    
    
    
    33,423Surety
    
    
    8,082
    
    
    
    6,111Other (including exited lines)
    
    
    (1,583
    )
    
    
    391Total gross written premiums
    
    
    49,364
    
    
    
    39,925Ceded written premiums
    
    
    11,332
    
    
    
    9,574Net written premiums
    
    $
    38,032
    
    
    
    30,351Net premiums earned
    
    $
    34,510
    
    
    
    24,592Net written premiums to gross written premiums
    
    
    77.0
    %
    
    
    76.0Net premiums earned to net written premiums
    
    
    90.7
    %
    
    
    81.0
 Gross Written Premiums Gross written premiums increased $9.4 million or 23.6% for the three
months ended March 31, 2004 compared to the same period in 2003. This increase
was due primarily to increased market penetration in our property/casualty and
surety segments, which was slightly offset by amounts representing returned
premiums for our other (including exited lines) segment. During the three
months ended March 31, 2004, gross written premiums for our property/casualty
segment increased $9.4 million or 28.3% due to continued favorable market
conditions that have allowed us to increase our premium volume and prices in
the casualty market for the fourth consecutive year. During the same period,
gross written premiums for our surety segment increased $2.0 million or 32.3%
due primarily to favorable market conditions that allowed us to increase our
volume. The growth in our property/casualty and surety segments was offset by
decrease in written premiums for the other (including exited lines) segment. Net Written and Earned Premiums Net written premiums for the three months ended March 31, 2004 were $38.0
million, representing an increase of 25.3% compared to the same period in 2003.
Net written premiums were consistent with the same period in 2003 of 77.0% of
gross written premiums for the three months ended March 31, 2004. Net premiums
earned, a function of net written premiums, amounted to $34.5 million for the
three months ended March 31, 2004 and were 90.7% of net written premiums. This
is higher than the relationship of net premiums earned to net written premiums
during the same period in 2003, reflecting a change in the 2003 reinsurance
agreements that resulted in a lower percentage of business ceded during 2003
that is earning in 2004. Net Investment Income Our investment portfolio is generally highly liquid and consists
substantially of readily marketable, investment-grade fixed-income securities.
Net investment income is primarily comprised of interest earned on these
securities, net of related investment expenses. Net investment income increased to $2.3 million for the three months ended
March 31, 2004, compared to $1.6 million for the same period in 2003. The
increase was due primarily to an increase in invested assets, including cash.
Invested assets, including cash, increased 41.0% to $248.7 million as of March
31, 2004 from $176.4 million as of March 31, 2003. Our average investment
yield for the first three months of 2004 was 4.3%, which is consistent with the
yield for the same period in 2003. In the first three months of 2004, we
decreased the amount of cash and short-term investments from 14.3% of invested
assets, including cash at December 31, 2003 to 4.3% at March 31, 2004. This
decrease in cash and short-term investments was part of an effort to increase
our investment yield throughout 2004 by investing in higher yielding investment
grade fixed-maturity securities while maintaining the targeted duration and
credit quality of our portfolio. Realized Gains (Losses) on Securities Realized gains and losses on securities are principally affected by
changes in interest rates, the timing of sales of investments and changes in
credit quality of the securities we hold as investments. We realized net investment gains of $161,000 on the sale of securities for
the three months ended March 31, 2004 and $82,000 for the same period in 2003.
These gains did not include any adjustments for other-than-temporary impairment
of securities. 18




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##### Table of Contents



Expenses Losses and Loss Expenses Losses and loss expenses represent our largest expense item and include
(1) payments made to settle claims, (2) estimates for future claim payments and
changes in those estimates for current and prior periods, and (3) costs
associated with settling claims. The items that influence the incurred losses
and loss expenses for a given period include, but are not limited to, the
following:  
    
    the number of exposures covered in the current year;
    
    trends in claim frequency and claim severity;
    
    changes in the cost of adjusting claims;
    
    changes in the legal environment relating to coverage interpretation, theories of liability and jury determinations; and
    
    the re-estimation of prior years reserves in the current year. We continue to perform an internal quarterly actuarial analysis and
establish or adjust (for prior accident quarters) our best estimate of the
ultimate incurred losses and loss expenses to reflect loss development
information and trends that have been updated for the most recent quarters
activity. As of December 31 of each year, we have an independent actuarial
analysis performed of the adequacy of our reserves. Our estimate of ultimate
loss and loss expenses is evaluated and re-evaluated by accident year and by
major coverage grouping and changes in estimates are reflected in the period
the additional information becomes known. Our reinsurance program significantly influences our net retained losses.
In exchange for premiums ceded to reinsurers under quota share and excess of
loss reinsurance agreements, our reinsurers assume a portion of the losses and
loss expenses incurred. Net loss and loss expenses increased to $18.7 million for the three months
ended March 31, 2004 from $13.9 million for the same period in 2003. Net loss
and loss expense ratios for the three months ended March 31, 2004 and 2003 were
54.1% and 56.5%, respectively. Our reserve for losses and loss expenses as of March 31, 2004 was $144.8
million (before the effects of reinsurance) and $102.1 million (after the
effects of reinsurance), as estimated through our internal actuarial analysis.
During 2004, we concluded, through our actuarial analysis, that the December
31, 2003 reserve for losses and loss expenses of $95.2 million (after the
effects of reinsurance) was deficient by $2.2 million primarily on our
construction defect and commercial auto reserves. Excluding construction
defect, we had no prior year development in our property and casualty segment
on accident years 2003, 2002, or 2001. Our reserve for losses and loss expenses (net of the effects of
reinsurance) at March 31, 2004 and December 31, 2003 by line was as follows: Three Months
    
    Year EndedEnded
    
    December 31,March 31, 2004
    
    2003(in thousands)Property/casualty:Casualty
    
    $
    75,712
    
    
    
    71,478Property
    
    
    16,976
    
    
    
    13,806Surety
    
    
    2,165
    
    
    
    2,327Other (including exited lines):Commercial auto
    
    
    3,722
    
    
    
    3,519Workers compensation
    
    
    3,478
    
    
    
    4,031Net reserves for losses and loss expenses
    
    
    102,053
    
    
    
    95,161Plus reinsurance recoverables on unpaid losses at end of period
    
    
    42,785
    
    
    
    41,821Gross reserves for losses and loss expenses
    
    $
    144,838
    
    
    
    136,982
 Based on a first quarter internal actuarial review, we recorded $16.4
million of incurred losses and loss expense attributable to the 2004 accident
year and $2.2 million attributable to events of prior years. The accident year
loss and loss expense ratios for the property and casualty segment for accident
years 2004, 2003, and 2002 were 52.2%, 48.9% and 53.2%, respectively. The
property and casualty segment combined accident year loss and loss expense
ratio for the 2004, 2003, and 2002 year was 50.7%. A significant portion of the 2004 increase for events of prior years
resulted principally from construction defect claims in the 19




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##### Table of Contents



other liability line in the property and casualty segment. During the
first quarter of 2004, new construction defect claim counts exceeded
expectations. As a result, the Companys actuaries revised the factors used in
the estimation of ultimate construction defect claim counts. This
re-estimation of claim count projection factors produced an increase in the
estimated ultimate cost of construction defect claims. The prior year
development recognized during the quarter for construction defect is
substantially due to adverse claim count experience. The claim severities for
the quarter were in line with the Companys recent experience and expectations.
Additionally, during the quarter, development on pending claims was favorable
and the amount of claims closed continued to exceed the amount of new claims
reported. As of March 31, 2004, we had 572 open claims relating to
construction defects compared to 597 open claims as of December 31, 2003.
During the first three months of 2004, 262 new claims were reported and 287
existing claims were settled or dismissed. Our net loss and loss expense
reserves for construction defect claims as of March 31, 2004 were $17.9
million. The re-estimation of construction defect reserves primarily affected
the 1996 and 1997 accident years and the 1999 to 2001 accident years. During the first quarter of 2004, we observed increases in paid and
incurred losses and loss expenses on seven commercial auto liability claims.
The increase in net incurred losses and loss expenses on these claims totaled $778,000. The increases
were related to one significant, unanticipated new claim ($155,000), reserve
increases related to coverage disputes on three claims ($297,000), and
unfavorable changes in conditions relating to three other claims ($326,000). Due to the development during the quarter, we are conducting further
analysis of the nature and impact of the commercial automobile activity. In
addition to its current methods for assessing the overall reserve needs on this
run-off business, the Companys actuaries have undertaken a project with claims
management to assess the range of potential costs on the 51 remaining pending
claims. As of March 31, 2004, we had 51 open claims relating to commercial
automobile compared to 63 open claims as of December 31, 2003. During the first
three months of 2004, four new claims were reported and 16 existing claims were
settled or dismissed. Our net loss and loss expense reserves for commercial
automobile as of March 31, 2004 were $3.8 million. In the first quarter of 2003, the Company recorded $2.8 million of
incurred losses and loss expenses attributable to events of prior years. During
this period, the Company experienced increases in claims and claim severity
above expectations in the property line that caused changes to the selected
development patterns primarily for the 2002 accident year that caused a
reestimation of reserves on the property line of $2.2 million. Operating Expenses Operating expenses include the costs to acquire a policy (included in
amortization of deferred policy acquisition costs), other operating expenses
(including corporate expenses) and interest expense. The following table
presents our amortization of deferred policy acquisition costs, other operating
expenses and related ratios and interest expense for the periods indicated: Three Months Ended March 31,2004
    
    2003(dollars in thousands)Amortization of deferred policy acquisition costs (ADAC)
    
    $
    8,785
    
    
    
    5,797Other operating expenses
    
    
    4,102
    
    
    
    4,274ADAC and other operating expenses
    
    
    12,887
    
    
    
    10,071Interest expense
    
    
    415
    
    
    
    318Total operating expenses
    
    $
    13,302
    
    
    
    10,389Expense ratio:ADAC
    
    
    25.5
    %
    
    
    23.6Other operating expenses
    
    
    11.9
    
    
    
    17.4Total expense ratio (1)
    
    
    37.4
    %
    
    
    41.0
   (1)
    
    Interest expense is not included in the calculation of the expense ratio. Operating expenses increased $3.0 million, or 28.0%, to $13.3 million for
the first three months of 2004 from $10.4 million for the same period in 2003.
The increase was primarily attributable to a $3.0 million increase in amortized
deferred policy acquisition costs, including commission expenses, associated
with the increase in the volume of insurance written and other increases to
support future growth. Additionally, other operating expenses include a
$250,000 non-recurring severance agreement and $100,000 of expenses related to
the IPO that could not be capitalized. In addition, interest expense increased
$97,000 due to interest on the $10.0 million trust preferred security that was
issued in May 2003. The overall decline in the expense ratio was due to an
increase in premiums without a corresponding increase in our fixed
expenditures. 20




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##### Table of Contents



Income Taxes The income tax expense differed from the amounts computed by applying the
U.S. federal income tax rate of 35% to income before minority interest and
income taxes as a result of the following: For the Three MonthsEnded March 31,2004
    
    2003Federal income tax expense at statutory rate
    
    
    35.00
    %
    
    
    35.00Increase (decrease) attributable to:Nontaxable interest income
    
    
    (0.26
    )
    
    
    (1.03
    )Dividend received deduction net of proration
    
    
    (1.62
    )
    
    
    Tax benefit on the sale of Continental
    
    
    (2.94
    )
    
    
    Tax expense
on the sale of Evergreen
    
    
    
    
    
    
    5.20Other
    
    
    0.89
    
    
    
    (3.73
    )Total
    
    
    31.07
    %
    
    
    35.44
 Pro Forma Information In connection with our IPO completed on April 26, 2004, we exited the
specialty surety lines of business written by Evergreen and Continental. To
effect our disposition of these lines of business, Evergreen purchased the
common shares of Continental owned by Century effective January 1, 2004 for
$6.3 million, representing its GAAP book value as of December 31, 2003.
Immediately prior to the completion of the IPO, Century distributed to
ProCentury all of the Class A and B common shares of Evergreen owned by
Century. ProCentury then distributed these shares on a pro rata basis to the
pre-offering Class A shareholders of ProCentury in the form of a stock dividend
that was approved by the Ohio Department of Insurance. As a result of these transactions following the IPO, which we refer to as
the Evergreen and Continental transactions, Century is ProCenturys only
operating insurance subsidiary, and Evergreen and Continental and the related
specialty surety business are no longer a part of ProCentury. The following unaudited pro forma condensed consolidated statement of
operations for the three months ended March 31, 2004 give effect to the
Evergreen and Continental transactions as if they occurred as of January 1,
2004. The transactions are presented in a columnar format beginning with
ProCenturys unaudited condensed consolidated historical information. The Evergreen and Continental Pro Forma column presents historical
information, adjusted on a pro forma basis, to give effect to the termination
of the intercompany pooling agreement that had existed among Century, Evergreen
and Continental and the implementation of reinsurance agreements, transitional
administrative agreements and fronting agreements. In other words, the
Evergreen and Continental Pro Forma column represents the statement of
operations of Evergreen and Continental and their related landfill, specialty
surety and bail bond business that would have been distributed to the
shareholders of ProCentury if the distribution had occurred as of January 1,
2004. The Other column represents adjustments related to the transfer of
proceeds from the sale of Continental and adjustments to remove the effects of
the minority interest ownership of Evergreen. The result of the adjustments, as presented in the ProCentury Pro Forma
column, presents the financial position of ProCentury after giving effect to
the Evergreen and Continental transactions. This column presents financial
information for ProCentury as an excess and surplus lines organization and
includes activity related to the exited lines. The Evergreen and Continental transactions have been accounted for as a
sale and dividend distribution of shares and will not change the historical
accounting basis of ProCenturys unaudited consolidated condensed financial
statements. The unaudited pro forma condensed financial information does not purport
to represent the consolidated financial position or results of operations that
we would have experienced if the Evergreen and Continental transactions had
occurred as of the dates indicated. This information is not intended to project
our consolidated financial position or results of operations for any future
date or period. The pro forma adjustments are based on available information
and assumptions that we believe are factually supportable and reasonable under
the circumstances. The unaudited pro forma condensed consolidated financial
information should be read in conjunction with the accompanying notes and the
other consolidated financial information pertaining to ProCentury included
elsewhere in this report. 21




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##### Table of Contents



Unaudited Pro Forma Condensed Consolidated Statement of Operations
For the Three Months Ended March 31, 2004 EvergreenandProCentury
    
    Continental
    
    
    
    
    
    
    
    
    
    ProCenturyHistorical
    
    Pro Forma
    
    
    
    Other
    
    
    
    Pro Forma(dollars in thousands)Gross written premiums
    
    $
    49,364
    
    
    
    6,491
    
    
    
    
    
    
    
    
    
    
    
    42,873Net written premium
    
    $
    38,032
    
    
    
    1,391
    
    
    
    
    
    
    
    
    
    
    
    36,641Premiums earned
    
    $
    34,510
    
    
    
    2,454
    (1)
    
    
    
    
    
    
    
    
    
    
    32,056Net investment income
    
    
    2,314
    
    
    
    349
    (2)
    
    
    
    
    
    
    
    
    
    
    1,965Net realized investment gains
    
    
    161
    
    
    
    38
    (3)
    
    
    
    
    
    
    
    
    
    
    123Total revenues
    
    
    36,985
    
    
    
    2,841
    
    
    
    
    
    
    
    
    
    
    
    34,144Losses and loss expenses
    
    
    18,675
    
    
    
    (216
    )(1)
    
    
    
    
    
    
    
    
    
    
    18,891Amortization of deferred policy
acquisition costs and other
operating expenses
    
    
    12,887
    
    
    
    930
    (1)
    
    
    
    
    1,009
    (5)
    
    
    
    
    10,948Interest expense
    
    
    415
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    415Total expenses
    
    
    31,977
    
    
    
    714
    
    
    
    
    
    1,009
    
    
    
    
    
    30,254Income (loss) before minority
interest and income tax expense
    
    
    5,008
    
    
    
    2,127
    
    
    
    
    
    (1,009
    )
    
    
    
    
    3,890Minority interest
    
    
    564
    
    
    
    
    
    
    
    
    
    564
    (6)
    
    
    
    
    Income tax expense (benefit)
    
    
    1,556
    
    
    
    731
    (4)
    
    
    
    
    (500
    )(7)
    
    
    
    
    1,325Net income (loss)
    
    $
    2,888
    
    
    
    1,396
    
    
    
    
    
    (1,073
    )
    
    
    
    
    2,565Key Financial RatiosLoss and loss expense ratio
    
    
    54.11
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    58.93
    %Expense ratio
    
    
    37.34
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    34.15Combined Ratio
    
    
    91.45
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    93.08
    %
   (1)
    
    The adjustments for Evergreen and Continental include the termination of
the intercompany pooling agreement and the implementation of the loss
portfolio agreements that occurred effective January 1, 2004. With these
adjustments, the activity in the ProCentury Pro Forma column only
represents activity for the excess and surplus lines operations and
activity related to the other exited lines including the workers
compensation line and commercial automobile.(2)
    
    The investment income adjustment is calculated based on pro forma
investment income balances for Evergreen and Continental and include the
effects of the termination of the intercompany pooling agreement and the
implementation of the loss portfolio agreements. The pro forma investment
income balances for Evergreen and Continental are lower than their actual
investment balances due to the fact that the termination of the
intercompany pooling agreement and the implementation of the loss
portfolio agreement requires Evergreen and Continental to transfer cash
and investments to Century in amounts equal to loss and loss expense
reserves and unearned premium.(3)
    
    Realized gains for Evergreen and Continental represent each companys
actual realized gain activity for the three month ended March 31, 2004.(4)
    
    Income tax expense for Evergreen and Continental represent each companys
actual tax expenses as adjusted by 35% of any pro forma adjustments such
as net investment income. See notes 2 and 3 above.(5)
    
    This adjustment includes the following items that occurred in connection
with the termination of the intercompany pooling agreement, the loss
portfolio transfer and the IPO. More specifically, this adjustment
includes $654,000 of income to ProCentury related to the reallocation of
deferred acquisition costs from the termination of the intercompany
pooling agreement and the loss portfolio transfer, $250,000 of a
nonrecurring expense related to a severance agreement and $105,000 of
expenses related to the IPO that could not be capitalized.(6)
    
    Minority interest resulted from the partial sales of Evergreen that
occurred in 2003 and 2002. As this pro forma assumes that Evergreen is no
longer part of ProCentury, minority interest has been adjusted
accordingly.(7)
    
    The income tax adjustment in the Other column relates to the tax effect
of the sale of Continental to Evergreen and the tax on the adjustments
that are outlined in footnote 5 above. The pro forma income tax provision
has been computed based on our estimated annual effective tax rate, which
differs from the federal income tax rate of 35% principally because of
tax-exempt investment income.   22




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##### Table of Contents



Liquidity and Capital Resources ProCentury is a holding company, the principal assets of which are the
common shares of Century. Although we can generate cash through loans from
banks and issuances of equity securities, our primary source of funds to meet
our short-term liquidity needs, including the payment of dividends to our
shareholders and corporate expenses, is dividends from Century. Centurys
principal sources of funds are underwriting operations, investment income,
proceeds from sales and maturities of investments and dividends from Evergreen
and Continental. Following the IPO, Century no longer receives dividends from
Evergreen or Continental. Centurys primary use of funds is to pay claims and
operating expenses, to purchase investments and to make dividend payments to
us. ProCenturys future liquidity is dependent on the ability of Century to pay
dividends. Our insurance subsidiary is restricted by statute as to the amount of
dividends it may pay without the prior approval of regulatory authorities.
Century may pay dividends to ProCentury without advance regulatory approval
only from unassigned surplus and only to the extent that all dividends in the
current twelve months do not exceed the greater of 10% of total statutory
surplus as of the end of the prior fiscal year or statutory net income for the
prior year. Using these criteria, the available ordinary dividend payable by
Century to ProCentury for 2004 is $6.0 million. Century paid ordinary dividends
of $1.5 million for the three months ended March 31, 2004, $3.0 million in 2003
and $1.8 million in 2002. Centurys ability to pay future dividends to
ProCentury without advance regulatory approval is dependent upon maintaining a
positive level of unassigned surplus, which in turn, is dependent upon Century
generating net income in excess of dividends to ProCentury. Century is required by law to maintain a certain minimum level of surplus
on a statutory basis. Surplus is calculated by subtracting total liabilities
from total admitted assets. The National Association of Insurance Commissioners
(NAIC) has a risk-based capital standard designed to identify property and
casualty insurers that may be inadequately capitalized based on inherent risks
of each insurers assets and liabilities and its mix of net written premiums.
Insurers falling below a calculated threshold may be subject to varying degrees
of regulatory action. As of December 31, 2003, the statutory surplus of Century
was in excess of the prescribed risk-based capital requirements that correspond
to any level of regulatory action. Centurys statutory surplus at December 31,
2003 was $59.7 million and the regulatory action level was $21.2 million. Consolidated net cash provided by operating activities was $12.4 million
for the three months ended March 31, 2004, compared to net cash used by
operating activities of $2.7 million for the three months ended March 31, 2003.
This improvement was primarily attributable to the increase in net written
premiums offset by an increase in paid losses. Net cash used by investing activities was $10.7 million for the three
months ended March 31, 2004, compared to net cash provided by investing
activities of $2.1 million for the three months ended March 31, 2003. This
increase was primarily attributable to the increased level of purchases of
fixed maturities and equity securities. Net cash used in financing activities was $234,000 for the three months
ended March 31, 2004, compared to net cash provided by financing activities of
$2.3 million for the three months ended March 31, 2003. This decrease was
primarily attributable to the proceeds from the issuance of subsidiary stock in
2003 that did not occur in 2004. As of March 31, 2004, the Companys contractual obligations have not
materially changed from the Companys contractual obligations as of December
31, 2003, which are described in the Prospectus. Given our historical cash flow, we believe that cash flow from operating
activities through the end of 2004 will provide sufficient liquidity for our
operations, as well as to satisfy debt service obligations and to pay other
operating expenses. Although we anticipate that we will be able to meet our
cash requirements, we can give no assurance in this regard. Investment Portfolio Our investment strategy is designed to capitalize on our strategy to
generate positive cash flow from our underwriting activities. Preservation of
capital is our first priority, with a secondary focus on maximizing appropriate
risk adjusted return. We seek to maintain sufficient liquidity from operations,
investing and financing activities to meet our anticipated insurance
obligations and operating and capital expenditure needs. The base fixed-income
portfolio is rated investment grade to protect invested assets. We believe that
our investment portfolio is highly liquid and consists substantially of readily
marketable, investment grade fixed-income and equity securities. Our investment
portfolio is managed by two independent investment advisors that operate under
investment guidelines approved by Centurys investment committee. Centurys
investment committee meets at least quarterly and reports to Centurys board of
directors. In addition, we employ stringent diversification rules and balance
our investment credit risk and related underwriting risks to minimize total
potential exposure to any one security or business sector. 23




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Our cash and investment portfolio increased to $248.7 million as of March
31, 2004 from $234.0 million as of December 31, 2003 and is summarized by type
of investment in note 2 to the unaudited consolidated condensed financial
statements. During the first three months of 2004, the Company made an effort
to increase our investment yield throughout 2004 by investing in higher yield
investment grade fixed-maturity securities while maintaining the targeted
duration and credit quality of our portfolio. This increase in net purchases
increased investments in fixed maturity securities from $173.3 million as of
December 31, 2003 to $210.8 million as of March 31, 2004, while investments in
equity securities remained unchanged at $27.2 million as of March 31, 2004.
Despite this increase in invested assets, the average duration and overall
credit quality of the portfolio remained relatively unchanged from December 31,
2003. Accounting Standards Effective December 31, 2003, we adopted the disclosure requirements of
Emerging Issues Task Force (EITF) Issue No. 03-01, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments.
Under the consensus, disclosures are required for unrealized losses on fixed
maturity and equity securities accounted for under SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities,that are accounted for as
either available-for-sale or held-to-maturity. The disclosure requirements
include quantitative information regarding the aggregate amount of unrealized
losses and the associated fair value of the investments in an unrealized loss
position, segregated into periods for which the investments have been in an
unrealized loss position. The consensus also requires certain qualitative
disclosures about the unrealized holdings in order to provide additional
information that we considered in concluding that the unrealized losses were
not other-than-temporary. In addition, in March 2004 the EITF reached consensus
on additional guidance concerning the identification of and accounting for
other-than-temporary impairments and the disclosures required for cost method
investments. We will apply the additional guidance concerning
other-than-temporary impairments during our third quarter beginning July 1,
2004, which is not expected to have a material impact on our consolidated
financial position and results of operations. Beginning with our Annual Report
on Form 10-K for the year ending December 31, 2004, we will make the required
disclosures for cost method investments. Cautionary Statement Regarding Forward-Looking Statements Some of the statements in this report are forward-looking statements as
defined in the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are derived from information that we currently have
and assumptions that we make and may be identified by words such as believes,
anticipates, expects, plans, should, estimates and similar
expressions. We cannot assure you that anticipated results will be achieved,
since actual results may differ materially because of both known and unknown
risks and uncertainties we face. We undertake no obligation to publicly update
or revise any forward-looking statements, whether as a result of new
information, future events or otherwise. Factors that could cause actual
results to differ materially from our forward-looking statements include, but
are not limited to, the following factors:  
    
    our actual incurred losses may be greater than our loss and loss
expense reserves, which could have a material adverse effect on our
financial condition and results of operations;
    
    a decline in our financial rating may result in a reduction of new or
renewal business;
    
    we are subject to extensive regulation, which may adversely affect
our ability to achieve our business objectives, and if we fail to comply
with these regulations, we may be subject to penalties, including fines
and suspensions, which may adversely affect our financial condition and
results of operations;
    
    changes in our operating environment may adversely affect our performance;
    
    our general agents may exceed their authority and could bind us to business outside our underwriting guidelines;
    
    if we lose key personnel or are unable to recruit qualified
personnel, our ability to implement our business strategies could be
delayed or hindered;
    
    our investment results and, therefore, our financial condition may be
impacted by changes in the business, financial condition or operating
results of the entities in which we invest, as well as changes in
interest rates, government monetary policies, general economic
conditions and overall market conditions;
    
    we distribute our products through a select group of general agents,
and there can be no assurance that such relationships will continue, or
if they do continue, that they will remain profitable for us;
    
    we rely on our information technology and telecommunication systems,
and the failure of these systems could materially and adversely affect
our business;
    
    our reinsurers may not pay claims made by us on losses in a timely
fashion;
    
    if we are not able to renew our existing reinsurance or obtain new
reinsurance, either our net exposure would increase or we would have to
reduce the level of our underwriting commitment;
    
    our business is cyclical in nature, which may affect our financial performance;
    
    we compete with a large number of companies in the insurance industry for underwriting revenues;
    
    severe weather conditions and other catastrophes may result in an
increase in the number and amount of claims filed against us; and 24




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
    
    as a holding company, we are dependent on the results of operations
of our insurance subsidiaries and the regulatory and contractual
capacity of our subsidiaries to pay dividends to us. Some states limit
the aggregate amount of dividends our subsidiaries may pay to us in any
twelve-month period, thereby limiting our funds to pay expenses and
dividends. You are cautioned not to place undue reliance on forward-looking
statements, which speak only as of their respective dates. 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the potential economic loss principally arising from
adverse changes in the fair value of financial instruments. The major
components of market risk affecting us are credit risk, equity price risk and
interest rate risk. Credit Risk.Credit risk is the potential economic loss principally
arising from adverse changes in the financial condition of a specific debt
issuer. We address this risk by investing in fixed-income securities that are
investment grade, which are those bonds rated BBB- or higher by Standard &
Poors. We also independently and through our outside independent investment
managers, monitor the financial condition of all of the issuers of fixed-income
securities in our portfolio. We utilize a ratings changes report, a ratings
watch list and an early warning report as part of this process. Finally, we
employ stringent diversification rules that limit our credit exposure to any
single issuer or business sector. Equity Price Risk.Equity price risk is the potential that we will incur
economic loss due to a decline in preferred and common stock prices. We manage
this risk by focusing on a long-term, conservative, value oriented, dividend
driven investment philosophy for our equity portfolio. The equity securities in
our portfolio are primarily mid-to-large capitalization issues with strong
dividend performance. Our strategy remains one of value investing, with
security selection taking precedence over market timing. We also employ
stringent diversification rules that limit our exposure to any individual stock
or business sector. Interest Rate Risk.We had fixed-income, preferred shares and bond mutual
fund investments with a fair value of $232.3 million at March 31, 2004 that are
subject to interest rate risk. We manage our exposure to interest rate risk
through a disciplined asset/liability matching and capital management process.
In the management of this risk, the characteristics of duration, credit quality
and variability of cash flows are critical elements. These risks are assessed
regularly and balanced within the context of our liability and capital
position. The Companys market risk associated with exposure to interest rate risk
has not materially changed from that identified in our Prospectus at December
31, 2003. 
 Item 4. CONTROLS AND PROCEDURES As of the end of the period covered by this quarterly report, the Company
carried out an evaluation, under the supervision and with the participation of
the Companys management, including the Chairman and Chief Executive Officer
(CEO) and the Executive Vice President and Chief Financial Officer (CFO),
of the effectiveness of the design and operation of the Companys disclosure
controls and procedures pursuant to Securities Exchange Act Rule 13a-15
(Disclosure Controls). The Companys management, including the CEO and CFO, does not expect that its
Disclosure Controls will prevent all error and all fraud. A control system, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met. Further,
the design of a control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to their
costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the Company 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. The design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions. Based upon the Companys controls evaluation, the CEO and CFO have concluded
that the Companys Disclosure Controls provide reasonable assurance that the
information required to be disclosed by the Company in its periodic reports is
accumulated and communicated to management, including the CEO and CFO, as
appropriate to allow timely decisions regarding disclosure and is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commissions rules and forms. There were no changes in the Companys internal control over financial
reporting during the Companys most recent fiscal quarter that materially
affected, or are reasonably likely to materially affect, the Companys internal
control over financial reporting. 25




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PART II: OTHER INFORMATION 
 Item 1. Legal Proceedings The Companys subsidiaries are regularly engaged in the defense of claims
arising out of the conduct of the insurance business. The Company does not
believe that such litigation, individually or in the aggregate, will have a
material effect on its consolidated financial condition or results of
operations. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities Not applicable. 
 Item 3. Defaults Upon Senior Securities Not applicable. 
 Item 4. Submission of Matters to a Vote of Security Holders By unanimous written consent as of March 18, 2004, the shareholders of
ProCentury (1) elected the board of directors; (2) acknowledged receipt of the
2003 Audited Financial Statements of ProCentury; (3) adopted a plan of
recapitalization effective upon the closing of the IPO pursuant to which
ProCentury converted each of its issued and outstanding Class A and Class B
Common Shares into 500 common shares, without par value, rounded down to the
nearest whole number to avoid the issuance of fractional shares; and (4)
adopted amended and restated articles of incorporation of ProCentury to effect
the plan of recapitalization. The following individuals were elected as directors of ProCentury to hold
office until the closing of the IPO or until his earlier resignation or
removal: Edward F. Feighan, ChairmanJohn A. MarazzaChristopher J. TimmRobert F. FixJeffrey A. Maffett
 
 Item 5. Other Information Not applicable. 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 3.1
    
    Amended and Restated Articles of Incorporation of ProCentury3.2
    
    Amended and Restated Code of Regulations of ProCentury31.1
    
    Certification of Principal Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act31.2
    
    Certification of Principal Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act32.1
    
    Certification of Principal Executive Officer pursuant to Rule 13a-14(b) of the Exchange
Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002132.2
    
    Certification of Principal Financial Officer pursuant to Rule 13a-14(b) of the Exchange
Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 20021
 ________________ 1These certifications are not deemed to be filed for purposes of Section 18
of the Exchange Act, or otherwise subject to the liability of that section.
These certifications will not be deemed to be incorporated by reference into
any filing under the Securities Act or the Exchange Act, except to the extent
that the registrant specifically incorporates them by reference. 26




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The registrant hereby undertakes to furnish supplementally a copy of any
omitted schedule or other attachment to the Securities and Exchange Commission
upon request. (b) Reports on Form 8-K None. 27




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf of the
undersigned thereunto duly authorized. PROCENTURY CORPORATIONDate: June 4, 2004By:
    
    /s/ Charles D. HammCharles D. HammChief Financial Officer and Treasurer(Principal Financial and Accounting Officer)
 28