##### Table of Contents



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 September 30, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period fromto. 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
     
x          
NO     o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES
     
o          
NO     x As of November 12, 2004, the registrant had 13,155,995 outstanding Common
Shares, without par value.




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PROCENTURY CORPORATION QUARTERLY REPORT ON FORM 10-Q
For the Quarterly Period Ended September 30, 2004 INDEX PagePART I: FINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    3Consolidated Condensed Statements of Operations - For the three and nine months ended
September 30, 2004 and 2003
    
    
    3Consolidated Condensed Balance Sheets - September 30, 2004 and December 31, 2003
    
    
    4Consolidated Condensed Statements of Shareholders Equity and Comprehensive Income - For
the nine months ended September 30, 2004 and 2003
    
    
    5Consolidated Condensed Statements of Cash Flows - For the nine months ended September 30,
2004 and 2003
    
    
    6Notes to Consolidated Condensed Financial Statements - September 30, 2004
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4. Controls and Procedures
    
    
    33PART II: OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    34Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3. Defaults Upon Senior Securities
    
    
    34Item 4. Submission of Matters to a Vote of Security Holders
    
    
    34Item 5. Other Information
    
    
    34Item 6. Exhibits
    
    
    34SIGNATURES
    
    
    35EX-31.1EX-31.2EX-32.1EX-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 Statements of Operations (Unaudited) (dollars in thousands, except per share data) For the Three Months Ended
    
    For the Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Premiums earned
    
    $
    39,543
    
    
    
    28,242
    
    
    
    107,421
    
    
    
    77,772Net investment income
    
    
    2,719
    
    
    
    1,681
    
    
    
    7,094
    
    
    
    4,710Net realized investment gains (losses)
    
    
    (22
    )
    
    
    648
    
    
    
    122
    
    
    
    847Total revenues
    
    
    42,240
    
    
    
    30,571
    
    
    
    114,637
    
    
    
    83,329Losses and loss expenses
    
    
    24,518
    
    
    
    17,130
    
    
    
    64,406
    
    
    
    62,542Amortization of deferred policy
acquisition costs
    
    
    8,526
    
    
    
    6,824
    
    
    
    24,019
    
    
    
    17,929Other operating expenses
    
    
    3,385
    
    
    
    3,918
    
    
    
    10,486
    
    
    
    9,579Interest expense
    
    
    352
    
    
    
    433
    
    
    
    1,113
    
    
    
    1,108Interest expense on the redemption of
Class B shares
    
    
    
    
    
    
    
    
    
    
    518
    
    
    
    Total expenses
    
    
    36,781
    
    
    
    28,305
    
    
    
    100,542
    
    
    
    91,158Income (loss) before loss on sale of
minority interest in subsidiary, net
    
    
    5,459
    
    
    
    2,266
    
    
    
    14,095
    
    
    
    (7,829
    )Loss on sale of minority interest in
subsidiary, net of transaction fees
    
    
    
    
    
    
    (309
    )
    
    
    
    
    
    
    (203
    )Income (loss) before minority interest
and income tax expense (benefit)
    
    
    5,459
    
    
    
    1,957
    
    
    
    14,095
    
    
    
    (8,032
    )Minority interest
    
    
    
    
    
    
    (1,695
    )
    
    
    
    
    
    
    (1,150
    )Income tax expense (benefit)
    
    
    1,747
    
    
    
    583
    
    
    
    4,510
    
    
    
    (2,930
    )Income (loss) from continuing operations
    
    
    3,712
    
    
    
    3,069
    
    
    
    9,585
    
    
    
    (3,952
    )Discontinued operations, net of
minority interest and taxes
    
    
    
    
    
    
    428
    
    
    
    
    
    
    
    991Net income (loss)
    
    $
    3,712
    
    
    
    3,497
    
    
    
    9,585
    
    
    
    (2,961
    )Basic income (loss) per share:Income (loss) from continuing operations
    
    $
    0.28
    
    
    
    0.61
    
    
    
    0.98
    
    
    
    (0.79
    )Discontinued operations, net of
minority interest and taxes
    
    
    
    
    
    
    0.09
    
    
    
    
    
    
    
    0.20Net income (loss)
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.98
    
    
    
    (0.59
    )Diluted net income (loss) per share:Income (loss) from continuing operations
    
    $
    0.28
    
    
    
    0.61
    
    
    
    0.98
    
    
    
    (0.79
    )Discontinued operations, net of
minority interest and taxes
    
    
    
    
    
    
    0.09
    
    
    
    
    
    
    
    0.20Net income (loss)
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.98
    
    
    
    (0.59
    )Weighted average of shares outstanding -
basic
    
    
    13,135,450
    
    
    
    5,000,532
    
    
    
    9,779,529
    
    
    
    5,000,532Weighted average of shares outstanding -
diluted
    
    
    13,179,052
    
    
    
    5,000,532
    
    
    
    9,803,101
    
    
    
    5,000,532Cash dividend per share
    
    $
    0.02
    
    
    
    
    
    
    
    0.02
    
    
    
    
 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 Balance Sheets (Unaudited) (dollars in thousands) September 30, 2004
    
    December 31, 2003AssetsInvestments:Fixed maturities:Available-for-sale, at fair value (amortized cost 2004, $251,045;
2003, $120,701)
    
    $
    252,457
    
    
    
    121,270Held-to-maturity, at amortized cost (fair value 2004, $1,168; 2003,
$1,511)
    
    
    1,145
    
    
    
    1,481Equities (available-for-sale):Equity securities, at fair value (cost 2004, $18,912; 2003, $16,041)
    
    
    19,034
    
    
    
    16,394Bond mutual funds, at fair value (cost 2004, $15,522; 2003, $8,882)
    
    
    15,491
    
    
    
    8,906Short-term investments, at amortized cost
    
    
    2,854
    
    
    
    17,336Total investments
    
    
    290,981
    
    
    
    165,387Cash
    
    
    5,208
    
    
    
    5,814Premiums in course of collection, net
    
    
    10,466
    
    
    
    9,686Deferred policy acquisition costs
    
    
    17,079
    
    
    
    11,714Prepaid reinsurance premiums
    
    
    9,373
    
    
    
    6,700Reinsurance recoverable on paid and unpaid losses, net
    
    
    35,426
    
    
    
    42,042Deferred federal income tax asset
    
    
    4,971
    
    
    
    1,774Receivable from subsidiary available for sale
    
    
    
    
    
    
    26,687Assets available for sale
    
    
    
    
    
    
    59,018Other assets
    
    
    5,435
    
    
    
    3,291Total assets
    
    $
    378,939
    
    
    
    332,113Liabilities and Shareholders EquityLoss and loss expense reserves
    
    $
    146,569
    
    
    
    129,236Unearned premiums
    
    
    80,423
    
    
    
    62,139Long term debt
    
    
    25,000
    
    
    
    34,133Accrued expenses and other liabilities
    
    
    6,480
    
    
    
    6,676Reinsurance balances payable
    
    
    2,637
    
    
    
    4,320Collateral held
    
    
    3,896
    
    
    
    5,716Federal income taxes payable
    
    
    3,688
    
    
    
    2,065Liabilities available for sale
    
    
    
    
    
    
    51,431Total liabilities
    
    
    268,693
    
    
    
    295,716Shareholders equity:Capital stock, without par value:Class A shares - Issued and outstanding 13,155,995 shares at
September 30, 2004 and 4,999,995 shares at December 31, 2003
    
    
    
    
    
    
    Class B shares - None authorized at September 30, 2004 and
authorized 15,000 shares, issued and outstanding 531.68 shares at
December 31, 2003
    
    
    
    
    
    
    Class C shares - None authorized at September 30, 2004 and
authorized 10,000 shares, issued and outstanding 0 shares at
December 31, 2003
    
    
    
    
    
    
    Additional paid-in capital
    
    
    98,610
    
    
    
    26,866Retained earnings
    
    
    10,596
    
    
    
    8,297Accumulated other comprehensive income, net of taxes
    
    
    1,040
    
    
    
    1,234Total shareholders equity
    
    
    110,246
    
    
    
    36,397Total liabilities and shareholders equity
    
    $
    378,939
    
    
    
    332,113
 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) (dollars in thousands) For the Nine Months Ended September 30,2004
    
    2003Shareholders EquityCapital stock:Beginning of period
    
    $
    
    
    
    
    Stock issued
    
    
    
    
    
    
    End of period
    
    
    
    
    
    
    Additional paid-in capital:Beginning of period
    
    
    26,866
    
    
    
    26,460Vesting of restricted common shares
    
    
    111
    
    
    
    Gain on sale of minority interest in subsidiary, net of tax.
    
    
    
    
    
    
    203Issuance of common shares
    
    
    77,931
    
    
    
    Issuance costs
    
    
    (1,298
    )
    
    
    Redemption of Class B shares
    
    
    (5,000
    )
    
    
    End of period
    
    
    98,610
    
    
    
    26,663Retained earnings:Beginning of period
    
    
    8,297
    
    
    
    7,983Net income (loss)
    
    
    9,585
    
    
    
    (2,960
    )Dividend of subsidiary available for sale
    
    
    (7,024
    )
    
    
    Dividend to shareholders
    
    
    (262
    )
    
    
    End of period
    
    
    10,596
    
    
    
    5,023Accumulated other comprehensive income, net of taxes:Beginning of period
    
    
    1,234
    
    
    
    1,952Unrealized holding gains arising during the period, net of
reclassification adjustment
    
    
    370
    
    
    
    54Unrealized holding gains arising during the period,
discontinued operations
    
    
    
    
    
    
    (101
    )Dividend of subsidiary available for sale
    
    
    (564
    )
    
    
    End of period
    
    
    1,040
    
    
    
    1,905Total shareholders equity
    
    $
    110,246
    
    
    
    33,591Comprehensive IncomeNet income (loss)
    
    $
    9,585
    
    
    
    (2,961
    )Other comprehensive income:Unrealized gains on securities:Unrealized holding gains arising during the period:Gross
    
    
    708
    
    
    
    922Related federal income tax expense
    
    
    (259
    )
    
    
    (317
    )Net unrealized gains
    
    
    449
    
    
    
    605Reclassification adjustment for gains included in net incomeGross
    
    
    122
    
    
    
    847Related federal income tax expense
    
    
    (43
    )
    
    
    (296
    )Net reclassification adjustment
    
    
    79
    
    
    
    551Other comprehensive income
    
    
    370
    
    
    
    54Total comprehensive income (loss)
    
    $
    9,955
    
    
    
    (2,906
    )
 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 
 For the Nine months EndedSeptember 30,2004
    
    2003Cash flows provided by operating activities:Net income (loss)
    
    $
    9,585
    
    
    
    (2,961
    )Adjustments:Net realized investment gains
    
    
    (122
    )
    
    
    (847
    )Gain on the sale of minority interest in subsidiary
    
    
    
    
    
    
    (322
    )Deferred federal income tax benefit
    
    
    (3,413
    )
    
    
    (806
    )Minority interest
    
    
    
    
    
    
    (1,150
    )Discontinued operations
    
    
    
    
    
    
    (991
    )Restricted share compensation expense
    
    
    111
    
    
    
    Changes in assets and liabilities:Premiums in course of collection, net
    
    
    (780
    )
    
    
    (8,214
    )Deferred policy acquisition costs
    
    
    (5,365
    )
    
    
    (3,905
    )Prepaid reinsurance premiums
    
    
    (2,673
    )
    
    
    (262
    )Reinsurance recoverable on paid and unpaid losses, net
    
    
    6,616
    
    
    
    (7,301
    )Federal income taxes payable
    
    
    1,623
    
    
    
    (30
    )Loss and loss expense reserves
    
    
    17,333
    
    
    
    34,991Unearned premiums
    
    
    18,284
    
    
    
    19,010Reinsurance balances payable
    
    
    (1,683
    )
    
    
    (2,172
    )Collateral held
    
    
    (1,820
    )
    
    
    (188
    )Receivable for subsidiary available for sale
    
    
    26,687
    
    
    
    (10,733
    )Discontinued operations
    
    
    
    
    
    
    2,209Other, net
    
    
    (1,328
    )
    
    
    1,561Net cash provided by operating activities
    
    
    63,055
    
    
    
    17,889Cash flows used in investing activities:Purchases of equity securities
    
    
    (50,591
    )
    
    
    (84,848
    )Purchases of fixed maturity securities available-for-sale
    
    
    (161,417
    )
    
    
    (93,644
    )Purchases of fixed maturity securities held to maturity
    
    
    
    
    
    
    (1,069
    )Proceeds from sales of equity securities
    
    
    41,132
    
    
    
    74,082Proceeds from sales and maturities of fixed maturity securities available-for-sale
    
    
    30,170
    
    
    
    80,396Proceeds from maturities of fixed maturities held-to-maturity
    
    
    325
    
    
    
    1,100Discontinued operations
    
    
    
    
    
    
    (2,234
    )Short-term investments, net
    
    
    14,482
    
    
    
    (9,805
    )Net cash used in investing activities
    
    
    (125,899
    )
    
    
    (36,022
    )Cash flows provided by financing activities:Issuance of common shares
    
    
    77,931
    
    
    
    Issuance cost
    
    
    (1,298
    )
    
    
    Redemption of Class B common shares
    
    
    (5,000
    )
    
    
    Principal payment on long term debt
    
    
    (9,133
    )
    
    
    (445
    )Issuance of trust preferred securities
    
    
    
    
    
    
    10,000Dividend of subsidiary
    
    
    (262
    )
    
    
    Discontinued operations
    
    
    
    
    
    
    5,000Net cash provided by financing activities
    
    
    62,238
    
    
    
    14,555Decrease in cash and cash equivalents
    
    
    (606
    )
    
    
    (3,578
    )Cash and equivalents at beginning of period
    
    
    5,814
    
    
    
    7,237Cash and equivalents at end of period
    
    $
    5,208
    
    
    
    3,659Supplemental disclosure of cash flow information:Interest paid
    
    $
    1,234
    
    
    
    1,089Federal income taxes paid
    
    $
    6,300
    
    
    
    3,540
 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 September 30, 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 subsidiary, Century Surety
Company (Century). The interim unaudited consolidated condensed 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, the interim unaudited consolidated condensed financial
statements do not include all of the information and notes required by GAAP
for complete financial statements. In the opinion of management, all
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) (Commission File No. 333-111294), in connection with the
Companys initial public offering (the IPO). The Companys results of
operations for interim periods are not necessarily indicative of the results
to be expected for the entire year.On April 26, 2004, the Company issued 8,000,000 common shares at $10.50 per
share in the IPO and received net proceeds (before expenses) of $77.9
million. The following transactions occurred in connection with the IPO:  
    
    Immediately prior to the completion of the IPO, each
outstanding Class A common share was converted into 500 common
 shares. After the conversion, but prior to the completion of the
IPO, the Company had 4,999,995 Class A common shares outstanding.
The share conversion is reflected for all periods presented.
    
    Immediately prior to the completion of the IPO, the common
 shares of Evergreen National Indemnity Company (Evergreen) and its
wholly owned subsidiary, Continental Heritage Insurance Company
(Continental) were distributed as dividends from Century to
ProCentury and then by ProCentury to ProCenturys existing Class A
shareholders. Prior to the dividends, Evergreen was a controlled
subsidiary of Century. The operations of Evergreen and Continental
consisted of ProCenturys historical surety and assumed workers
compensation lines of insurance, which were re-classified (net of
minority interest and income taxes) as discontinued operations in
the accompanying interim unaudited consolidated condensed financial
statements and notes for all periods presented.
    
    The Company issued 8,000,000 Class A common shares and
received net proceeds (before expenses) of $77.9 million.
    
    The Company granted 101,200 restricted common shares and
364,000 stock options to certain employees of ProCentury.
    
    The Company repaid $8.7 million of bank indebtedness
outstanding at the closing of the IPO.
    
    The Company redeemed all of its outstanding Class B common shares for an aggregate redemption price of $5.0 million and
recorded interest expense of $518,000 in connection with the
redemption; and
    
    The Company amended its articles of incorporation to
eliminate the authority to issue Class B and Class C common shares.  Additionally, on August 5, 2004 the Company issued 54,800 of additional
restricted common shares to certain employees of ProCentury. 7




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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.All significant intercompany balances and transactions have been eliminated.Share Option AccountingThe Company follows the provisions of Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees(APB 25), the Financial
Accounting Standards Board (FASB) Interpretation No. 44, Accounting for
Certain Transactions involving Stock Compensation (an interpretation of APB
Opinion No. 25), and other related accounting interpretations for the
Companys share option and restricted common share plans utilizing the
intrinsic value method. The Company also follows the disclosure provisions
of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting
for Stock-Based Compensation,for the Companys share option grants, as
amended by SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure; an amendment of FASB Statement No. 123. This
disclosure requires pro forma net income (loss) and earnings (loss) per
share information, which is calculated assuming the Company has accounted
for its stock option plans under the fair value method described in SFAS
No. 123 and SFAS No. 148.If the Company recorded compensation expense for its share option grants
based on the fair value method, the Companys net income (loss) and
earnings (loss) per share would have been adjusted to the pro forma amounts
as indicated in the following table: For the Three Months Ended
    
    For the Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands, except per share data)Net income (loss):As reported
    
    $
    3,712
    
    
    
    3,497
    
    
    
    9,585
    
    
    
    (2,961
    )Less: Additional share-based employee
compensation expense determined under
fair value-based method for all
awards, net of related tax effects
    
    
    (58
    )
    
    
    
    
    
    
    (106
    )
    
    
    Pro Forma
    
    $
    3,654
    
    
    
    3,497
    
    
    
    9,479
    
    
    
    (2,961
    )Basic income (loss) per common share:As reported
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.98
    
    
    
    (0.59
    )Pro Forma
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.97
    
    
    
    (0.59
    )Diluted income (loss) per common share:As reported
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.98
    
    
    
    (0.59
    )Pro Forma
    
    $
    0.28
    
    
    
    0.70
    
    
    
    0.97
    
    
    
    (0.59
    )
 8




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Restricted common share-based compensation expense of $111,000 ($72,000 net
of tax) is included in reported net income for the three months and nine
months ended September 30, 2004. No share option or restricted common
share-based compensation expense is included in reported net income (loss)
for any period presented for 2003, as the Company had no common share
equivalents granted during 2003.The fair values of the share options and restricted common shares are
estimated on the dates of grant using the Black Scholes option pricing model
with the following weighted average assumptions: Three Months and NineMonthsEnded September 30, 2004Risk free interest rate
    
    
    4.01
    %Dividend yield
    
    
    0.76
    %Volatility factor
    
    
    .221Weighted average expected option life
    
    7 Years
  (2)
    
    Income (loss) per Common ShareBasic income (loss) per share (EPS) excludes dilution and is calculated by
dividing income (loss) available to common shareholders by the
weighted-average number of common shares outstanding for the period. Diluted
EPS reflects the dilution that could occur if securities or other contracts
to issue common shares (common share equivalents) were exercised. When
inclusion of common share equivalents increases the EPS or reduces the loss
per share, the effect on earnings is antidilutive. Under these
circumstances, diluted net earnings or net loss per share is computed
excluding the common share equivalents.On April 21, 2004, the Companys Class A common shares split on a 500 to 1
basis. Prior periods share and per share data has been adjusted to reflect
this split. On April 26, 2004, the Company issued 8,000,000 common shares
and 101,200 restricted common shares, which are reflected in the Companys
share and per share data for all periods after April 26, 2004. In addition,
on August 5, 2004, the Company issued 54,800 restricted common shares which
are reflected in the Companys share and per share data for all periods
after August 5, 2004.Pursuant to disclosure requirements contained in SFAS No. 128, Earnings Per
Share, the following information represents a reconciliation of the
numerator and denominator of the basic and diluted EPS computations
contained in the Companys interim unaudited consolidated condensed
financial statements. For the Three Months Ended September 30, 2004Income
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    AmountBasic EPSIncome available to common shareholders
    
    $
    3,711,358
    
    
    
    13,135,450
    
    
    $
    0.28Effect of Dilutive SecuritiesRestricted common shares
    
    
    
    
    
    
    43,602
    
    
    
    .00Diluted EPSIncome available to common shareholders
    
    $
    3,711,358
    
    
    
    13,179,052
    
    
    $
    0.28
 For the Nine Months Ended September 30, 2004Income
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    AmountBasic EPSIncome available to common shareholders
    
    $
    9,585,135
    
    
    
    9,779,529
    
    
    $
    0.98Effect of Dilutive SecuritiesRestricted common shares
    
    
    
    
    
    
    103,572
    
    
    
    .00Diluted EPSIncome available to common shareholders
    
    $
    9,585,135
    
    
    
    9,883,101
    
    
    $
    0.98
  Diluted EPS is the same as Basic EPS for the three months ended September
30, 2003 and the nine months ended September 30, 2003 because the Company
had no common share equivalents granted during those periods.


9



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##### Table of Contents



(3)
    
    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: September 30, 2004Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    value(dollars in thousands)U.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    1,145
    
    
    
    23
    
    
    
    
    
    
    
    1,168Total
    
    $
    1,145
    
    
    
    23
    
    
    
    
    
    
    
    1,168
 December 31, 2003Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    value(dollars in thousands)U.S. Treasury
securities and
obligations of U.S.
government
corporations and
agencies
    
    $
    1,481
    
    
    
    30
    
    
    
    
    
    
    
    1,511Total
    
    $
    1,481
    
    
    
    30
    
    
    
    
    
    
    
    1,511
 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: September 30, 2004Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    value(dollars in thousands)Fixed maturity securities:U.S. Treasury securities and obligations of
U.S. government corporations and agencies
    
    $
    24,182
    
    
    
    146
    
    
    
    (129
    )
    
    
    24,199Obligations of states and political subdivisions
    
    
    97,944
    
    
    
    1,267
    
    
    
    (329
    )
    
    
    98,882Corporate securities
    
    
    52,175
    
    
    
    322
    
    
    
    (160
    )
    
    
    52,337Mortgage-backed securities
    
    
    34,702
    
    
    
    294
    
    
    
    (47
    )
    
    
    34,949Collateralized mortgage obligations
    
    
    20,862
    
    
    
    60
    
    
    
    (95
    )
    
    
    20,827Asset-backed securities
    
    
    21,180
    
    
    
    196
    
    
    
    (113
    )
    
    
    21,263Total fixed maturity securities
    
    
    251,045
    
    
    
    2,285
    
    
    
    (873
    )
    
    
    252,457Equities:Equity securities
    
    
    18,912
    
    
    
    317
    
    
    
    (195
    )
    
    
    19,034Bond mutual funds
    
    
    15,522
    
    
    
    
    
    
    
    (31
    )
    
    
    15,491Total equities
    
    
    34,434
    
    
    
    317
    
    
    
    (226
    )
    
    
    34,525Total
    
    $
    285,479
    
    
    
    2,602
    
    
    
    (1,099
    )
    
    
    286,982
 10




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##### Table of Contents





December 31, 2003Gross
    
    Gross
    
    EstimatedAmortized
    
    unrealized
    
    unrealized
    
    faircost
    
    gains
    
    losses
    
    value(dollars in thousands)Fixed maturity securities:U.S. Treasury securities and obligations of
U.S. government corporations and agencies
    
    $
    22,300
    
    
    
    189
    
    
    
    (140
    )
    
    
    22,349Obligations of states and political subdivisions
    
    
    7,909
    
    
    
    16
    
    
    
    (145
    )
    
    
    7,780Corporate securities
    
    
    35,671
    
    
    
    382
    
    
    
    (122
    )
    
    
    35,931Mortgage-backed securities
    
    
    25,011
    
    
    
    356
    
    
    
    (6
    )
    
    
    25,361Collateralized mortgage obligations
    
    
    8,611
    
    
    
    38
    
    
    
    (74
    )
    
    
    8,575Asset-backed securities
    
    
    21,199
    
    
    
    196
    
    
    
    (121
    )
    
    
    21,274Total fixed maturity securities
    
    
    120,701
    
    
    
    1,177
    
    
    
    (608
    )
    
    
    121,270Equities:Equity securities
    
    
    16,041
    
    
    
    428
    
    
    
    (75
    )
    
    
    16,394Bond mutual funds
    
    
    8,882
    
    
    
    24
    
    
    
    
    
    
    
    8,906Total equities
    
    
    24,923
    
    
    
    452
    
    
    
    (75
    )
    
    
    25,300Total
    
    $
    145,624
    
    
    
    1,629
    
    
    
    (683
    )
    
    
    146,570




| |  | The Company considers four factors in determining if an other-than-temporary
decline in fair value exists: (1) length of time and extent that a security
has been in an unrealized loss position; (2) the existence of an event that
would impair the issuers future earnings potential; (3) the near-term
prospects for recovery of the fair value of a security; and (4) 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 accompanying interim unaudited
consolidated condensed statements of operations. No other-than-temporary
declines were realized in the nine month period ended September 30, 2004.
For the nine month period ended September 30, 2003, one fixed maturity
security was written down in the amount of $87,000, which was included as a
realized loss in the accompanying interim unaudited consolidated condensed
statements of operations.
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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 presented in the following
table:
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

September 30, 2004Less than 12 months
    
    12 months or longer
    
    TotalEstimated
    
    Gross
    
    Estimated
    
    Gross
    
    Estimated
    
    Grossfair
    
    unrealized
    
    fair
    
    unrealized
    
    fair
    
    unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    losses(dollars in thousands)Fixed maturity securities:U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies
    
    $
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    


11



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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: September 30, 2004Less than 12 months
    
    12 months or longer
    
    TotalEstimated
    
    Gross
    
    Estimated
    
    Gross
    
    Estimated
    
    Grossfair
    
    unrealized
    
    fair
    
    unrealized
    
    fair
    
    unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    losses(dollars in thousands)Fixed maturity securities:U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies
    
    $
    5,258
    
    
    
    (74
    )
    
    
    4,530
    
    
    
    (55
    )
    
    
    9,788
    
    
    
    (129
    )Obligations of states and
political subdivisions
    
    
    20,839
    
    
    
    (247
    )
    
    
    3,860
    
    
    
    (82
    )
    
    
    24,699
    
    
    
    (329
    )Corporate securities
    
    
    13,814
    
    
    
    (112
    )
    
    
    3,379
    
    
    
    (48
    )
    
    
    17,193
    
    
    
    (160
    )Mortgage-backed securities
    
    
    6,993
    
    
    
    (43
    )
    
    
    212
    
    
    
    (4
    )
    
    
    7,205
    
    
    
    (47
    )Collateralized mortgage
obligations
    
    
    11,720
    
    
    
    (82
    )
    
    
    821
    
    
    
    (13
    )
    
    
    12,541
    
    
    
    (95
    )Asset-backed securities
    
    
    6,700
    
    
    
    (51
    )
    
    
    3,802
    
    
    
    (62
    )
    
    
    10,502
    
    
    
    (113
    )Total fixed maturity
securities
    
    
    65,324
    
    
    
    (609
    )
    
    
    16,604
    
    
    
    (264
    )
    
    
    81,928
    
    
    
    (873
    )Equities:Equity securities
    
    
    5,637
    
    
    
    (184
    )
    
    
    300
    
    
    
    (11
    )
    
    
    5,937
    
    
    
    (195
    )Bond mutual funds
    
    
    15,443
    
    
    
    (31
    )
    
    
    48
    
    
    
    
    
    
    
    15,491
    
    
    
    (31
    )Total equities
    
    
    21,080
    
    
    
    (215
    )
    
    
    348
    
    
    
    (11
    )
    
    
    21,428
    
    
    
    (226
    )Total
    
    $
    86,404
    
    
    
    (824
    )
    
    
    16,952
    
    
    
    (275
    )
    
    
    103,356
    
    
    
    (1,099
    )
  At September 30, 2004, the Company had twenty-five fixed maturity securities
that have been in an unrealized loss position for one year or longer.
Twenty-four of these securities are investment grade, of which twenty-two of
these securities are rated A1/A or better (including fourteen securities
which are rated AAA). The two remaining investment grade securities are
rated BBB and have a fair value equal to 98.2% of their book value as of
September 30, 2004. The one security that is not investment grade had a
fair value equal to 96.5% of its book value as of September 30, 2004. All
twenty-five securities are current on interest and principal. Management
believes the declines are temporary and are not indicative of
other-than-temporary impairments.(4)
    
    Loss and Loss Expense Reserves  Liability for losses and loss expenses represents 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.Net loss and loss expenses incurred were $24.5 million for the quarter ended
September 30, 2004 compared to $17.1 million for the quarter ended September
30, 2003. In the third quarter of 2004, the Company recorded $20.6 million
of incurred losses and loss expenses attributable to the 2004 accident year
and $3.9 million attributable to events of prior years. In the third quarter
of 2003, the Company recorded $16.8 million of incurred losses and loss
expenses attributable to the 2003 accident year and $300,000 attributable to
events of prior years.Net loss and loss expenses incurred were $64.4 million for the nine months
ended September 30, 2004 compared to $62.5 million for the nine months ended
September 30, 2003. For the nine months ended September 30, 2004, the
Company recorded $56.4 million of incurred losses and loss expenses
attributable to the 2004 accident year and $8.0 million attributable to
events of prior years. In the first nine months of 2003, the Company
recorded $39.2 million of incurred losses and loss expenses attributable to
the 2003 accident year and $23.3 million attributable to events of prior
years. 12




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##### Table of Contents



A significant portion of the three months and nine months ended September
30, 2004 and 2003 prior year increases resulted principally from
construction defect claims in the other liability line in the property and
casualty segment. During the first nine months of 2004 and 2003, new
construction defect claim counts exceeded expectations. Based on the claim
count experience that 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, causing adverse development on prior accident
years during the three and nine month periods ended September 30, 2003 and September 30, 2004. In addition, in the nine months ended September 30,
 2004, increases in incurred amounts on four claims also increased the amount
of incurred development.As of September 30, 2004, the Company had 575 open claims relating to
construction defect compared to 597 open claims as of December 31, 2003.
During the third quarter of 2004, 269 new claims were reported and 272
existing claims were settled or dismissed. During the nine months ended
September 30, 2004, 773 new claims were reported and 795 existing claims
were settled or dismissed. Our net loss and loss expense reserves for
construction defect claims as of September 30, 2004 were $18.8 million
compared to $18.6 million as of December 31, 2003.Additionally, during the second quarter of 2004, the Company experienced
development related to 19 new contractors claim counts received in the
second quarter and development on pending claims in the 1994 through 1999
accident years. The 19 new claim counts were higher than recent experience
and the development on pending claims exceeded our expectations. This
development does not arise from construction defect claims. A significant
portion of the 2003 prior year development resulted from the
non-construction defect contractor lines.During the first quarter of 2004, the Company recorded 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 first quarter, the Company conducted
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 remaining commercial auto liability pending claims. Based on
this analysis, the Company did not record any additional net incurred losses
in the second and third quarter of 2004.As of September 30, 2004, the Company had 40 open claims relating to
commercial automobile compared to 63 open claims as of December 31, 2003.
During the third quarter of 2004, three new claims were reported and five
existing claims were settled or dismissed. During the nine months ended
September 30, 2004, eight new claims were reported and 31 existing claims
were settled or dismissed. Our net loss and loss expense reserves for
commercial automobile as of September 30, 2004 were $2.4 million compared to
$3.5 million as of December 31, 2003.(5)
    
    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 of 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 the Companys excess of loss contracts effective January 1, 2004. 13




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##### Table of Contents



The effects of assumed and ceded reinsurance on premiums written, premiums
earned and loss and loss expenses incurred were as follows: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Premiums written:Direct
    
    $
    49,963
    
    
    
    36,230
    
    
    
    141,939
    
    
    
    110,069Assumed
    
    
    38
    
    
    
    (93
    )
    
    
    135
    
    
    
    (915
    )Ceded
    
    
    (6,535
    )
    
    
    (4,481
    )
    
    
    (19,042
    )
    
    
    (14,843
    )Net premiums written
    
    $
    43,466
    
    
    
    31,656
    
    
    
    123,032
    
    
    
    94,311Premiums earned:Direct
    
    $
    45,768
    
    
    
    32,652
    
    
    
    124,235
    
    
    
    92,912Assumed
    
    
    95
    
    
    
    (92
    )
    
    
    375
    
    
    
    (559
    )Ceded
    
    
    (6,320
    )
    
    
    (4,318
    )
    
    
    (17,189
    )
    
    
    (14,581
    )Net premiums earned
    
    $
    39,543
    
    
    
    28,242
    
    
    
    107,421
    
    
    
    77,772Loss and loss expenses
incurred:Direct
    
    $
    29,397
    
    
    
    24,114
    
    
    
    76,612
    
    
    
    78,461Assumed
    
    
    575
    
    
    
    779
    
    
    
    2,521
    
    
    
    566Ceded
    
    
    (5,453
    )
    
    
    (7,763
    )
    
    
    (14,727
    )
    
    
    (16,485
    )Net losses and loss
expenses incurred
    
    $
    24,518
    
    
    
    17,130
    
    
    
    64,406
    
    
    
    62,542
  (6)
    
    Deferred Policy Acquisition CostsThe following table reflects the amounts of policy acquisition costs
deferred and amortized: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Balance at beginning of
period
    
    $
    15,616
    
    
    
    10,259
    
    
    $
    11,714
    
    
    
    7,218Policy acquisition costs
deferred
    
    
    9,989
    
    
    
    7,529
    
    
    
    29,384
    
    
    
    21,675Amortization of deferred
policy acquisition costs
    
    
    (8,526
    )
    
    
    (6,824
    )
    
    
    (24,019
    )
    
    
    (17,929
    )Balance at end of period
    
    $
    17,079
    
    
    
    10,964
    
    
    $
    17,079
    
    
    
    10,964
  Amortization of deferred policy acquisition costs for the nine months ended
September 30, 2004 includes a reduction of amortization expense of $2.5
million relating to the transfer of capitalized acquisition costs from
Evergreen and Continental for the property and casualty segment, which was
partially offset by $1.9 million of capitalized acquisition costs for the
surety segment that was transferred from Century to Evergreen and
Continental. These transactions occurred in conjunction with the termination
of the intercompany pooling agreement and the implementation of the loss
portfolio agreements discussed in the Companys Prospectus in The Evergreen
and Continental Transactions.(7)
    
    Federal Income TaxesThe 2004 income tax provision for the quarter and year ended September 30,
2004, has been computed based on our estimated annual effective tax rate of
32.0%, which differs from the federal income tax rate of 35% principally
because of tax-exempt investment income. The estimated tax rate for the
three months ended September 30, 2003 was 29.8% and for the nine months
ended September 30, 2003 was a tax benefit of 36.5%, which differs from the
federal income tax rate of 35% principally because of tax-exempt investment
income. 14




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##### Table of Contents



(8)
    
    Commitments and ContingenciesThe Company is a defendant in various lawsuits in the ordinary course of its
business. 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.(9)
    
    Segment Reporting DisclosuresThe Company operates in the Property and Casualty Lines (P/C) (including
general liability, multi-peril, and commercial property) segment of the
specialty insurance market.All investment activities are included in the Investing 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 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 segment is measured by net investment income and
net realized gains or losses.The Company does not allocate assets to the P/C and Other (including exited
lines) segments for management reporting purposes. The total investment
portfolio and cash are allocated to the Investment operating segment.The following is a summary of segment disclosures: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Segment revenue:P/C
    
    $
    39,550
    
    
    
    28,243
    
    
    
    107,427
    
    
    
    77,796Investing
    
    
    2,697
    
    
    
    2,329
    
    
    
    7,216
    
    
    
    5,557Other (including exited
lines)
    
    
    (7
    )
    
    
    (1
    )
    
    
    (6
    )
    
    
    (24
    )Segment revenue
    
    $
    42,240
    
    
    
    30,571
    
    
    
    114,637
    
    
    
    83,329Segment profit (loss):P/C
    
    $
    2,895
    
    
    
    1,119
    
    
    
    8,469
    
    
    
    (8,488
    )Investing
    
    
    2,697
    
    
    
    2,329
    
    
    
    7,216
    
    
    
    5,557Other (including exited
lines)
    
    
    (4
    )
    
    
    (615
    )
    
    
    (1,119
    )
    
    
    (2,412
    )Segment profit (loss)
    
    $
    5,588
    
    
    
    2,833
    
    
    
    14,566
    
    
    
    (5,343
    )Segment assets:Investing
    
    $
    290,981
    
    
    
    156,254
    
    
    
    290,981
    
    
    
    156,254Assets not allocated
    
    
    87,958
    
    
    
    156,036
    
    
    
    87,958
    
    
    
    156,036Total consolidated assets
    
    $
    378,939
    
    
    
    312,290
    
    
    
    378,939
    
    
    
    312,290
 15




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##### Table of Contents



The following summary reconciles significant segment items to the Companys
interim unaudited consolidated condensed financial statements: Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Income (loss) before
income taxes:Segment profit (loss)
    
    $
    5,588
    
    
    
    2,833
    
    
    
    14,566
    
    
    
    (5,343
    )Unallocated
(expenses) income:Corporate expenses
    
    
    223
    
    
    
    (134
    )
    
    
    1,160
    
    
    
    (1,378
    )Gain on sale of
minority interest
in subsidiary,
net
    
    
    
    
    
    
    (309
    )
    
    
    
    
    
    
    (203
    )Interest expense
    
    
    (352
    )
    
    
    (433
    )
    
    
    (1,113
    )
    
    
    (1,108
    )Interest expense
on redemption of
Class B shares
    
    
    
    
    
    
    
    
    
    
    (518
    )
    
    
    Income (loss)
before minority
interest and
income tax
expense (benefit)
    
    $
    5,459
    
    
    
    1,957
    
    
    
    14,095
    
    
    
    (8,032
    )
  The following is a summary of segment earned premium by group of products: Property
    
    Casualty
    
    Other
    
    Consolidated(dollars in thousands)Three Months ended September 30, 2004:P/C
    
    $
    14,858
    
    
    
    24,692
    
    
    
    
    
    
    
    39,550Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    (7
    )
    
    
    (7
    )Earned premiums
    
    $
    14,858
    
    
    
    24,692
    
    
    
    (7
    )
    
    
    39,543Three Months ended September 30, 2003:P/C
    
    $
    12,229
    
    
    
    16,014
    
    
    
    
    
    
    
    28,243Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )Earned premiums
    
    $
    12,229
    
    
    
    16,014
    
    
    
    (1
    )
    
    
    28,242Nine Months ended September 30, 2004:P/C
    
    $
    42,152
    
    
    
    65,275
    
    
    
    
    
    
    
    107,427Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    (6
    )
    
    
    (6
    )Earned premiums
    
    $
    42,152
    
    
    
    65,275
    
    
    
    (6
    )
    
    
    107,421Nine Months ended September 30, 2003:P/C
    
    $
    33,188
    
    
    
    44,608
    
    
    
    
    
    
    
    77,796Other (including exited lines)
    
    
    
    
    
    
    
    
    
    
    (24
    )
    
    
    (24
    )Earned premiums
    
    $
    33,188
    
    
    
    44,608
    
    
    
    (24
    )
    
    
    77,772
  The Company does not manage property and casualty products at this level of
detail. 16




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##### Table of Contents



(10)
    
    Initial Public OfferingOn April 26, 2004, ProCentury issued 8,000,000 common shares and 101,200
restricted common shares in the IPO and received net proceeds (before
expenses) of $77.9 million. Immediately prior to the IPO, each outstanding
Class A common share was converted into 500 common shares. Immediately after
the IPO, 13,101,195 common shares were outstanding. The following
transactions were completed in contemplation of or in connection with the
IPO:  (a)
    
    Termination of the Intercompany Pooling AgreementEffective January 1, 2004, the intercompany pooling agreement among
ProCenturys 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 with an equal amount of cash. 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 was
recorded by the Company from this transaction. Tax expense of $130,000 is
included in the calculation of our estimated annual effective tax rate.(c)
    
    Transfer of Ownership of EvergreenPrior to the completion of the IPO, 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 the existing Class A
shareholders of ProCentury in the form of a $7.6 million stock dividend. The
dividend was approved by the Ohio Department of Insurance.(d)
    
    Contribution of SurplusProCentury 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 $518,000 of interest expense that was recorded in
April 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 for $8.7 million. With the repayment of the bank
debt, the outstanding common shares of Century were released as collateral.(11)
    
    Discontinued OperationsIn connection with the IPO, the Company exited the surety and assumed
workers compensation lines of business written and assumed by Evergreen and
Continental. To effect the disposition of these lines of business, Evergreen
purchased the common shares of Continental owned by Century on February 19,
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
existing Class A shareholders of ProCentury in the form of a stock dividend. 17




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##### Table of Contents



As a result of these transactions, the surety and assumed workers
compensation business were classified as discontinued operations, which are
recorded net of minority interest and income taxes in all periods presented
in the accompanying interim unaudited consolidated condensed financial
statements. The following table summarizes the Companys discontinued
operations for the following periods: For the Three Months Ended
    
    For the Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Income before
minority interest
and income taxes
    
    $
    
    
    
    
    1,000
    
    
    
    760
    
    
    
    2,468Minority interest
    
    
    
    
    
    
    240
    
    
    
    518
    
    
    
    655Income tax expense
    
    
    
    
    
    
    332
    
    
    
    242
    
    
    
    822Net income
    
    $
    
    
    
    
    428
    
    
    
    
    
    
    
    991
  As a result of the reinsurance transactions discussed in Note 10(a),
Evergreen and Continentals operations consist entirely of the Companys
surety and assumed workers compensation business. Prior to January 1, 2004,
Evergreen and Continental participated in an intercompany pooling agreement
with Century, pursuant to which each company was allocated a portion of the
combined operations of the three companies and therefore, all segments. As a
result, the minority interest owners of Evergreen not only shared in the
discontinued surety and assumed workers compensation businesses but also
shared in Evergreens share of the ongoing operations of Century. The method
used to determine the discontinued operations required management to
identify the portion of the minority interest related to the results from
the discontinued operations.At December 31, 2003, the assets and liabilities available for sale are
broken out into the major categories as follows: December 31, 2003(dollars in thousands)Assets available for saleInvestments
    
    $
    61,357Receivable from subsidiary available for sale
    
    
    (26,687
    )Prepaid reinsurance premium
    
    
    8,226Reinsurance recoverable on paid and unpaid losses, net
    
    
    6,278Other assets
    
    
    9,844Assets available for sale
    
    $
    59,018Liabilities available for saleMinority interest
    
    $
    25,320Loss and loss expense reserves
    
    
    7,746Unearned premium
    
    
    12,595Other liabilities
    
    
    5,770Liabilities available for sale
    
    $
    51,431
  As of September 30, 2003, accumulated other comprehensive income includes
$578,000 of unrealized gains, net of minority interest and taxes, on
investments available for sale. These investments were included in the
dividend of Evergreen.(12)
    
    Dividend to Common ShareholdersOn August 5, 2004, the Board of Directors declared a dividend of $0.02 per
common share that was paid on September 15, 2004. In addition, on November
4, 2004, the Board of Directors declared a dividend of $0.02 per common
share, which is payable on December 2, 2004. 18




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##### Table of Contents



(13)
    
    Line of CreditOn September 8, 2004, the Company obtained a $5,000,000 line of credit with
a maturity date of September 7, 2006 and interest only payments due
quarterly based on LIBOR plus 2.5% of the outstanding balance. All of the
outstanding shares of Century were pledged as collateral. As of September
30, 2004, no amounts were outstanding under the line of credit. 19




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##### 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 interim unaudited consolidated condensed
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 Corporation (ProCentury) is a holding company that
underwrites selected property and casualty and surety insurance through its
subsidiary, Century Surety Company (Century). On April 26, 2004, ProCentury
issued 8,000,000 common shares in an Initial Public Offering (IPO).
Immediately prior to the closing of the IPO, we disposed of our subsidiaries,
Evergreen National Indemnity Company (Evergreen) and Continental Heritage
Insurance Company (Continental), and the related surety and assumed workers
compensation business. As a niche company, ProCentury offers 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 that are generally underserved by admitted insurers,
or insurance companies licensed by the state in which the insurance policy is
sold. We are very selective in the lines of business and types of risks we
choose to write. Typically, we market our specialty insurance products through
a select group of general agents and brokers seeking coverage for a specific
group of clients. Immediately prior to the completion of the IPO, the common shares of
Evergreen and its wholly owned subsidiary, Continental were distributed as
dividends from Century to ProCentury and then by ProCentury to ProCenturys
existing Class A shareholders. Prior to the dividends, Evergreen was a
controlled subsidiary of Century. The operations of Evergreen and Continental
consisted of ProCenturys historical surety and assumed workers compensation
lines of insurance, which were re-classified (net of minority interest and
income taxes) as discontinued operations in the accompanying interim unaudited
consolidated condensed financial statements and notes for all periods
presented. Operations are evaluated by monitoring key measures of growth and
profitability. We measure growth by examining gross written premiums.
Operating results are generally measured by examining net income (loss), return
on equity and loss, expense and combined ratios. The following discussion
provides further explanation of the key measures used to evaluate results: Gross Written Premiums.Gross written premiums are the sum of direct
written premiums and assumed written premiums. Gross written premiums, which
excludes the impact of premiums ceded to reinsurers, are used as a measure of
the underlying growth of our insurance business from period to period. Net Written Premiums.Net written premiums are the sum of direct written
premiums and assumed written premiums less ceded written premiums. Net written
premiums, primarily in relation to gross written premiums, are used 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. The
gross loss ratio is used as a measure of the overall underwriting profitability
of the insurance business written and an assessment of the adequacy of pricing.
The net loss ratio is meaningful in evaluating our financial results, which are
net of ceded reinsurance, as reflected in the accompanying interim unaudited
consolidated condensed financial statements. 20




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##### Table of Contents



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. Operating expenses are reduced by ancillary income (excluding
net investment income and realized gains (losses) on securities) to calculate
net operating expenses. Due to historically high levels of reinsurance, the
expense ratio is calculated 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 financial results that are net of
ceded reinsurance, as reflected in the accompanying interim unaudited
consolidated condensed financial statements, management believes 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). The GAAP combined ratio is used in evaluating the overall
underwriting profitability, and as a measure for comparing our profitability
relative to the profitability of our competitors. Critical Accounting Policies It is important to understand ProCenturys accounting policies in order to
understand the financial statements. Management considers certain of these
policies to be critical to the presentation of 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. The 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. Actuarial methodologies
are used to assist management 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 4 to our interim
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 that could
be subject to interpretations that differ from managements, based on judicial
theories of liability. In addition, we bear credit risk with respect to our
reinsurers that 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 5 to the interim unaudited consolidated
condensed financial statements included in this Form 10-Q. 21




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##### Table of Contents



Impairment of Invested Assets.Impairment of investment securities results
in a charge to operations when a decline in market value below cost is deemed
to be other-than-temporary. Fixed maturity and equity securities portfolios are
reviewed monthly 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: (1)
the current fair value as compared to amortized cost or cost, as appropriate,
of the security; (2) the length of time the securitys fair value has been
below amortized cost or cost; (3) specific credit issues related to the issuer
and current economic conditions; and (4) the intent and ability to hold the
security until the fair value
recovers. In general, management focuses its attention on securities that
have a fair value of less than 80% of their amortized cost or cost, as
appropriate, for six or more consecutive months. In evaluating potential
impairment, consideration is also given to the current fair value compared to
amortized cost or cost, as appropriate, managements 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 these factors considered when evaluating investments for impairment
losses could result in a significant change in impairment losses reported in
the interim unaudited consolidated condensed financial statements. See Note 3
to the interim unaudited consolidated financial statements included in this
Form 10-Q. Deferred Policy Acquisition Costs.Commissions, premium taxes and certain
other costs that vary with and are primarily related to the acquisition of
insurance contracts are deferred. These costs are capitalized and charged as
expenses 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 6 to our interim unaudited consolidated condensed financial
statements included in this Form 10-Q. Deferred Taxes.Income taxes are accounted for under the asset and
liability method of accounting for income tax. Accordingly, 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. 22




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##### Table of Contents



Results of Operations The table below summarizes certain operating results and key measures used
in monitoring and evaluating operations. The information is intended to
summarize and supplement information contained in interim unaudited
consolidated condensed financial statements and to assist the reader in gaining
a better understanding of results of operations. Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Selected Financial Data:Gross written premiums
    
    $
    50,001
    
    
    
    36,137
    
    
    
    142,074
    
    
    
    109,154Net premiums earned
    
    
    39,543
    
    
    
    28,242
    
    
    
    107,421
    
    
    
    77,772Net investment income
    
    
    2,719
    
    
    
    1,681
    
    
    
    7,094
    
    
    
    4,710Net realized investment
gains/(losses)
    
    
    (22
    )
    
    
    648
    
    
    
    122
    
    
    
    847Total revenues
    
    
    42,240
    
    
    
    30,571
    
    
    
    114,637
    
    
    
    83,329Total expenses
    
    
    36,781
    
    
    
    28,305
    
    
    
    100,542
    
    
    
    91,158Other transactions:Loss on sale of minority
interest in subsidiary,
net
    
    
    
    
    
    
    (309
    )
    
    
    
    
    
    
    (203
    )Income (loss) before
minority interest and
income tax expense
(benefit)
    
    
    5,459
    
    
    
    1,957
    
    
    
    14,095
    
    
    
    (8,032
    )Income (loss) from
continuing operations
    
    
    3,712
    
    
    
    3,069
    
    
    
    9,585
    
    
    
    (3,952
    )Discontinued operations,
net of minority interest
and taxes
    
    
    
    
    
    
    428
    
    
    
    
    
    
    
    991Net income (loss)
    
    $
    3,712
    
    
    
    3,497
    
    
    
    9,585
    
    
    
    (2,961
    )Key Financial Ratios:Loss and loss expense ratio
    
    
    62.0
    %
    
    
    60.7
    %
    
    
    60.0
    %
    
    
    80.4
    %Expense ratio
    
    
    30.1
    %
    
    
    38.0
    %
    
    
    32.1
    %
    
    
    35.4
    %Combined ratio
    
    
    92.1
    %
    
    
    98.7
    %
    
    
    92.1
    %
    
    
    115.8
    %
 Overview of Operating Results Net income increased from $3.5 million for the three months ended
September 30, 2003 to $3.7 million for the three months ended September 30,
2004. For the first nine months of 2004, ProCenturys net income was $9.6
million or $0.98 per diluted share, compared to a net loss of $3.0 million or a
net loss of $.59 per diluted share, for the same period in 2003. The increase in net income is attributable to several factors. Loss and
loss expenses attributable to prior accident years were significantly
higher in 2003 than the current year due to
development in our construction defect line and our non-construction defect
casualty lines. In the nine months ended September 30, 2003, we recorded loss
and loss expenses attributable to prior accident years of $23.3 million,
resulting in an overall loss and loss expense ratio of 80.4% for the nine
months ended September 30, 2003, compared to $8.0 million in the nine months
ended September 30, 2004. Loss and loss expense ratios were 62.0% for the three
months ended September 30, 2004 and 60.0% for the nine months ended September
30, 2004. Our 2004 accident year, loss and loss expense ratio was 52.5% at
September 30, 2004. The increase in net income for the nine months ended September 30, 2004
was accompanied by an increase in premium volume and an increase of investment
income due to higher invested assets, primarily related to capital raising
activities and increases in operating cash flows. See Revenues. Net income for the nine months ended September 30, 2004 includes $518,000,
or $337,000 net of taxes, of interest expense related to the redemption of our
Class B shares, $655,000, or $426,000 net of taxes, of reduced amortization of
deferred acquisition costs related to the termination of the intercompany
pooling agreement and
implementation of the loss portfolio transfers and $355,000, or $231,000
net of taxes, of nonrecurring expense related to the IPO. 23




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##### Table of Contents



Gross written premiums increased to $50.0 million for the quarter ended
September 30, 2004, an increase of 38.5% from $36.1 million for the same period
in 2003. The property/casualty segment represents 99.6% of our gross written
premium. Gross written premiums were $142.1 million for the nine months ended
September 30, 2004, an increase of 30.1% from $109.2 million for the same
period in 2003. Net premiums earned were $39.5 million in the third quarter of
2004, an increase of 40.1% compared with the $28.2 million reported for the
third quarter of 2003. Net premiums earned were $107.4 million in the first
nine months of 2004, an increase of 38.0% from $77.8 million for the same
period in 2003. The increase in premium activity in the current year is primarily a result
of favorable market conditions in the casualty market that have allowed us to
increase our premium volume for the fourth consecutive year. This increase is
offset by slightly decreasing property premiums. During the first nine months
of 2004, the pricing environment on certain property lines began to soften as a
result of increased competition on our larger property accounts. In addition,
we have started to experience tightening in our casualty rates as well. This
rate competition has resulted in the loss of certain large property accounts,
as the reduced rates would not have produced the rate of return required
internally. While we have experienced market pressure to maintain rate levels
in some lines, management believes the rates being obtained across all lines
are at levels that support our underwriting profit objectives. Our combined ratio improved to 92.1% for the quarter ended September 30,
2004, compared to 98.7% for the third quarter of 2003. The combined ratio for
the nine months ended September 30, 2004 was 92.1% compared to 115.8% for the
same period of 2003. Discontinued operations represent the historical surety segment and
assumed workers compensation line, which were exited with the disposition of
Evergreen and Continental in April 2004. Revenues Premiums Premiums include insurance premiums underwritten by Century (which are
referred 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 are referred to as assumed premiums). Direct and
assumed premiums combined represent gross premiums. Written premiums are 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. Historically, we have relied on quota share, excess of loss and
catastrophe reinsurance for management of regulatory capital requirements and
also to limit exposure to loss. Our underwriting business is divided into two primary segments:
property/casualty and other (including exited lines). The property/casualty segment primarily includes general liability,
commercial property and multi-peril insurance for small and mid-sized
businesses. The other (including exited lines) segment includes workers
compensation and commercial auto, which were exited in January 2002 and May
2000, respectively. Historically,
surety was written through Continental and Evergreen. Since the
disposition of these two subsidiaries in the second quarter of 2004, the surety
segment is no longer a material part of our business. 24




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##### Table of Contents



The following table presents a summary of gross, ceded and net written
premiums and net premiums earned for the periods indicated. Three Months Ended September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Gross written premiums
    
    $
    50,001
    
    
    
    36,137
    
    
    
    142,074
    
    
    
    109,154Ceded written premiums
    
    
    (6,535
    )
    
    
    (4,481
    )
    
    
    (19,042
    )
    
    
    (14,843
    )Net written premiums
    
    $
    43,466
    
    
    
    31,656
    
    
    
    123,032
    
    
    
    94,311Net premiums earned
    
    $
    39,543
    
    
    
    28,242
    
    
    
    107,421
    
    
    
    77,772Net written premiums
to gross written
premiums
    
    
    86.9
    %
    
    
    87.6
    %
    
    
    86.6
    %
    
    
    86.4
    %Net premiums earned
to net written
premiums
    
    
    91.0
    %
    
    
    89.2
    %
    
    
    87.3
    %
    
    
    82.5
    %
 Gross Written Premiums Gross written premiums increased $13.9 million and $32.9 million for the
three and nine months ended September 30, 2004, respectively, compared to the
same periods in 2003. The increase primarily resulted from favorable market
conditions in the casualty market that have allowed an increase in the casualty
premium volume for the fourth consecutive year. The pricing environment began
to soften on certain property lines during the first nine months of 2004 as a
result of increased competition on the larger property accounts. While property
rates have softened, property premiums did increase 2.8% for the nine months
ended September 30, 2004, compared to the same period of 2003. Property
premiums accounted for 36.3% of gross written premiums for the nine months
ended September 30, 2004, while casualty premiums accounted for 63.7%. For the
nine months ended September 30, 2003, property premiums accounted for 45.2% of
gross written premium and casualty accounted for the remaining 54.8%. Net Written Premiums and Net Premiums Earned Net written premiums for the three months ended September 30, 2004 were
$43.5 million, representing an increase of 37.3% compared to the same period in
2003. For the nine months ended September 30, 2004, net written premiums were
$123.0 million, representing an increase of 30.5% over the same period of 2003.
Net written premiums represented 86.9% of gross written premiums for the three
months ended September 30, 2004. For the nine months ended September 30, 2004,
net written premiums represented 86.6% of gross written premiums. This is
higher than the relationship of net written premiums to gross written premiums
during the same periods in 2003, reflecting an increase in retention for the
current year due to decreased use of facultative reinsurance. This decrease is
attributable to a lower number of property accounts that have been historically
ceded under the facultative treaty. Net premiums earned, a function of net written premiums, were $39.5
million for the three months ended September 30, 2004 or 91.0% of net written
premiums. Net premiums earned were $107.4 million for the nine months ended
September 30, 2004, or 87.3% of net written premiums. This is higher than the
relationship of net premiums earned to net written premiums during the same
periods in 2003, reflecting a higher rate of retention over 2003. Net Investment Income Our investment portfolio is generally highly liquid and consists
substantially of readily marketable, investment-grade fixed maturity and equity
securities. Net investment income is primarily comprised of interest and
dividends earned on these securities, net of related investment expenses. 25




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##### Table of Contents



Net investment income increased to $2.7 million for the three months ended
September 30, 2004, compared to $1.7 million for the same period in 2003. For
the nine months ended September 30, 2004, net investment income
was $7.1 million, compared to $4.7 million for the same period in 2003.
The increase was due primarily to an increase in invested assets, including
cash, partially offset by a lower investment yield. Invested assets, including
cash, increased by $136.3 million to $296.2 million as of September 30, 2004
from $159.9 million as of September 30, 2003. Pre-tax investment yield for the
first nine months ended September 30, 2004 was 3.7%, compared to 4.1% for the
same period in 2003. In the nine months ended September 30, 2004, our cash and
short-term investments decreased from 13.5% of invested assets, at December 31,
2003, to 2.7%. This decrease in cash and short-term investments was part of an
effort to increase investment yield for 2004 by investing in higher yield
investment grade fixed maturity securities while maintaining the targeted
duration and credit quality of the portfolio. In 2004, as part of our effort to improve our after-tax yield, we
increased our allocation to tax exempt bonds. This increase has allowed us to
increase the tax equivalent yield from 4.1% at December 31, 2003 to 4.6% at
September 30, 2004, which has created an overall gross tax
savings of $319,000 for the three months
ended September 30, 2004 and $584,000
for the nine months ended September 30, 2004. 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 held as investments. For the three months ended September 30, 2004, net realized losses were
$22,000, and for the nine months ended September 30, 2004, net realized gains
were $122,000. For the three months ended September 30, 2003, net realized
gains were $648,000, and for the nine months ended September 30, 2003, net
realized gains were $847,000. No other-than-temporary declines were realized in
the nine month period ended September 30, 2004. For the nine month period ended
September 30, 2003, one fixed maturity security was written down in the amount
of $87,000, which was included as a realized loss in the accompanying interim
unaudited consolidated condensed financial statements. 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 periods) 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. Changes in estimates are reflected in the period the
additional information becomes known. 26




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##### Table of Contents



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 losses and loss expenses increased to $24.5 million for the three
months ended September 30, 2004 from $17.1 million for the same period in 2003.
For the nine months ended September 30, 2004, net losses and loss expenses were
$64.4 million, compared to $62.5 million for the same period in 2003. Net
losses and loss expense ratios for the three months ended September 30, 2004
and 2003 were 62.0% and 60.7%, respectively. The net losses and loss expense
ratios for the nine months ended September 30, 2004 and 2003 were 60.0% and
80.4%, respectively. Our reserve for losses and loss expenses as of September 30, 2004 was
$146.6 million (before the effects of reinsurance) and $115.8 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 $92.8 million (after
the effects of reinsurance) was deficient by $8.0 million primarily on our
construction defect and commercial auto reserves. Our reserve for losses and loss expenses (net of the effects of
reinsurance) at September 30, 2004 and December 31, 2003 by line was as
follows: September 30,
    
    December 31,2004
    
    2003(in thousands)Property/casualty:Casualty
    
    $
    92,230
    
    
    
    71,478Property
    
    
    17,631
    
    
    
    13,806Other (including exited lines):Commercial auto
    
    
    2,647
    
    
    
    3,519Workers compensation
    
    
    3,250
    
    
    
    4,031Net reserves for losses and loss expenses
    
    
    115,758
    
    
    
    92,834Plus reinsurance recoverables on unpaid losses at end of period
    
    
    30,811
    
    
    
    36,402Gross reserves for losses and loss expenses
    
    $
    146,569
    
    
    
    129,236
 Based on the third quarter 2004 internal actuarial review, the Company
recorded $20.6 million of incurred losses and loss expenses attributable to the
2004 accident year and $3.9 million attributable to events of prior years for
the three months ended September 30, 2004. For the nine months ended September
30, 2004, the Company recorded $56.4 million of incurred losses and loss
expenses attributable to the 2004 accident year and $8.0 million attributable
to events of prior years. The accident year losses and loss expense ratios for
the property and casualty segment for accident years 2004, 2003 and 2002 were
52.3%, 48.6% and 53.5%, respectively. As of September 30, 2004, the property
and casualty segment combined accident year losses and loss expense ratio in
total for the 2004, 2003 and 2002 years was 51.1%. A significant portion of the three months and nine months ended September
30, 2004 and 2003 prior year increases resulted principally from construction
defect claims in the other liability line in the property and casualty segment.
During the first nine months of 2004 and 2003, 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
three and nine month periods ended September 30, 2004 and September 30, 2003
for construction defect was substantially due to adverse claim count
experience. In addition, in the nine months ended September 30, 2004, increases
in incurred amounts on four claims also increased the amount of incurred
development. 27




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##### Table of Contents



As of September 30, 2004, we had 575 open claims relating to construction
defect compared to 597 open claims as of December 31, 2003. During the third
quarter of 2004, 269 new claims were reported and 272 existing claims were
settled or dismissed. During the nine months ended September 30, 2004, 773 new
claims were reported and 795 existing claims were settled or dismissed. Our net
loss and loss expense reserves for construction defect claims as of September
30, 2004 were $18.8 million compared to $18.6 million as of December 31, 2003. Additionally, during the second quarter of 2004, the Company experienced
development related to 19 new contractors claim counts received in the second
quarter and development on pending claims in the 1994 through 1999 accident
years. The 19 new claim counts were higher than recent experience and the
development on pending claims exceeded our expectations. This development does
not arise from construction defect claims. A significant portion of the 2003
prior year development resulted from the non construction defect contractors
lines. During the first quarter of 2004, the Company recorded 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 first quarter, the Company conducted
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
remaining commercial auto liability pending claims. Based on this analysis, the
Company did not record any additional net incurred losses in the second and
third quarter of 2004. As of September 30, 2004, the Company had 40 open claims relating to
commercial automobile compared to 63 open claims as of December 31, 2003.
During the third quarter of 2004, three new claims were reported and five
existing claims were settled or dismissed. During the nine months ended
September 30, 2004, eight new claims were reported and 31 existing claims were
settled or dismissed. Our net loss and loss expense reserves for commercial
automobile as of September 30, 2004 were $2.6 million compared to $3.5 million
as of December 31, 2003. 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 September 30,
    
    Nine Months Ended September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands)Amortization of deferred
policy acquisition costs
(ADAC)
    
    $
    8,526
    
    
    
    6,824
    
    
    
    24,019
    
    
    
    17,929Other operating expenses
    
    
    3,385
    
    
    
    3,918
    
    
    
    10,486
    
    
    
    9,579ADAC and other operating
expenses
    
    
    11,911
    
    
    
    10,742
    
    
    
    34,505
    
    
    
    27,508Interest expense
    
    
    352
    
    
    
    433
    
    
    
    1,113
    
    
    
    1,108Interest expense on the
redemption of Class B
shares
    
    
    
    
    
    
    
    
    
    
    518
    
    
    
    Total operating expenses
    
    $
    12,263
    
    
    
    11,175
    
    
    
    36,136
    
    
    
    28,616Expense ratio:ADAC
    
    
    21.5
    %
    
    
    24.2
    %
    
    
    22.3
    %
    
    
    23.1
    %Other operating expenses
    
    
    8.6
    %
    
    
    13.9
    %
    
    
    9.8
    %
    
    
    12.3
    %Total expense ratio (1)
    
    
    30.1
    %
    
    
    38.0
    %
    
    
    32.1
    %
    
    
    35.4
    %
   (1)
    
    Interest expense and interest expense on the redemption of the Class B
shares are not included in the calculation of the expense ratio. 28




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##### Table of Contents



Operating expenses increased $1.1 million, or 9.7%, to $12.3 million for
the three month period ended September 30, 2004 from $11.2 million for the same
period in 2003. For the nine months ended September 30, 2004, operating
expenses increased $7.5 million, or 26.3%, to $36.1 million. The increases are
primarily attributable to an increase in ADAC, including commission expenses.
This increase resulted from an increase in the volume of insurance written. For
the nine months ended September 30, 2004, the increase is offset by $655,000 of
reductions to amortization expense that related to the termination of the
intercompany pooling agreement and the implementation of the loss portfolio
transfers that occurred on January 1, 2004. Other operating expenses decreased slightly to $3.4 million for the third
quarter 2004 compared to $3.9 million for the same period in 2003.
Additionally, for the nine months ended September 30, 2004, other operating
expenses increased compared to the same period in 2003 due to a $1.2 million
reduction in 2003 related to a bonus expense that was not paid due to the
projected overall 2003 net loss. Without the 2003 reduction of the 2002 bonus
accrual, the overall expense ratio for the nine months ended September 30, 2003
would have been 36.9%, which is 4.8 percentage points higher than that of the
same period in 2004. The lower expense ratio in the three and nine month
periods ended September 30, 2004 is due to an increase in operational
efficiencies achieved through a focus on expense management. In addition, the
nine months ended September 30, 2004 balance includes $250,000 of expenses
related to a non-recurring severance agreement and $105,000 of expenses related
to the IPO that could not be capitalized. The decrease in interest expense related to the payoff of the $8.7 million
bank loan in April 2004 is offset by the fact that interest expense in 2003
only included interest on the $10.0 million trust preferred security that was
not issued until May 2003. In addition, in April 2004, we used a portion of the
IPO proceeds to redeem our Class B shares. With this redemption, we recorded
$518,000 of interest expense which is included in operating expenses. Income Taxes The 2004 income tax provision for the quarter and year ended September 30,
2004, has been computed based on our estimated annual effective tax rate of
32.0%, which differs from the federal income tax rate of 35% principally
because of tax-exempt investment income. The estimated tax rate for the three
months ended September 30, 2003 was 29.8% and for the nine months ended
September 30, 2003 was a tax benefit of 36.5%, which differs from the federal
income tax rate of 35% principally because of tax-exempt investment income. 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 and
proceeds from sales and maturities of investments. 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. Century is restricted by statute as to the amount of dividends it may pay
without the prior approval of regulatory authorities. It 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 distributed ordinary dividends of $3.7 million and $5.4
of extraordinary dividends for the nine months ended September 30, 2004, $2.3
million of ordinary dividends in the first nine months of 2003 and $1.5 million
of ordinary dividends in the first nine months of 2002. Of the total dividends
in 2004, $7.6 million consisted of the dividend of Centurys interest in
Evergreen. 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. 29




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##### Table of Contents



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. The
statutory surplus at September 30, 2004 was $109.4 million. Net cash provided by operating activities was $63.1 million for the nine
months ended September 30, 2004, compared to $17.9 million for the nine months
ended September 30, 2003. This improvement was primarily attributable to the
increase in net written premiums partially offset by an increase in paid
losses. Net cash used by investing activities was $125.9 million for the nine
months ended September 30, 2004, compared to net cash used by investing
activities of $36.0 million for the nine months ended September 30, 2003. This
increase was primarily attributable to the increased level of purchases of
fixed maturity securities. Net cash provided by financing activities was $62.2 million for the nine
months ended September 30, 2004, compared to net cash provided by financing
activities of $14.6 million for the nine months ended September 30, 2003. This
increase in cash provided by financing activities is directly related to the
proceeds from the IPO, which was reduced by the redemption of the Class B
shares, the repayment of the bank debt, and the dividend of Evergreen. During the nine months ended September 30, 2004, we repaid our $8.7
million of bank debt with the proceeds from our IPO in April 2004. In
addition, on September 8, 2004, we obtained a $5,000,000 line of credit with a
maturity date of September 7, 2006 and interest only payments due quarterly
based on LIBOR plus 2.5% of the outstanding balance. All of the outstanding
shares of Century were pledged as collateral. As of September 30, 2004, no
borrowings were made under the line of credit. Our remaining contractual obligations have not materially changed from our
contractual obligations as of December 31, 2003, which are described in the
Prospectus. In addition, during the second quarter of 2004, we redeemed all of
our Class B common shares for $5.0 million. Given our historical cash flow, we believe that cash flow from operating
activities for the next twelve months will provide sufficient liquidity for our
operations, as well as to satisfy debt service obligations and 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 ProCentury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. 30




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##### Table of Contents



Our cash and investment portfolio increased to $296.2 million as of
September 30, 2004 from $171.2 million as of December 31, 2003 and is
summarized by type of investment in note 3 to the interim unaudited
consolidated condensed financial statements. During the first nine months of
2004, the Company increased taxable equivalent yield to 4.7% at September 30,
2004 from 4.1% at December 31, 2003, by investing in higher yield investment
grade fixed-maturity securities and tax exempt municipal bonds while
maintaining the targeted duration and credit quality of our portfolio. Our
fixed maturity securities increased from $122.8 million as of December 31, 2003
to $253.6 million as of September 30, 2004, and equity securities from $25.3
million as of December 31, 2003 to $34.5 million as of September 30, 2004.
During the nine months ended September 30, 2004, we extended the duration of
the fixed income portfolio from 3.3 years at December 31, 2003 to 4.3 years at
September 30, 2004, and increased the allocation to municipals from 4.7% of the
total investment portfolio at December 31, 2003 to 34.0% at September 30, 2004.
Despite the increase in invested assets, the increase in the allocation to
municipals and the extension of the duration, the overall credit quality of the
portfolio remained unchanged from December 31, 2003. Accounting Standards The Emerging Issues Task Force (EITF) has reached a consensus regarding
Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments, pursuant to which 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. Effective December 31, 2003, we adopted the disclosure
requirements of the EITFs consensus, which 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. On
September 30, 2004, the Financial Accounting Standards Board (FASB) delayed the
effective date for the measurement and recognition guidance contained in
paragraphs 10-20 of EITF Issue No. 03-1. We will continue to monitor the
activities of the EITF and FASB concerning the additional guidance on the
identification of and accounting for other-than-temporary impairments and the
disclosures required 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 and loss expenses 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; 31




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##### Table of Contents




    
    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
    
    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/or common stock prices. We
manage this risk by focusing on a long-term, conservative, value oriented and
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. 32




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##### Table of Contents



Interest Rate Risk.We had fixed-income, preferred shares and bond mutual
fund investments with a fair value of $285.0 million at September 30, 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. 33




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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. Unrestricted Sales of Equity Securities and Use of Proceeds Not applicable. 
 Item 3. Defaults Upon Senior Securities Not applicable. 
 Item 4. Submission of Matters to a Vote of Security Holders Not applicable. 
 Item 5. Other Information Not applicable. 
 Item 6. Exhibits 3.1
    
    Amended and Restated Articles of Incorporation of ProCentury (1)3.2
    
    Amended and Restated Code of Regulations of ProCentury (1)31.1
    
    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 2002 (2)32.2
    
    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 2002 (2)
   (1)
    
    Incorporated by reference from the Companys Quarterly Report on Form 10-Q
for the period ended March 31, 2004, filed with the Securities and Exchange
Commission on September 4, 2004.(2)
    
    These 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. 34




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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: November 12, 2004
    
    By:
    
    /s/ Charles D. HammCharles D. HammChief Financial Officer and Treasurer(Principal Financial and Accounting Officer)
 35