**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

**FORM 10-K**

| x          | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**      |
|------------|----------------------------------------------------------------------------------------------------------|
| ** ** | **For the fiscal year ended December 31, 2005**                                                     |
|       | **Or**                                                                                                   |
| **o**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom                      to**

**Commissionfile number 000-50070**

**SAFETY INSURANCE GROUP, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                     | **13-4181699**       |
|----------------------------------|----------------------|
| (State or other  jurisdiction of | (I.R.S. Employer     |
| incorporation or  organization)  | Identification  No.) |

 

**20 Custom House Street,Boston, Massachusetts 02110**

(Address of principalexecutive offices including zip code)

**(617) 951-0600**

(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(g) of the Act:**

| Title of each class                           | Name of each  exchange on which registered |
|-----------------------------------------------|--------------------------------------------|
| **Common  Shares, $0.01 par value per share** | **NASDAQ  National Market**                |

 

Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.   Yes    o    No x

Indicateby check mark whether the registrant is not required to file reports pursuantto Section 13 of Section 15(d) of the Act.   Yes    o    No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.   Yes x   No   o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405of this chapter) is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.   x

Indicate by check markwhether the registrant is large accelerated filer, an accelerated filer, or anon-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   

Large accelerated filer   o   Accelerated filer   x    Non-accelerated filer   o

**Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of theExchange Act).**   Yes o   No x

The aggregate market valueof the registrant’s voting and non-voting common equity (based on the closingsales price on NASDAQ) held by non-affiliates of the registrant as of June 30,2005, was approximately $414,203,996.

As of March 10, 2006,there were 15,863,808 Common Shares with a par value of $0.01 per shareoutstanding.

**DocumentsIncorporated by Reference**

Portionsof the registrant’s definitive proxy statement for its Annual Meeting ofShareholders to be held on May 19, 2006, which Safety Insurance Group, Inc.(the “Company,” “we,” “our,” “us”) intends to file within 120 days afterits December 31, 2005 year-end, are incorporated by reference into Part IIIhereof.

 

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**SAFETY INSURANCEGROUP, INC.**

**Tableof Contents**

| PART I.Item 1. | ** ** | **Business**                                                                                                            | ** ** | **Page  No.** |   |   |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|---------------|--------|--------|
|                |       | A. General                                                                                                              |       |          | 1      |   |   |
|                |       | B. The Massachusetts  Property and Casualty Insurance Market                                                            |       |          | 3      |   |   |
|                |       | C. Products                                                                                                             |       |          | 6      |   |   |
|                |       | D. Distribution                                                                                                         |       |          | 8      |   |   |
|                |       | E. Marketing                                                                                                            |       |          | 9      |   |   |
|                |       | F. Underwriting                                                                                                         |       |          | 10     |   |   |
|                |       | G. Technology                                                                                                           |       |          | 11     |   |   |
|                |       | H. Claims                                                                                                               |       |          | 13     |   |   |
|                |       | I. Reserves                                                                                                             |       |          | 14     |   |   |
|                |       | J. Reinsurance                                                                                                          |       |          | 17     |   |   |
|                |       | K. Competition                                                                                                          |       |          | 18     |   |   |
|                |       | L. Employees                                                                                                            |       |          | 19     |   |   |
|                |       | M. Investments                                                                                                          |       |          | 19     |   |   |
|                |       | N. Ratings                                                                                                              |       |          | 21     |   |   |
|                |       | O. Supervision and  Regulation                                                                                          |       |          | 22     |   |   |
| **Item  1A.**       | ** ** | **Risk  Factors**                                                                                                       |       |          | 25     |   |   |
| **Item 1B.**        | ** ** | **Unresolved Staff Comments**                                                                                           |       |          | 30     |   |   |
| **Item 2.**         | ** ** | **Properties**                                                                                                          |       |          | 31     |   |   |
| **Item  3.**        | ** ** | **Legal  Proceedings**                                                                                                  |       |          | 31     |   |   |
| **Item 4.**         | ** ** | **Submission of Matters to a Vote of Security Holders**                                                                 |       |          | 31     |   |   |
| **Item 4A.**        | ** ** | **Executive Officers of the Registrant**                                                                                |       |          | 31     |   |   |
| **PART II.**   |       |                                                                                                                    |       |          |   |   |   |
| **Item 5.**         | ** ** | **Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer  Purchases of Equity Securities** |       |          | 34     |   |   |
| **Item  6.**        | ** ** | **Selected  Financial Data**                                                                                            |       |          | 35     |   |   |
| **Item 7.**         | ** ** | **Management’s Discussion and Analysis of Financial  Condition and Results of  Operation**                         |       |          |   |   |   |
|                |       | A. Executive Summary and  Overview                                                                                      |       |          | 38     |   |   |
|                |       | B. Critical Accounting  Policies and Estimates                                                                          |       |          | 43     |   |   |
|                |       | C. Results of  Operations—For the years ended December 31, 2005,   2004 and 2003                    |       |          | 51     |   |   |
|                |       | D. Liquidity and Capital  Resources                                                                                     |       |          | 58     |   |   |
|                |       | E. Forward-Looking  Statements                                                                                          |       |          | 61     |   |   |
| **Item 7A.**        | ** ** | **Quantitative and Qualitative Disclosures About Market  Risk**                                                         |       |          | 61     |   |   |
| **Item 8.**         | ** ** | **Financial Statements and Supplementary Data**                                                                         |       |          | 64     |   |   |
| **Item 9.**         | ** ** | **Changes in and Disagreements With Accountants on  Accounting and Financial  Disclosure**                              |       |          | 91     |   |   |
| **Item 9A.**        | ** ** | **Controls and Procedures**                                                                                             |       |          | 91     |   |   |
| **Item  9B.**       | ** ** | **Other  Information**                                                                                                  |       |          | 91     |   |   |
| **PART III.**  |       |                                                                                                                    |       |          |   |   |   |
| **Item 10.**        | ** ** | **Directors and Executive Officers of the Registrant**                                                                  |       |          | 92     |   |   |
| **Item 11.**        | ** ** | **Executive Compensation**                                                                                              |       |          | 92     |   |   |
| **Item 12.**        | ** ** | **Security Ownership of Certain Beneficial Owners and  Management**                                                     |       |          | 92     |   |   |
| **Item 13.**        | ** ** | **Certain Relationships and Related Transactions**                                                                      |       |          | 92     |   |   |
| **Item 14.**        | ** ** | **Principal Accounting Fees and Services**                                                                              |       |          | 93     |   |   |
| **PART IV.**   |       |                                                                                                                    |       |          |   |   |   |
| **Item 15.**        |       | **Exhibits, Financial Statement Schedules**                                                                             |       |          | 93     |   |   |
| **SIGNATURES**      |       |                                                                                                                    | 102        |          |   |

 

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*In this Form 10K, all dollar amounts are presented inthousands, except average premium, share and per share data.*

**PART I.**

**ITEM 1.**                BUSINESS

**A.  General**

We are a leading provider of private passengerautomobile insurance in Massachusetts. In addition to private passengerautomobile insurance (which represented 80.3% of our direct written premiums in2005), we offer a portfolio of property and casualty insurance products,including commercial automobile, homeowners, dwelling fire, umbrella andbusiness owner policies. Operating exclusively in Massachusetts through ourinsurance subsidiaries, Safety Insurance Company (“Safety Insurance”) and SafetyIndemnity Insurance Company (together referred to as the “InsuranceSubsidiaries”), we have established strong relationships with 637 independentinsurance agents in 743 locations throughout Massachusetts. We have used theserelationships and our extensive knowledge of the Massachusetts market to becomethe second largest private passenger automobile carrier, capturing anapproximate 11.3% share of the Massachusetts private passenger automobileinsurance market, and the fourth largest commercial automobile carrier, with a9.0% share of the Massachusetts commercial automobile insurance market, in 2005according to statistics compiled by Commonwealth Automobile Reinsurers (“CAR”).In addition, we were also ranked the 48th largest automobile writer in the countryaccording to A.M. Best, based on 2004 direct written premiums. We wereincorporated under the laws of Delaware in 2001, but through our predecessors,we have underwritten insurance in Massachusetts since 1979.

Our share of the Massachusetts private passengerautomobile insurance market has grown from 9.8% in 2000 to 11.3% in 2005. As aresult of this increased market share and the expansion of our productofferings, our direct written premiums have increased by 51.9% between 2000 and2005, from $427,457 to $649,113. We have also maintained profitability in partby managing our cost structure through, for example, the use of technology.

**Website Access to Information**

The Internet address for our website is *www.SafetyInsurance.com*. All of our pressreleases and SEC reports are available for viewing or download at our website.These documents are made available on our website as soon as reasonablypracticable after each press release and SEC report is filed with, or furnishedto, the SEC. Copies of any current public information about our company areavailable without charge upon written, telephone, faxed or e-mailed request tothe Office of Investor Relations, Safety Insurance Group, Inc., 20 CustomHouse Street, Boston, MA 02110, Tel: 877-951-2522, Fax: 617-603-4837,or e-mail: *InvestorRelations@SafetyInsurance.com*.The materials on our website are not part of this report on Form 10-Kor incorporated by reference into this report and the URL above is intended tobe an inactive textual reference only.

**Our CompetitiveStrengths**

*We Have StrongRelationships with Independent Agents**.*   In 2004,independent agents accounted for approximately 80.5% of the Massachusettsautomobile insurance market measured by direct written premiums as compared toonly about 42.0% nationwide, according to A.M. Best. For that reason, ourstrategy is centered around, and we sell exclusively through, a network of 637independent agents (of which 203 are Exclusive Representative Producers (“ERPs”))in 743 locations throughout Massachusetts. In order to support our independentagents and enhance our relationships with them, we:

·       Provideour agents with a portfolio of property and casualty insurance products atcompetitive prices to help our agents address effectively the insurance needsof their clients;

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·       Provideour agents with a variety of technological resources which enable us to deliversuperior service and support to them; and

·       Offerour agents competitive commission schedules and profit sharing programs.

Through these measures, we strive to become thepreferred provider of the independent agents in our agency network and capturea growing share of the total insurance business written by these agents inMassachusetts. We must compete with other insurance carriers for the business ofindependent agents.

*We Have an UninterruptedRecord of Profitable Operations.**  *In every year since our inceptionin 1979, we have been profitable and increased our direct written premiums fromthe prior year. We have achieved profitable growth by, among other things:

·       Increasingby 19.7% the number of private passenger automobile exposures we underwritefrom 392,889 in 2000 to 470,221 in 2005 and the average premium we receive perautomobile exposure from $915 to $1,093;

·       Maintaininga statutory combined ratio (refer to page 41 for a definition of statutorycombined ratio) that is consistently below industry averages;

·       Takingadvantage of the institutional knowledge our management has amassed during ourlong operating history in the unique Massachusetts market;

·       Introducingnew lines of insurance products, such as homeowners, which unlike privatepassenger automobile do not have state-established maximum premium rates;

·       Investingin technology to simplify internal processes and enhance our relationships withour agents; and

·       Maintaininga high-quality investment portfolio.

*WeAre a Technological Leader.**  *We have dedicated significant human and financialresources to the development of advanced information systems. Our technologyefforts have benefited us in two distinct ways. First, we continue to developtechnology that empowers our independent agent customers to make it easier forthem to transact business with their clients and with the InsuranceSubsidiaries. In our largest business line, private passenger automobileinsurance, our agents now submit approximately 98% of all applications for newpolicies or endorsements for existing policies to us electronically through ourproprietary information portal, the Agents Virtual Community (“AVC”). Second,our investment in technology has allowed us to re-engineer internal back officeprocesses to provide more efficient service at lower cost. Our adjustedstatutory expense ratios have been below the average industry statutory expenseratio in each of the past five years. Our systems have also improved ouroverall productivity, as evidenced by our direct written premiums per employeeincreasing to $1,153 in 2005 from $835 in 2000.

*We Have an Experienced,Committed and Knowledgeable Management Team.**  *Our senior management team ownsapproximately 10% of the common stock of Safety Insurance Group, Inc. on afully diluted basis. Our senior management team, led by our President, ChiefExecutive Officer and Chairman of the Board, David F. Brussard, has an averageof over 26 years of industry experience per executive, as well as anaverage of over 24 years of experience with Safety Insurance. The team hasdemonstrated an ability to operate successfully within the regulatedMassachusetts private passenger automobile insurance market.

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**Our Strategy**

Toachieve our goal of increasing shareholder value, our strategy is to maintainand develop strong independent agent relationships by providing our agents witha full package of insurance products and information technology services. Webelieve this strategy will allow us to:

·       Furtherpenetrate the Massachusetts private passenger automobile insurance market;

·       Continueto selectively cross-sell homeowners, dwelling fire, personal umbrella andbusiness owner policies in order to capture a larger share of the totalMassachusetts property and casualty insurance business written by each of ourindependent agents; and

·       Continueto expand our technology to enable independent agents to more easily servetheir customers and conduct business with us, thereby strengthening theirrelationships with us.

**B.  The Massachusetts Property and CasualtyInsurance Market**

*Introduction.**  *We are licensed by the Commonwealthof Massachusetts Commissioner of Insurance (“the Commissioner”) to transactproperty and casualty insurance in Massachusetts. All of our business isextensively regulated by the Commissioner.

*TheMassachusetts Market for Private Passenger Automobile Insurance.**  *Private passenger automobileinsurance is heavily regulated in Massachusetts. In many respects, the privatepassenger automobile insurance market in Massachusetts is unique, in comparisonto other states. This is due to a number of factors, including unusualregulatory conditions, the market dominance of domestic companies, the relativeabsence of large national companies, and the heavy reliance on independentinsurance agents as the market’s principal distribution channel. For manyinsurance companies, these factors present substantial challenges, but webelieve they provide us a competitive advantage, because, as our financialhistory shows, we have a thorough understanding of this market.

The principalfactors that generally distinguish the Massachusetts private passengerautomobile insurance market from that market in other states are as follows:

·       *Compulsory Insurance.*Massachusettsmotorists must obtain automobile insurance prior to registering a vehicle withthe Registry of Motor Vehicles. Insurers are required to notify the Registry ofMotor Vehicles when coverage is cancelled and the Registry of Motor Vehicles isauthorized to seize the license plates of uninsured motor vehicles.

·       *“Take All Comers.”*  With very few exceptions, CAR, which is theresidual market program for automobile insurance in Massachusetts, may notrefuse to cover an applicant. Servicing carriers of CAR, such as us, may notrefuse to issue a policy to an applicant based on the applicant’s drivingrecord or other underwriting criteria commonly used by insurers in other statesto decide whether to insure a motorist.

·       *Standard Policy Form.*The policy form thatis used by all automobile insurers is developed by the Commissioner and must beused by all companies. The policy consists of several mandatory coverages: nofault coverage (i.e., “personal injury protection”); minimum limits of bodilyinjury and property damage liability coverage; and coverage for accidentscaused by uninsured or hit-and-run motorists. In addition to these standardmandatory coverages, several additional optional coverages (such as higherbodily injury and property damage liability coverages, and collision andcomprehensive coverages) must be offered. No carrier may offer any other typeof coverage or deductible or use any form of policy endorsement without theprior approval of the Commissioner, which can be granted only after a formalhearing.

·       *Premium Rates are “fixed and established” by theCommissioner*. In Massachusetts, automobile insurance companies areobligated to use premium rates that are determined on an annual basis by 

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the Commissioner. Beginningin 2007, the Commissioner’s annual rate decision will become effective onApril 1 of each year. As a matter of law, the Commissioner’s rate must beadequate, which the Massachusetts courts have ruled requires that the rate besufficient to allow insurers the opportunity to earn a reasonable rate ofreturn. The rate setting process involves a lengthy and complex administrativeproceeding in which the Commissioner considers historic information related toclaim costs as well as outside factors affecting insurance costs. Differentdata is presented for the Commissioner’s consideration by the AutomobileInsurers Bureau (on behalf of the insurance industry), the State Rating Bureau,and the Massachusetts Attorney General. At the close of this proceeding, theCommissioner sets a premium rate for each of several classes of drivers, manydifferent types of vehicles, and twenty-seven different geographicterritories within Massachusetts. The Commissioner usually sets the rate duringthe last quarter of the year. The Commissioner mandated an average ratedecrease in private passenger automobile premiums of 1.7% for 2005. TheCommissioner mandated  average rateincreases of  2.5% and 2.7% for  2004 and 2003, respectively, and no rate changefor 2002. The Commissioner announced on December 15, 2005, an 8.7%statewide average rate decrease for 2006 which will be in effect until April 1,2007. In addition, the Commissioner annually establishes the minimum commissionrate that insurers must pay their auto insurance agents. The Commissionerapproved a commission rate, as a percentage of premiums of 10.9%, 10.5%, and11.0% in 2005, 2004, and 2003, respectively. The Commissioner approved acommission rate of 11.8% for 2006 which will be in effect until April 1,2007.

·       *Safe Driver Insurance Plan.*In otherstates, insurance companies are free to design their own systems for rewardingdrivers with superior driving records by providing lower prices to such driversand charging higher prices for drivers who have caused claims or who have poordriving records. In Massachusetts, all companies must use the system theCommissioner has developed. Known as the Safe Driver Insurance Plan, the systemwas revised effective January 1, 2006 and is based on points assessed forat-fault accidents and conviction of certain traffic violations. The Planconsists of a series of points ranging from 0 points to 45 points, with eachpoint above 0 points imposing surcharges on motorists. The revised Plan offerscredits to motorists with two excellent driver awards, an Excellent DriverDiscount Plus  (Credit code 99) for adriver with no accidents or violations in the preceding 6 years, and anExcellent Driver Discount (Credit code 98) for a driver with no accidents orviolations in the preceding 5 years. Each driver is assigned points by thestate. The Safe Driver Insurance Plan system is revenue neutral, which meansthat the aggregate cost of the discounts must be funded by the aggregate incomeof the surcharges.

·       *Price competition is limited.*An insurermay charge less than the Commissioner’s fixed and established premium rates byoffering discounts to all members of a particular class of motorists, but onlyif the discount is approved by the Commissioner after a public hearing. Duringthe years 1996 to 2001, most insurance companies offered rate discounts fordrivers with the best driving records. We offered competitively priceddiscounts during the 1996 to 2001 time period, but like most of ourcompetitors, we have discontinued using these discounts since 2001. Only twocompanies offered such discounts in 2005, further reduced to one company in2006.

·       *Affinity Group Marketing.*In addition tothe use of class discounts, insurers can charge lower rates than theCommissioner’s fixed rate by providing discounts to all members of an affinitygroup. An affinity group consists of all of the employees of a particularemployer or the members of a trade union, association or other organization.These discounts must be filed with the Commissioner and are subject to theCommissioner’s approval. We currently offer discounts to 184 groupsrepresenting approximately 9.3% of the private passenger automobile policies weissue, with discounts ranging from 3% to 5%.

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·       *Exclusive Representative Producers.*Asnoted above, the Commissioner sets a different rate for each of twenty-seventerritories in Massachusetts. The methodology the Commissioner uses to adjustthe rates among each territory results in the reduction of rates in high costurban communities from the actuarially appropriate rate while increasing ratesin suburban and rural parts of Massachusetts. As a result, in the aggregate,rates in urban communities are considered inadequate by most insurers. In orderto ensure that motorists living in such communities have access to automobileinsurance, licensed insurance producers located in such areas who have not beenappointed as a voluntary agent of a company may apply to CAR, to be appointedas an involuntary agent, or ERP, of an insurer selected by CAR. Under CAR’scurrent rules, ERPs are assigned to all insurers writing private passengerautomobile insurance in Massachusetts. ERP assignments are intended to be basedupon an insurer’s market share. The Commissioner approved a redistribution planfor ERPs, on January 27, 2006. On March 1, 2006, CAR reassigned 18 Safety ERPswith 25,590 exposures to other servicing carriers. In addition, CAR assigned 29ERPs with 24,672 exposures from other servicing carriers to Safety Insurance,however 25 of these ERPs with 22,838 exposures were given voluntary contractsby their former servicing carrier or other carriers and are no longer eligiblefor assignment to Safety Insurance as ERPs. See Item 7—Management’s Discussionand Analysis of Financial Condition and Results of Operations, ExecutiveSummary and Overview.

·       *Commonwealth Automobile Reinsurers.*Inorder to protect insurers from the assignment of ERPs and certain otherinsurance regulatory conditions, the Massachusetts Legislature created CAR,which runs a reinsurance pool. CAR is governed by a committee that is appointedby the Commissioner, but its rules and decisions are subject to the reviewand approval of the Commissioner. Under CAR’s current rules, companies may cedeto the reinsurance pool policies that they determine are not likely to beprofitable. As a result, CAR operates at an underwriting deficit. This deficitis allocated among every automobile insurance company based on a complexformula that takes into consideration a company’s voluntary market share, theamount of business it cedes to CAR and credits the company earns under a systemCAR has designed to encourage carriers to voluntarily write business inselected under-priced classes and territories. We have developedunderwriting and actuarial analysis systems to evaluate the profitability ofceding a risk to CAR or writing it voluntarily.

·       *Proposed Reform of CAR.*On December 31,2004, the Commissioner approved new rules for CAR, which became effectiveon January 1, 2005 (the “Approved Rules”). Pursuant to the Approved Rules,CAR’s current system of assigning ERPs to each insurer and providingreinsurance to insurers is to be replaced by the Massachusetts AssignedInsurance Plan (the “MAIP”). The MAIP is a type of assigned risk plan similarto that used to manage the automobile insurance residual market in most otherstates. On January 14, 2005, we filed, on Form 8-K, an estimateof the financial impact the Approved Rules may have on us and we statedthat a lawsuit had been filed in Suffolk Superior Court by Commerce InsuranceCompany against the Commissioner that seeks an order permanently enjoiningimplementation and/or enforcement of the Approved Rules. On June 20, 2005,the Massachusetts Superior Court ruled that the Commissioner lacked thestatutory authority to implement the Approved Rules and ordered themvacated. As a result, the Approved Rules did not go into effect. TheCommissioner appealed the decision of the Massachusetts Superior Court. On October 26,2005, the Massachusetts Supreme Judicial Court agreed to take on directappellate review of the Commissioner’s appeal. At the present time, we areunable to predict whether the Commissioner’s appeal will be successful. TheApproved Rules and other recent related developments are discussed furtherin Item 7—Management’s Discussion and Analysis of Financial Condition andResults of Operations, Executive Summary and Overview.

·       *Dominance of Domestic Companies.*Manylarge national private passenger automobile insurance writers, such as StateFarm, Allstate, Progressive, Berkshire Hathaway (GEICO), and Farmers, 

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write very little or noprivate passenger automobile insurance business in Massachusetts. We activelyparticipate in major industry policy-making organizations in Massachusetts,such as the Automobile Insurers Bureau and CAR, where our employees serve on anumber of committees.

·       *Prominence of Independent Insurance Agents.*Finally, andperhaps most importantly to our Company’s success, approximately 80.5% of thedirect written premiums in the Massachusetts automobile insurance market wasplaced by independent agents in 2004, according to A.M. Best. Nationally,independent agents wrote only about 42.0% of the automobile insurance market in2004, according to A.M. Best. Accordingly, to be successful, a companymust have a strategy designed to encourage the best agents to place their bestbusiness with that company. We have designed a system of agent commissions,profit sharing, bonuses and other strategies, such as our informationtechnology capabilities, that we believe favorably distinguishes our companyfrom our competitors. We aggressively market our company to independent agentsin attempting to get the best agents and the best business.

**C.**               Products

Historically,we have focused on underwriting private passenger automobile insurance. Since1997, we have expanded the breadth of our product line in order for agents toaddress a greater portion of their clients’ insurance needs by selling multipleproducts. The table below shows our premiums in each of these product lines forthe periods indicated and the portions of our total premiums each product linerepresented.

| ** **                            | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------|------------|---------------------------------------------------------------|-------------|
| **Direct Written Premiums** | ** ** | ** **                                                    | ** **  | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Private passenger  automobile         | ** ** | **$**                                                         | **521,062** | ** ** | **80.3** | **%** | $ | 509,038 |   | 81.0 | % | $ | 463,199 |   | 81.0 | % |
| Commercial  automobile                | ** ** | **69,963**                                                    | ** **  | **10.8** |   | 65,057 |   | 10.4 |   | 58,042 |   | 10.2 |   |
| Homeowners                            | ** ** | **47,055**                                                    | ** **  | **7.2** |   | 45,175 |   | 7.2 |   | 42,460 |   | 7.4 |   |
| Business owners  policies             | ** ** | **7,073**                                                     | ** **  | **1.1** |   | 5,332 |   | 0.8 |   | 4,301 |   | 0.8 |   |
| Personal umbrella                     | ** ** | **1,645**                                                     | ** **  | **0.3** |   | 1,647 |   | 0.3 |   | 1,579 |   | 0.3 |   |
| Dwelling fire                         | ** ** | **1,878**                                                     | ** **  | **0.3** |   | 1,728 |   | 0.3 |   | 1,729 |   | 0.3 |   |
| Commercial  umbrella                  | ** ** | **437**                                                       | ** **  | **—** |   | 318 |   | — |   | 235 |   | — |   |
| Total                                 | ** ** | **$**                                                         | **649,113** | ** ** | **100.0** | **%** | $ | 628,295 |   | 100.0 | % | $ | 571,545 |   | 100.0 | % |
|                                       |            |                                                               |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our product lines are as follows:

*PrivatePassenger Automobile (80.3% of 2005 direct written premiums).**  *Private passenger automobileinsurance is our primary product, and we support all Massachusetts policy formsand limits of coverage. Private passenger automobile policies provide coveragefor bodily injury and property damage to others, no-fault personal injurycoverage for the insured/insured’s car occupants, and physical damage coveragefor an insured’s own vehicle for collision or other perils. We have priced ourprivate passenger coverage competitively by offering group discounts since 1995and Safe Driver Insurance Plan rate deviations from 1996 to 2001. Since 2001,we have not filed for any Safe Driver Insurance Plan deviation. We currentlyoffer approximately 184 affinity group discount programs ranging from 3% to 5%discounts.

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*Commercial Automobile(10.8% of 2005 direct written premiums).**  *Our commercial automobile programsupports all Massachusetts policy forms and limits of coverage includingendorsements that broaden coverage over and above that offered on the standardMassachusetts policy forms. Commercial automobile policies provide coverage forbodily injury and property damage to others, no-fault personal injury coverage,and physical damage coverage for an insured’s own vehicle for collision orother perils resulting from the ownership or use of commercial vehicles in abusiness. We offer insurance for commercial vehicles used for business purposessuch as private passenger-type vehicles, trucks, tractors and trailers, andinsure individual vehicles as well as commercial fleets. Commercial automobilepolicies are written at a standard rate with qualifying risks eligible forpreferred lower rates. We received approval for a rate increase of 2.1%effective December 16, 2004, and did not file for a rate change during2005.

*Homeowners (7.2% of 2005direct written premiums).**  *We offer a broad selection of coverage forms forqualified policyholders. Homeowners policies provide coverage for losses to adwelling and its contents from numerous perils, and coverage for liability toothers arising from ownership or occupancy. We write policies on homes,condominiums, and apartments. We offer loss-free credits of up to 16% for eightyears of loss free experience, along with a discount of 15% when a home iswritten together with an automobile. All forms of homeowners coverage are writtenat a standard rate with qualifying risks eligible for preferred lower rates. Wereceived approval for a rate increase of 3.5% effective June 15, 2005.

*Business Owners Policies(1.1% of 2005 direct written premiums).**  *We serve eligible small and mediumsized commercial accounts with a program that covers apartments and residentialcondominiums; mercantile establishments, including limited cooking restaurants;offices, including office condominiums; processing and services businesses;special trade contractors; and wholesaling businesses. Business owner policiesprovide liability and property coverage for many perils, including businessinterruption from a covered loss. Equipment breakdown coverage is automaticallyincluded, and a wide range of additional coverage is available to qualifiedcustomers. We write policies for business owners at standard rates withqualifying risks eligible for preferred lower rates.

*Commercial PackagePolicies (Included in our Business Owners Policies direct written premiums).**  *For larger commercial accounts, orthose clients that require more specialized or tailored coverages, we offer acommercial package policy program that covers a more extensive range ofbusiness enterprises. Commercial package policies provide any combination ofproperty, general liability, crime and inland marine insurance. Propertyautomatically includes equipment breakdown coverage, and a wide range ofadditional coverage is available to qualified customers. We write commercialpackage policies at standard rates with qualifying risks eligible for preferredlower rates.

*Personal Umbrella (Lessthan 1.0% of 2005 direct written premiums).**  *We offer personal excess liabilitycoverage over and above the limits of individual automobile, watercraft, andhomeowner’s insurance policies to clients. We offer a discount of 10% when anumbrella policy is written together with an automobile insurance policy. Wewrite policies at standard rates with limits of $1.0 million to$5.0 million.

*Dwelling Fire (Less than1.0% of 2005 direct written premiums).**  *We underwrite dwelling fireinsurance, which is a limited form of a homeowner’s policy for non-owner occupiedresidences. We offer superior construction and protective device credits, witha discount of 5% when a dwelling fire policy is issued along with an automobilepolicy. We write all forms of dwelling fire coverage at standard rates withqualifying risks eligible for preferred lower rates.

*Commercial Umbrella (Lessthan 1.0% of 2005 direct written premiums).**  *We offer an excess liabilityproduct to clients for whom we underwrite both commercial automobile andbusiness owner policies. The program is directed at commercial automobile riskswith private passenger-type automobiles or light and medium trucks. We writecommercial umbrella policies at standard rates with limits ranging from$1.0 million to $5.0 million.

*Inland Marine (Included inour Homeowners direct written premiums).**  *We offer inland marine coverage asan endorsement for all homeowners and business owner policies, and as part ofour 

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commercial packagepolicy. Inland marine provides additional coverage for jewelry, fine arts andother items that a homeowners or business owner policy would limit or notcover. Scheduled items valued at more than $5 must meet our underwritingguidelines and be appraised.

*Watercraft (Included inour Homeowners direct written premiums).**  *We offer watercraft coverage forsmall and medium sized pleasure craft with maximum lengths of 32 feet, valuesless than $75 and maximum speeds of 39 knots. We write this coverage as anendorsement to our homeowner’s policies.

In the wake of the September 11,2001 tragedies, the insurance industry is also impacted by terrorism, and wehave filed and received approval for a number of terrorism endorsements fromthe Commissioner, which limit our liability and property exposure according tothe Terrorism Risk Insurance Act of 2002, and the Terrorism Risk InsuranceExtension Act of 2005. See “J. Reinsurance,” discussed below.

**D.**               Distribution

We distribute our productsexclusively through independent agents, unlike some of our competitors, whichuse multiple distribution channels. We believe this gives us a competitiveadvantage with the agents. We have two types of independent agents: those withwhich we have voluntarily entered into an agreement, which we refer to asvoluntary agents, and those that CAR has assigned to us as ERPs. With theexception of our ERPs, we do not accept business from insurance brokers. Ourvoluntary agents have authority pursuant to our voluntary agency agreement tobind our Insurance Subsidiaries for any coverage that is within the scope oftheir authority. We reserve the ability under Massachusetts law to cancel anycoverage, other than private passenger automobile insurance, within the first30 days after it is bound. In total, our 637 independent agents have 743offices (some agencies have more than one office) and approximately 3,000customer service representatives.

*Voluntary Agents.**  *In 2005, we obtained approximately73.6% of our direct written premiums for automobile insurance and 100% of ourdirect written premiums for all of our other lines of business through ourvoluntary agents. As of February 28, 2006, we had agreements with 434voluntary agents. Our voluntary agents are located in all regions ofMassachusetts.

We look for agents withprofitable portfolios of business. To become a voluntary agent for our Company,we generally require that an agency: (i) have been in business for atleast five years; (ii) have exhibited a three year average ratio oflosses, excluding loss adjustment expenses, to net earned premiums (“pure lossratio”) of 64.0% or less on the portion of the agent’s portfolio that we wouldunderwrite; (iii) currently write policies for a minimum of two automobilecarriers; (iv) make a commitment for us to underwrite at least 500policies from the agency during the first twelve months after entering anagreement with us; and (v) offer multiple product lines. Every year, wereview the performance of our agents during the prior year. If an agent failsto meet our profitability standards, we try to work with the agent to improvethe profitability of the business it places with us. We generally terminatecontracts each year with a few agencies, which, despite our efforts, have beenconsistently unable to meet our standards. Although independent agents usuallyrepresent several unrelated insurers, our goal is to be one of the top twoinsurance companies represented in each of our agencies, as measured bypremiums. No individual agency generated more than 3.0% of our direct writtenpremiums in 2005.

*Exclusive RepresentativeProducers.**  *In2005, our ERPs generated approximately 26.4% of our direct written premiums forautomobile insurance. As of December 31, 2005, we had 86 private passengerautomobile ERPs. CAR defines ERPs as licensed dwelling fire or casualtyinsurance agents or brokers who have a place of business in Massachusetts, buthave no existing voluntary independent agency relationship with an automobileinsurer conducting business in Massachusetts. An ERP’s policy portfoliotypically includes a significant percentage of what are considered to be under-pricedautomobile policies.

Massachusetts lawguarantees that CAR provide motor vehicle insurance coverage to all qualifiedapplicants. To facilitate this system, under CAR’s current rules, any qualifiedlicensed insurance producer that is unable to obtain a voluntary automobilerelationship with an insurer becomes an ERP and is 

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assignedto an insurer, which is then required to write that agent’s policies. Thenumber of mandated ERP policies assigned to a Massachusetts insurance carrieris intended to be proportionate to its voluntary market share. However, becauseno insurer can control the relative volumes of voluntary and ERP business withcertainty, carriers are usually either relatively oversubscribed orundersubscribed with ERP policies. Periodically, CAR assigns or re-assigns anERP to the most undersubscribed insurer. According to the February 25,2006 CAR Private Passenger Subscription Report, as of December 31, 2005,our ERP policies totaled 125,612, or approximately 99.3% of our market sharepercentage of ERP policies, making us the second most undersubscribed carrieras of that date.

**E.**                Marketing

We view the independentagent as our customer and business partner. As a result, our marketing effortsfocus on developing interdependent relationships with leading Massachusettsagents that write profitable business and positioning ourselves as thepreferred insurance carrier of those agents, thereby receiving a larger portionof each agent’s aggregate business. We do not market ourselves to potentialpolicyholders.

Ourprincipal marketing strategies are:

·       Tooffer a range of products, which we believe enables our agents to meet theinsurance needs of their clients, and overcomes agents’ resistance to placingtheir clients’ automobile insurance and other coverages with differentinsurers;

·       Toprice our products competitively, including offering discounts when and whereappropriate for safer drivers and for affinity groups, and also offeringaccount discounts for policyholders that have both an automobile and homeownerspolicy with us;

·       Tooffer agents competitive commissions, with incentives for placing their moreprofitable business with us; and

·       Toprovide a level of support and service that enhances the agent’s ability to dobusiness with its clients and with us.

*Commission Schedule andProfit Sharing Plan.**  *Wehave several programs designed to attract profitable new private passengerautomobile business from agents by paying them more than the minimum commissionthe law requires (which is 10.9% of premiums for 2005, and 11.8% in 2006). Werecognize our top performing agents by making them members of our President’sClub or Executive Club. In 2006, President’s Club members receive a commissionequal to 17.0% of premiums for each new policy with a safe driver credit codeof 99 and 98 (drivers with no accidents or violations in the prior six and fiveyears respectively), while Executive Club members receive a commission equal to14.0% of premiums for such policies. In 2005, 68.1% of our drivers were in SafeDriver Insurance Plan steps 9 or 10 (similar to credit code 99 and 98), ascompared to 68.6% for the Massachusetts private passenger automobile industryas a whole, based on the number of drivers per month in each step according toCAR.

Further, we have acompetitive agency incentive commission program under which we pay agents up to7.5% of premiums based on the loss ratio on their business.

We have received noinquiries from the Commissioner, the Massachusetts Attorney General, or anyother government agency relative to how we conduct our contingent commissionsand profit sharing programs.

*Service and Support.**  *We believe that the level andquality of service and support we provide helps differentiate us from otherinsurers. We have made a significant investment in information technologydesigned to facilitate our agents’ business. Our AVC website helps agentsmanage their work efficiently. We provide a substantial amount of informationonline that agents need to serve their customers, such as information about thestatus of new policies, bill payments and claims. Providing this type ofcontent reduces the number of customer calls we receive and empowers the agent’scustomer service 

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representatives byenabling them to respond to customers’ inquiries while the customer is on thetelephone. Finally, we believe that the knowledge and experience of ouremployees enhance the quality of support we provide.

**F.**                 Underwriting

Ourunderwriting department is responsible for a number of key decisions affectingthe profitability of our business, including:

·       Pricingof discounts offered on our private passenger automobile product;

·       Pricingof our commercial automobile, homeowners, dwelling fire, personal umbrella,business owners policies, commercial umbrella and commercial package products;

·       Determiningwhich policies to cede to CAR’s reinsurance pool and which to retain; and

·       Evaluatingwhether to accept transfers of a portion of an existing or potential new agent’sportfolio from another insurer.

We are organized intothree underwriting units, a separate unit for Massachusetts private passengerautomobile, a separate unit for all other personal lines underwriting includinghomeowners, dwelling fire, personal umbrella and inland marine coverages, and aseparate unit for commercial lines, including commercial auto, business ownerspolicies, commercial umbrella and commercial package policies.

*Pricing.**  *Our pricing strategy for privatepassenger automobile insurance primarily depends on the maximum permittedpremium rates and minimum permitted commission levels mandated by theCommissioner. For several years prior to 2002, we offered discounts off thestate-mandated rates to drivers in the lower Safe Driver Insurance Plansteps, as did a number of other insurers. However, starting in 1998, we beganto reduce the discounts we offered, in light of the reductions or minimalincreases in average rates the Commissioner has mandated in each year since1998. We currently do not offer any Safe Driver Insurance Plan creditcode-based discounts. Primarily as a result of reducing discounts and thepurchasing of new cars by our insureds (for which we are permitted to chargehigher premiums), our average premium received per policy increased 6.9% in2003, 6.1% in 2004 and 0.1% in 2005.

In addition to Safe DriverInsurance Plan discounts, we also offer group discounts to members of 184affinity groups, including the Boston College Alumni Association, theMassachusetts Bar Association and the Massachusetts Medical Society. Ingeneral, we target affinity groups with a mature and stable membership basealong with favorable driving records, offering between a 3% and 5% discount(with 4% being the average discount offered). Approximately 9.3% of the privatepassenger policies we issue receive an affinity group discount.

CAR and the Commissionerset the premium rates for commercial automobile policies reinsured through CAR.Subject to Commissioner review, we set rates for commercial automobile policiesthat are not reinsured through CAR, and for all other insurance lines we offer,including homeowners, dwelling fire, personal umbrella, commercial umbrella,commercial package policies and business owner policies. We base our rates onindustry loss cost data, our own loss experience, catastrophe modeling andprices charged by our competitors in the Massachusetts market. We receivedapproval for a rate increase of 2.1% for our commercial automobile lineeffective December 16, 2004, and also received approval for a rateincrease of 3.5% for our homeowners line effective June 15, 2005.

*Cede/Retain Decisions.**  *Under CAR’s current rules, we mustdecide, within 23 days after the effective date of a new policy or beforerenewing an existing policy, whether to cede it to CAR’s reinsurance pool. EachMassachusetts automobile insurer must bear a portion of the losses of thereinsurance pool. Under CAR’s current rules, we are able to reduce our totalallocated share of the losses of the reinsurance pool by ceding less businessto the pool than our proportionate share. As a result, in determining whetherto cede an under priced policy to CAR’s private passenger automobilereinsurance pool, we attempt to 

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evaluate whether weare likely to incur greater total losses by ceding it to the pool or byretaining it. According to the February 27, 2006 CAR Cession VolumeAnalysis—Private Passenger Report, as of December 31, 2005, we have ceded6.9% of our private passenger automobile business to the pool in 2005, comparedto an average of 6.2% for the industry. Our goal is to cede only those policiesthat incur less total losses resulting from a cession to CAR, than the totallosses incurred by retaining the policy.

CAR also runs areinsurance pool for commercial automobile policies. We analyze whether to cedeor retain our business in that line in a similar fashion. According to the January 31,2006 CAR Cession Volume Analysis-All Other Than Private Passenger Report, as ofDecember 31, 2005, we have ceded 17.3% of our commercial automobilebusiness to the pool in 2005, compared to an average of 26.2% for the industry.

*Bulk Policy Transfers andNew Voluntary Agents.**  *Fromtime to time, we receive proposals from existing voluntary agents to transfer aportfolio of the agent’s business from another insurer to us. Our underwritersmodel the profitability of these portfolios before we accept these transfers.Among other things, we usually require that the portfolio have a pure lossratio of 64.0% or less on the portion of the agent’s portfolio that we wouldunderwrite. In addition, we require any new voluntary agent to commit totransfer a portfolio to us consisting of at least 500 policies.

*Policy Processing and RatePursuit.**  *Ourunderwriting department assists in processing policy applications,endorsements, renewals and cancellations. In the past three years, we haveintroduced new proprietary software that enables agents to connect to ournetwork and enter policy and endorsement applications for private passengerautomobile insurance from their office computers. In our private passengerautomobile insurance line, our agents now submit approximately 98% of allapplications for new policies or endorsements for existing policies through ourproprietary information portal, the AVC.

Our rate pursuit teamaggressively monitors all insurance transactions to make sure we receive thecorrect premium for the risk insured. We accomplish this by verifyingMassachusetts pricing criteria, such as proper classification of drivers, themake, model and age of insured vehicles and the availability of discounts. Weverify that operators are properly listed and classified, assignment ofoperators to vehicles, vehicle garaging, vehicle pre-inspection requirementsand in some cases the validity of discounts. In our homeowners and dwellingfire lines, our team has completed a project to update the replacement costsfor each dwelling. We use third-party software to assist in theseappraisal efforts.

**G.**               Technology

Thefocuses of our information technology effort are:

·       toconstantly reengineer internal processes to allow more efficient operations,resulting in lower operating costs;

·       tomake it easier for independent agents to transact business with us; and

·       toenable agents to efficiently provide their clients with a high level ofservice.

We believe that ourtechnology initiatives have increased revenue and decreased cost. For example,these initiatives have allowed us to reduce the number of call-centertransactions which we perform, and to transfer many manual processing functionsfrom our internal operations to our independent agents. We also believe thatthese initiatives have contributed to our overall increases in productivity. In1990, we had 399 employees and $154,997 in direct written premiums. As of December 31,2005, we had 563 employees and $649,113 in direct written premiums, whichrepresents an increase from $388 direct written premiums per employee in 1990to $1,153 direct written premiums per employee in 2005.

*Internal Applications(Intranet).**  *Ouremployees access our proprietary applications through our corporate intranet.Our intranet applications streamline internal processes and improve overalloperational efficiencies in areas including:

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*Claims.**  *Our claims workload managementapplication allows our claims and subrogation adjusters to better manage injuryclaims. Subrogation refers to the process by which we are reimbursed by otherinsurers for claims costs we incur due to the fault of their insureds. The useof this application has reduced the time it takes for us to respond to andsettle casualty claims, which we believe helps reduce the total amount of ourclaims expense.

The automated adjusterassignment system categorizes our new claims by severity and assigns them tothe appropriate adjuster responsible for investigation. Once assigned, theintegrated workload management tools facilitate the work of promptly assigningappraisers, investigating liability, issuing checks and receiving subrogationreceipts.

*Billing.**  *Proprietary billing systems,integrated with the systems of our print and lock-box vendors, expedite theprocessing and collection of premium receipts and finance charges from agentsand policyholders. We believe the sophistication of our direct bill systemhelps us to limit our bad debt expense. In both 2005 and 2004 our bad debtexpense as a percentage of direct written premiums was less than 0.2%.

*External Applications.**  *Agency employees can securelyaccess business critical applications through our corporate extranet, which wecall AVC. AVC includes Web-enabled applications, advanced security and anInternet-enabled communications network, which we believe constitutesmany of our agents’ only high-speed Internet connection. We believe that AVC isunique to the Massachusetts private passenger automobile insurance industrybecause using AVC allows an agent to access a variety of vendors and othercarriers over the Internet through a single portal. We currently have a patentapplication pending on AVC. The patent application pertains to the method andsystem by which AVC delivers customer services to independent insurance agents.The capability for agency personnel to schedule online appointments with third-partyvendors (such as glass repair retailers and rental car agencies) for theirclients is also available. We designed AVC to be scalable so that these typesof vendors and potentially, other insurers, can link to the network and createa “once and done” environment for the independent agent.

Listed below are examplesof the business critical applications agents may access through AVC.

*New Business andEndorsement Processing.**  *Agents can perform new business and endorsementprocessing with our point of sale application. Agents can upload policy data toour system directly from their agency system or rate quote software in AVC’ssecure Web environment without having to re-enter policy information.

*Inquiry Access.**  *Inquiry Access is a customerservice application designed to provide agency customer service representativeswith real-time access to our database of insured information. This applicationallows agents to view the status of claims, billing and policy detail.

*Policyholder Inquiry.**  *Policyholder Inquiry provides24 hours a day, 7 days a week self-service account information to ourpolicyholders through our website or through their independent agents’websites. This application provides policyholders with round-the-clock accessto billing and claims information.

*Other Tools and Services*   AVCgives agents access to electronic versions of underwriting manuals, whichinclude updated guidelines for acceptable risks, commission levels and productpricing. Further, we have our agents using third party software (the XNET CostEstimator from Marshall Swift/Boeck) that we make available through AVC to helpassess home replacement costs. This initiative helps ensure that we receive thecorrect premium with respect to homeowners policies and provide the correctlevel of coverage against home loss. Finally, we provide agents a daily reportof all their insurance transactions processed through AVC. This report allowsour agents to monitor their performance and review profitability goals.

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**H.**              Claims

Because of the uniquedifferences between the management of casualty claims and property claims, weuse separate departments for each of these types of claims.

*Casualty Claims*

We have a proven record of settling casualty claimsbelow the industry average in Massachusetts. According to the AutomobileInsurers Bureau, our average casualty claim settlement during the period from January 1994through September 30, 2005 was $5,457, approximately 4.4% lower than theMassachusetts industry average of $5,707.

We have adopted stringent claims settlementprocedures, which include guidelines that establish maximum settlement offersfor soft tissue injuries, which constituted approximately 75% of our bodilyinjury claims. If we are unable to settle these claims within our guidelines,we generally take the claim to litigation. We believe that these proceduresresult in providing our adjusters with a uniform approach to negotiation.

We believe an important component of handling claimsefficiently is prompt investigation and settlement. We find that faster claimssettlements often result in less expensive claims settlements. Our E-Claimreporting system is an online product that reduces the time it takes for agentsto notify our adjusters about claims, thereby enabling us to contact third-partyclaimants and other witnesses quickly. After business hours we outsource claimsadjustment support to an independent firm whose employees contact third-partyclaimants and other witnesses. We believe that early notification results inour adjusters conducting prompt investigations of claims and compiling moreaccurate information about those claims. Our claims workload managementsoftware also assists our adjusters in handling claims quickly.

We believe the structure of our casualty claims unitallows us to respond quickly to claimants anywhere in the Commonwealth ofMassachusetts. Comprising 124 people, the department is organized into distinctclaim units that contain loss costs for soft tissue injuries. Field adjustersare located geographically for prompt response to claims, with our litigationunit focused on managing loss costs and litigation expenses for serious injuryclaims.

Additionally, we utilize aspecial unit to investigate fraud in connection with casualty claims. Thisspecial unit has one manager and eight employees. In cases where adjusterssuspect fraud in connection with a claim, we deploy this special unit toconduct investigations. We deny payment to claimants in cases in which we havesucceeded in accumulating sufficient evidence of fraud.

*Property Claims*

Our property claims unit handles property claimsarising in our private passenger and commercial automobile, homeowners andother insurance lines. Process automation has streamlined our property claimsfunction. Many of our property claims are now handled by the agents through AVCusing our Power Desk software application. As agents receive calls fromclaimants, Power Desk permits the agent to immediately send information relatedto the claim directly to us and to an independent appraiser selected by theagent to value the claim. Once we receive this information, an automated systemredirects the claim to the appropriate internal adjuster responsible forinvestigating the claim to determine liability. Upon determination ofliability, the system automatically begins the process of seeking a subrogationrecovery from another insurer, if liable. We believe this process results in ashorter time period from when the claimant first contacts the agent to when theclaimant receives a claim payment, while enabling our agents to buildcredibility with their clients by responding to claims in a timely andefficient manner. We benefit from decreased labor expenses from the need forfewer employees to handle the reduced property claims call volume.

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Another important factorin keeping our overall property claims costs low is collecting subrogationrecoveries. Subrogation refers to the process by which we are reimbursed byother insurers for claims costs we incur due to the fault of their insureds. Wetrack the amounts we pay out in claims costs and identify cases in which webelieve we can reclaim some or all of those costs through the use of ourautomated workload management tools.

**I.**                   Reserves

Significant periods of time can elapse between theoccurrence of an insured loss, the reporting of the loss to the insurer and theinsurer’s payment of that loss. To recognize liabilities for unpaid losses,insurers establish reserves as balance sheet liabilities representing estimatesof amounts needed to pay reported and unreported losses and the expensesassociated with investigating and paying the losses, or loss adjustmentexpenses. Every quarter, we review our reserves internally. Regulationspromulgated by the Commissioner require us to annually obtain a certificationfrom either a qualified actuary or an approved loss reserve specialist that ourloss and loss adjustment expenses reserves are reasonable.

When a claim is reported, claims personnel establish a“case reserve” for the estimated amount of the ultimate payment. The amount ofthe reserve is primarily based upon an evaluation of the type of claiminvolved, the circumstances surrounding each claim and the policy provisionsrelating to the loss. The estimate reflects informed judgment of such personnelbased on general insurance reserving practices and on the experience andknowledge of the claims person. During the loss adjustment period, theseestimates are revised as deemed necessary by our claims department based onsubsequent developments and periodic reviews of the cases.

In accordance with industry practice, we also maintainreserves for estimated losses incurred but not yet reported. Incurred but notyet reported reserves are determined in accordance with commonly acceptedactuarial reserving techniques on the basis of our historical information andexperience. We make adjustments to incurred but not yet reported reservesquarterly to take into account changes in the volume of business written,claims frequency and severity, our mix of business, claims processing and otheritems that can be expected to affect our liability for losses and lossadjustment expenses over time.

When reviewing reserves, we analyze historical dataand estimate the impact of various loss development factors, such as ourhistorical loss experience and that of the industry, legislative enactments,judicial decisions, legal developments in imposition of damages, and changesand trends in general economic conditions, including the effects of inflation.There is no precise method, however, for evaluating the impact of any specificfactor on the adequacy of reserves, because the eventual development ofreserves is affected by many factors. After taking into account all relevantfactors, management believes that our provision for net unpaid losses and lossadjustment expenses at December 31, 2005 is adequate to cover the ultimatenet cost of losses and claims incurred as of that date.

Management calculates its loss and LAE reservesestimates, independently from the Company’s actuaries. The Company’s actuarialestimate for loss and LAE reserves, net of the effect of ceded reinsurance,ranges from a low of $332,266 to a high of $382,506 as of December 31,2005. The Company’s loss and LAE reserves, based on management’s best estimate,were set at $370,166 as of December 31, 2005. The ultimate liability maybe greater or less than reserves carried at the balance sheet date.Establishment of appropriate reserves is an inherently uncertain process, and therecan be no certainty that currently established reserves will prove adequate inlight of subsequent actual experience. To the extent that reserves areinadequate and are strengthened, the amount of such increase is treated as acharge to earnings in the period that the deficiency is recognized. To theextent that reserves are redundant and are released, the amount of the releaseis a credit to earnings in the period the redundancy is recognized. We do notdiscount any of our reserves.

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Thefollowing table presents development information on changes in the reserves forlosses and loss adjustment expenses (“LAE”) of our Insurance Subsidiaries forthe three years ended December 31, 2005.

| ** **                                              | ** ** | **For the Years Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reserves for  losses and LAE, beginning of year         | ** ** | **$ 450,897**                                            |       | $ 383,551 |   | $ 333,297 |   |
| Less reinsurance  recoverable on unpaid losses and LAE  | ** ** | **(84,167**                                                   | **)**      | (73,539 | ) | (66,661 | ) |
| Net reserves for  losses and LAE, beginning of year     | ** ** | **366,730**                                                   |       | 310,012 |   | 266,636 |   |
| Incurred losses and  LAE, related to:                   |       |                                                          |       |   |   |   |   |
| Current year                                            | ** ** | **425,213**                                                   |       | 431,839 |   | 420,788 |   |
| Prior years                                             | ** ** | **(39,620**                                                   | **)**      | (6,778 | ) | 181 |   |
| Total incurred  losses and LAE                          | ** ** | **385,593**                                                   |       | 425,061 |   | 420,969 |   |
| Paid losses and  LAE related to:                        |       |                                                          |       |   |   |   |   |
| Current year                                            | ** ** | **237,557**                                                   |       | 217,989 |   | 240,501 |   |
| Prior years                                             | ** ** | **144,600**                                                   |       | 150,354 |   | 137,092 |   |
| Total paid losses  and LAE                              | ** ** | **382,157**                                                   |       | 368,343 |   | 377,593 |   |
| Net reserves for  losses and LAE, end of year           | ** ** | **370,166**                                                   |       | 366,730 |   | 310,012 |   |
| Plus reinsurance  recoverables on unpaid losses and LAE | ** ** | **80,550**                                                    |       | 84,167 |   | 73,539 |   |
| Reserves for losses and  LAE, end of year               | ** ** | **$ 450,716**                                            |       | $ 450,897 |   | $ 383,551 |   |

 

At the end of each period, the reserves werere-estimated for all prior accident years. The Company’s prior year reservesdecreased by $39,620 and $6,778 for the years ended December 31, 2005 and2004, respectively. The Company’s prior year reserves increased by $181 for theyear ended December 31, 2003. The decrease in prior year reserves during2005 resulted from re-estimations of prior year ultimate loss and LAEliabilities and is primarily composed of reductions of $22,162 in CommonwealthAutomobile Reinsurers (“CAR”) assumed reserves and $14,600 in the Company’sautomobile reserves.  It is notappropriate to extrapolate future favorable or unfavorable development ofreserves from this past experience.

The following table represents the development ofreserves, net of reinsurance, for calendar years 1995 through 2005. The topline of the table shows the reserves at the balance sheet date for each of theindicated years. This represents the estimated amounts of losses and lossadjustment expenses for claims arising in all years that were unpaid at thebalance sheet date, including losses that had been incurred but not yetreported to us. The upper portion of the table shows the cumulative amountspaid as of the end of each successive year with respect to those claims. Thelower portion of the table shows the re-estimated amount of the previouslyrecorded reserves based on experience as of the end of each succeeding year,including cumulative payments made since the end of the respective year. Theestimate changes as more information becomes known about the payments,frequency and severity of claims for individual years. Favorable lossdevelopment, shown as a cumulative redundancy in the table, exists when theoriginal reserve estimate is greater than the re-estimated reserves at December 31,2005.

Information with respect to the cumulative developmentof gross reserves (that is, without deduction for reinsurance ceded) alsoappears at the bottom portion of the table.

Inevaluating the information in the table, it should be noted that each amountentered incorporates the effects of all changes in amounts entered for priorperiods. Thus, if the 1998 estimate for a previously incurred loss was $150,000and the loss was reserved at $100,000 in 1994, the $50,000 deficiency (laterestimate minus original estimate) would be included in the cumulativeredundancy (deficiency) in each of the years 1995-1998 shown in thetable. It should further be noted that the table does not present accident 

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or policy year development data. In addition,conditions and trends that have affected the development of liability in thepast may not necessarily recur in the future. Accordingly, it is notappropriate to extrapolate future redundancies or deficiencies from the table.

| ** **                                           | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** | **1995** | ** ** |
| **Reserves for losses and LAE originally estimated** |       | $ 370,166                                                                        |       | $ 366,730 |   | $ 310,012 |   | $ 266,636 |   | $ 227,377 |   | $ 211,834 |   | $ 206,613 |   | $ 195,990 |   | $ 195,145 |   | $ 189,420 |   | $ 175,125 |   |
| **Cumulative amounts paid as of:**                   |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                                       |       |                                                                                  |       | 144,600 |   | 150,354 |   | 137,092 |   | 118,141 |   | 114,016 |   | 107,937 |   | 92,791 |   | 75,233 |   | 68,246 |   | 56,912 |   |
| Two years later                                      |       |                                                                                  |       |   |   | 201,287 |   | 199,119 |   | 168,347 |   | 163,768 |   | 133,414 |   | 113,323 |   | 105,046 |   | 96,219 |   | 82,299 |   |
| Three years later                                    |       |                                                                                  |       |   |   |   |   | 225,350 |   | 196,340 |   | 185,398 |   | 154,395 |   | 135,024 |   | 125,574 |   | 111,706 |   | 93,866 |   |
| Four years later                                     |       |                                                                                  |       |   |   |   |   |   |   | 212,079 |   | 194,891 |   | 163,904 |   | 144,985 |   | 136,730 |   | 121,100 |   | 99,854 |   |
| Five years later                                     |       |                                                                                  |       |   |   |   |   |   |   |   |   | 204,290 |   | 167,829 |   | 149,549 |   | 141,843 |   | 126,924 |   | 103,384 |   |
| Six years later                                      |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   | 171,148 |   | 150,940 |   | 143,459 |   | 128,804 |   | 105,284 |   |
| Seven years later                                    |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   | 152,243 |   | 143,998 |   | 129,358 |   | 105,759 |   |
| Eight years later                                    |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 144,727 |   | 129,535 |   | 105,823 |   |
| Nine years later                                     |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 130,047 |   | 105,860 |   |
| Ten years later                                      |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 105,984 |   |

 

| ** **                                   | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** | **1995** | ** ** |
| **Reserves  re-estimated as of:**            |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One year later                               |       |                                                                                  |       | $ 327,110 |   | $ 303,234 |   | $ 266,817 |   | $ 225,115 |   | $ 204,531 |   | $ 179,650 |   | $ 169,940 |   | $ 171,803 |   | $ 161,083 |   | $ 140,728 |   |
| Two years later                              |       |                                                                                  |       |   |   | 291,100 |   | 269,941 |   | 227,771 |   | 206,340 |   | 176,008 |   | 156,590 |   | 153,846 |   | 144,727 |   | 125,496 |   |
| Three years later                            |       |                                                                                  |       |   |   |   |   | 264,961 |   | 231,190 |   | 208,592 |   | 175,868 |   | 154,867 |   | 147,455 |   | 134,721 |   | 114,597 |   |
| Four years later                             |       |                                                                                  |       |   |   |   |   |   |   | 229,699 |   | 209,517 |   | 176,029 |   | 154,530 |   | 146,059 |   | 131,694 |   | 108,705 |   |
| Five years later                             |       |                                                                                  |       |   |   |   |   |   |   |   |   | 208,343 |   | 175,367 |   | 154,576 |   | 145,670 |   | 131,051 |   | 106,763 |   |
| Six years later                              |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   | 174,469 |   | 153,926 |   | 145,612 |   | 130,903 |   | 106,578 |   |
| Seven years later                            |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   | 153,920 |   | 145,465 |   | 130,735 |   | 106,545 |   |
| Eight years later                            |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 145,452 |   | 130,599 |   | 106,396 |   |
| Nine years later                             |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 130,590 |   | 106,213 |   |
| Ten years later                              |       |                                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 106,169 |   |
| **Cumulative  (redundancy) deficiency 2005** |       |                                                                                  |       | (39,620 | ) | (18,912 | ) | (1,675 | ) | 2,322 |   | (3,491 | ) | (32,144 | ) | (42,070 | ) | (49,693 | ) | (58,830 | ) | (68,956 | ) |

 

| ** **                            | ** ** | **As of and for the Year Ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** | **1996** | ** ** | **1995** | ** ** |
| Gross liability-end of year           |       | $ 450,716                                                                        |       | $ 450,897 |   | $ 383,551 |   | $ 333,297 |   | $ 302,556 |   | $ 302,131 |   | $ 315,226 |   | $ 311,846 |   | $ 319,453 |   | $ 326,802 |   | $ 303,330 |   |
| Reinsurance recoverables              |       | 80,550                                                                                |       | 84,167 |   | 73,539 |   | 66,661 |   | 75,179 |   | 90,297 |   | 108,613 |   | 115,856 |   | 124,308 |   | 137,382 |   | 128,205 |   |
| Net liability—end of year        |       | 370,166                                                                               |       | 366,730 |   | 310,012 |   | 266,636 |   | 227,377 |   | 211,834 |   | 206,613 |   | 195,990 |   | 195,145 |   | 189,420 |   | 175,125 |   |
| Gross estimated liability—latest |       |                                                                                  |       | 399,546 |   | 357,066 |   | 327,258 |   | 283,280 |   | 274,715 |   | 242,060 |   | 225,379 |   | 220,923 |   | 210,789 |   | 181,089 |   |
| Reinsurance recoverables—latest  |       |                                                                                  |       | 72,436 |   | 65,966 |   | 62,297 |   | 53,581 |   | 66,372 |   | 67,591 |   | 71,459 |   | 75,471 |   | 80,199 |   | 74,920 |   |
| Net estimated  liability—latest  |       |                                                                                  |       | 327,110 |   | 291,100 |   | 264,961 |   | 229,699 |   | 208,343 |   | 174,469 |   | 153,920 |   | 145,452 |   | 130,590 |   | 106,169 |   |

 

As the table shows, ournet reserves grew at a faster rate than our gross reserves over the ten-yearperiod. As we have grown, we have been able to retain a greater percentage ofour direct business. Additionally, we used to conduct substantial business as aservicing carrier for other insurers, in which we would service the residualmarket automobile insurance business assigned to other carriers for a fee. Allbusiness generated through this program was ceded to the other carriers. As wereduced the amount of our servicing carrier business, our proportion ofreinsurance ceded diminished.

The table also shows thatwe have substantially benefited in the current and prior years from releasingredundant reserves. Massachusetts private passenger automobile insurancepricing was very favorable in 

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theearly to mid-1990s and the reserves we established for business writtenduring that period developed favorably, allowing us to release substantialreserves in following years. As maximum permitted rates declined in the latterpart of the 1990s through 2001, and the redundancies resulting from favorabledevelopment of earlier years were released, our redundancies in subsequentyears began to diminish. In the year ended December 31, 2003 we increasedloss reserves by $181. In the year ended December 31, 2004 we released$6,778 in reserves related to prior years. In the year ended December 31,2005 we released $39,620 in reserves related to prior years

As a result of our focuson core business lines since our founding in 1979, we believe we have noexposure to asbestos or environmental pollution liabilities.

**J.**                   Reinsurance

We reinsure with otherinsurance companies a portion of our potential liability under the policies wehave underwritten, thereby protecting us against an unexpectedly large loss ora catastrophic occurrence that could produce large losses. Reinsurance involvesan insurance company transferring (ceding) a portion of its exposure oninsurance underwritten by it to another insurer (reinsurer). The reinsurerassumes a portion of the exposure in return for a share of the premium.Reinsurance does not legally discharge an insurance company from its primaryliability for the full amount of the policies, but it does make the reinsurerliable to the company for the reinsured portion of any loss realized.

We are selective inchoosing our reinsurers, seeking only those companies that we consider to befinancially stable and adequately capitalized. In an effort to minimizeexposure to the insolvency of a reinsurer, we continuously evaluate and reviewthe financial condition of our reinsurers. Swiss Re, our primary reinsurer,maintains an A.M. Best rating of “A+” (Superior). All of our otherreinsures have an A.M. Best rating of “A” (excellent) or better except forEndurance Re, Montpelier Re and Amlin Bermuda which are rated “A-” (excellent).

We maintain reinsurancecoverage to help lessen the effect of losses from catastrophic events,maintaining coverage that currently protects us in the event of a “415-yearstorm” (that is, a storm of a severity expected to occur once in a415 year period). We use various software products to measure our exposureto catastrophe losses to model the probable maximum loss to us for catastrophelosses such as hurricanes. In 2005, we purchased four layers of excesscatastrophe reinsurance contracts providing coverage for property losses inexcess of $10,000 up to a maximum of $250,000. Our reinsurers co-participationis 25.0% of $5,000 for the 1st layer, 90.0% of$15,000 for the 2nd layer, 90.0% of $30,000 for the 3rd layer, and 90.0% of $190,000 for the 4th layer.

In 2006, we have purchasedthree layers of excess catastrophe reinsurance contracts providing coverage forproperty losses in excess of $15,000 up to a maximum of $250,000. Ourreinsurers co-participation is 90.0% of $15,000 for the 1st layer, 90.0% of $30,000 forthe  2nd layer, and 90.0% of $190,000 for the 3rd layer.

We also have a casualtyexcess of loss reinsurance contract for large casualty losses occurring in ourautomobile, homeowners, dwelling fire, business owners policies, commercialpackage policies, personal umbrella and commercial umbrella lines of businessin excess of $1,000 up to a maximum of $5,000, with an annual aggregatedeductible of $500. We have property excess of loss reinsurance coverage forlarge property losses, with coverage in excess of $1,500 up to a maximum of$15,000, for our homeowners, business owner, and commercial package policies.In addition, we have a quota share reinsurance agreement under which we cede90.0% of the premiums and losses under our personal and commercial umbrellapolicies. We also have a reinsurance agreement with Hartford Steam BoilerInspection and Insurance Company, which is a quota share agreement under whichwe cede 100% of the premiums and losses for the equipment breakdown coverageunder our business owner policies and commercial package policies.

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In the wake of the September 11, 2001 tragedies,reinsurers have begun to exclude coverage for claims in connection with any actof terrorism. Our reinsurance programs for 2003, 2004, 2005 and 2006 excludescoverage for acts of terrorism, except for fire or collapse losses as a resultof terrorism, under homeowners, dwelling fire, private passenger automobile andcommercial automobile policies. For business owner policies and commercialpackage policies, terrorism is excluded if the total insured value is greaterthan $20,000.

The Terrorism Risk Insurance Act of 2002 (“TRIA”) wassigned into law on November 26, 2002 and expired December 31, 2005.The Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”) was signed intolaw on December 22, 2005, which reauthorizes TRIA for two years, whileexpanding the private sector role and reducing the federal share ofcompensation for insured losses under the program. The intent of thislegislation is to provide federal assistance to the insurance industry for theneeds of commercial insurance policyholders with the potential exposure forlosses due to acts of terrorism. The TRIEA provides reinsurance for certifiedacts of terrorism. Effective January 1, 2006 we issued policy endorsementsfor all commercial policyholders to comply with TRIEA after obtainingCommissioner approval.

As of December 31, 2005, we had no materialamounts recoverable from any reinsurer, excluding the residual marketsdescribed below. On March 10, 2005, our Board of Directors adopted aresolution that prohibits Safety from purchasing finite reinsurance withoutapproval by the Board. To date, the Company has never purchased a finitereinsurance contract.

In addition to the abovementioned reinsurance programs, we are a participant in CAR, the Massachusettsmandated residual market under which premiums, expenses, losses and lossadjustment expenses on ceded business are shared by all insurers writingautomobile insurance in Massachusetts. We also participate in the MassachusettsProperty Insurance Underwriting Association in which premiums, expenses, lossesand loss adjustment expenses on homeowners business that cannot be placed inthe voluntary market are shared by insurers writing homeowners insurance inMassachusetts.

**K.**              Competition

The property and casualty insurance business is highlycompetitive and many of our competitors have substantially greater financialand other resources than we. We compete with both large national writers andsmaller regional companies. Our competitors include companies, which, like us,serve the independent agency market, as well as companies which sell insurancedirectly to customers. Direct writers may have certain competitive advantagesover agency writers, including increased name recognition, loyalty of the customerbase to the insurer rather than to an independent agency and, potentially,lower cost structures. A material reduction in the amount of businessindependent agents sell would adversely affect us. In the past, competition inthe Massachusetts private passenger automobile market has included offeringsignificant discounts from the maximum permitted rates, and there can be noassurance that these conditions will not recur. Further, we and others competeon the basis of the commissions and other cash and non-cash incentives providedto agents. Although a number of national insurers that are much larger than weare do not currently compete in a material way in the Massachusetts privatepassenger automobile market, if one or more of these companies decided to aggressivelyenter the market it could have a material adverse effect on us. These companiesinclude some that would be able to sustain significant losses in order toacquire market share, as well as others which use distribution methods thatcompete with the independent agent channel. There can be no assurance that wewill be able to compete effectively against these companies in the future.

In Massachusetts, as of December 31,2005, 19 insurers actively wrote private passenger automobile insurance,according to CAR. Of these 19 insurers, 4 are national companies which useindependent agents to sell their products, 8 are regional or Massachusetts-onlycompanies which use independent agents to sell 

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theirproducts (including us) and 7 are national, regional or Massachusetts-onlycompanies which sell their products directly to policyholders. Our principalcompetitors within the Massachusetts private passenger automobile insuranceindustry are both regional companies, Commerce Group, Inc. and ArbellaInsurance Group, which held 29.9% and 9.1% market shares based on automobileexposures, respectively, in 2005 according to CAR.

**L.**                Employees

At December 31, 2005,we employed 563 employees. Our employees are not covered by any collectivebargaining agreement. Management considers our relationship with our employeesto be good.

**M.**            Investments

Investment income is an important source of revenuefor us and the return on our investment portfolio has a material effect on ournet earnings. Our investment objective is to focus on maximizing total returnswhile investing conservatively. We maintain a high quality investment portfolioconsistent with our established investment policy. As of December 31,2005, there were no securities below investment grade (as defined by Moody’s,S&P, and the Securities Valuation Office of the NAIC (see further detailsbelow)) in our fixed income securities portfolio. According to our investmentguidelines, no more than 1% of our portfolio may be invested in the securitiesof any one issuer (excluding U.S. government-backed securities), and nomore than 0.5% of our portfolio may be invested in securities rated “BBB,” orthe lowest investment grade assigned by Moody’s. We continually monitor the mixof taxable and tax-exempt securities, in an attempt to maximize our totalafter-tax return. Since 1986, our investment manager has been Deutsche AssetManagement, formerly known as Scudder Investments.

Thefollowing table reflects the composition of our investment portfolio at December 31,2005 and 2004:

| ** **                                        | ** ** | **At December 31,** | ** **  |
|---------------------------------------------------|------------|-------------------------------|-------------|
| ** **                                        | ** ** | **2005**                      | ** **  | **2004** | ** ** |
| ** **                                        | ** ** | **Estimated**                 | ** **  | ** ** | ** ** | **Estimated** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **Fair Value**           | ** **  | **% of Portfolio** | ** ** | **Fair Value** | ** ** | **% of Portfolio** | ** ** |
| U.S. Treasury securities  and obligations         | ** ** | ** **                    | ** **  |   | ** ** | ** ** |   | ** ** | ** ** |   | ** ** | ** ** |   |
| of U.S.  Government agencies(1)                   | ** ** | **$**                         | **125,220** | ** ** |   | **17.5** | **%** |   | $ | 124,162 |   |   | 18.7 | % |   |
| Obligations of  states and political subdivisions | ** ** | **322,609**                   | ** **  |   | **45.1** | ** ** |   | 327,925 |   |   | 49.3 |   |   |
| Asset-backed  securities(1)                       | ** ** | **123,475**                   | ** **  |   | **17.3** | ** ** |   | 79,940 |   |   | 12.0 |   |   |
| Corporate and  other securities                   | ** ** | **141,234**                   | ** **  |   | **19.8** | ** ** |   | 131,482 |   |   | 19.8 |   |   |
| Subtotal, fixed maturity securities               | ** ** | **$**                         | **712,538** | ** ** |   | **99.7** | **%** |   | $ | 663,509 |   |   | 99.8 | % |   |
| Equity securities                                 | ** ** | **2,005**                     | ** **  |   | **0.3** | ** ** |   | 1,087 |   |   | 0.2 |   |   |
| Totals                                            | ** ** | **$**                         | **714,543** | ** ** |   | **100.0** | **%** |   | $ | 664,596 |   |   | 100.0 | % |   |

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(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC),and Federal National Mortgage Association (FNMA). The total of these fixedmaturity securities was $115,284 and $120,636 at fair value and $117,766 and$120,729 at amortized cost as of December 31, 2005 and 2004, respectively.As such, the asset-backed securities presented exclude such issuersalready presented under U.S. Treasury securities and obligations of U.S.Government Agencies.

While we have held common equity securities in ourinvestment portfolio in the past, as of December 31, 2005, we held no suchsecurities in our investment portfolio, except for interests in mutual funds tofund the Safety Insurance Company Executive Incentive Compensation Plan, anon-qualified deferred compensation plan maintained for the purpose ofproviding deferred compensation to a select 

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group of management. Wemade the decision to divest common equity securities in order to maximize thecurrent investment income earned by our portfolio and to reduce our overallinvestment risk. We continuously evaluate market conditions and we expect inthe future to purchase common equity securities.

The principal risks inherent in holding mortgage-backedsecurities and other pass-through securities are prepayment and extensionrisks, which affect the timing of when cash flows will be received. Wheninterest rates decline, mortgages underlying mortgage-backed securitiestend to be prepaid more rapidly than anticipated, causing early repayments.When interest rates rise, the underlying mortgages tend to be prepaid at aslower rate than anticipated, causing the principal repayments to be extended.Although early prepayments may result in acceleration of income fromrecognition of any unamortized discount, the proceeds typically are reinvestedat a lower current yield, resulting in a net reduction of future investmentincome.

Thefollowing table reflects our investment results for each year in the three-yearperiod ended December 31, 2005:

| ** **                                      | ** ** | **Year Ended December 31,** | ** **  |
|-------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                      | ** ** | **2005**                                   | ** **  | **2004** | ** ** | **2003** | ** ** |
| Average cash and  invested securities (at cost) | ** ** | **$**                                      | **837,200** | ** ** | $ | 734,576 |   | $ | 638,931 |   |
| Net investment  income(1)                       | ** ** | **$**                                      | **31,573**  | ** ** | $ | 27,259 |   | $ | 26,086 |   |
| Net effective yield(2)                          | ** ** | **3.8**                                    | **%**       | 3.7 | % | 4.1 | % |

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(1)          After investmentexpenses, excluding realized investment gains (losses).

(2)          Net investment incomefor the period divided by average invested securities and cash for the sameperiod.

Net effective yield increased in 2005 from 2004 due tohigher yields on our short-term investments combined with a $72,871 increase inaverage cash and cash equivalents. Net effective yield declined in 2004 from2003 as a result of management’s investment strategy to shorten the duration ofour portfolio, shift to higher rated securities, and increase our tax-exemptholdings.

As of December 31, 2005, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’sInvestors Service, Inc. of Baa or higher, except the few securities notrated by Moody’s which received Standard and Poor’s ratings of A- or higher, aswell as a rating assigned by the Securities Valuation Office of the NationalAssociation of Insurance Commissioners of 1 or 2).

Thecomposition of our fixed income security portfolio by Moody’s rating was asfollows:

| ** **                                                            | ** ** | **December 31, 2005** | ** **  |
|-----------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                            | ** ** | **Estimated**                   | ** **  | ** ** | ** ** |
| ** **                                                            | ** ** | **Fair Value**             | ** **  | **Percent** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                           | **122,237** | ** ** |   | **17.2** | **%** |   |
| Aaa/Aa                                                                | ** ** | **443,200**                     | ** **  |   | **62.1** | ** ** |   |
| A                                                                | ** ** | **86,179**                      | ** **  |   | **12.1** | ** ** |   |
| Baa                                                                   | ** ** | **46,183**                      | ** **  |   | **6.5** | ** ** |   |
| Not rated  (Standard & Poor’s rating of A-  or higher)  | ** ** | **14,739**                      | ** **  |   | **2.1** | ** ** |   |
| Total                                                                 | ** ** | **$**                           | **712,538** | ** ** |   | **100.0** | **%** |   |

 

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Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

Moody’s rating system utilizes nine symbols toindicate the relative investment quality of a rated bond. Aaa rated bonds arejudged to be of the best quality and are considered to carry the smallestdegree of investment risk. Aa rated bonds are also judged to be of high qualityby all standards. Together with Aaa bonds, these bonds comprise what aregenerally known as high grade bonds. Bonds rated A possess many favorableinvestment attributes and are considered to be upper medium grade obligations.Baa rated bonds are considered as medium grade obligations; they are neitherhighly protected nor poorly secured. Bonds rated Ba or lower (those rated B,Caa, Ca and C) are considered to be too speculative to be of investmentquality.

The Securities Valuation Office of the NationalAssociation of Insurance Commissioners evaluates all public and private bondspurchased as investments by insurance companies. The Securities ValuationOffice assigns one of six investment categories to each security it reviews.Category 1 is the highest quality rating and Category 6 is thelowest. Categories 1 and 2 are the equivalent of investment grade debt asdefined by rating agencies such as Standard & Poor’s Ratings Servicesand Moody’s, while Categories 3-6 are the equivalent of below investmentgrade securities. Securities Valuation Office ratings are reviewed at leastannually. At December 31, 2005, approximately 85.2% of our fixed maturityinvestments were rated Category 1, and 14.8% of our fixed maturityinvestments were rated Category 2, the two highest ratings assigned by theSecurities Valuation Office. At December 31, 2005, we had no fixedmaturity investments rated Category 3 or lower by the Securities ValuationOffice.

Thefollowing table indicates the composition of our fixed income securityportfolio (at carrying value) by time to maturity as of December 31, 2005:

| ** **                                | ** ** | **December 31, 2005** | ** **  |
|-------------------------------------------|------------|---------------------------------|-------------|
| ** **                                | ** ** | **Amount**                      | ** **  | **Percent** | ** ** |
| Due in one year  or less                  | ** ** | **$**                           | **26,235**  | ** ** |   | **3.7** | **%** |   |
| Due after one  year through five years    | ** ** | **172,606**                     | ** **  |   | **24.2** | ** ** |   |
| Due after five  years through ten years   | ** ** | **189,254**                     | ** **  |   | **26.5** | ** ** |   |
| Due after ten  years through twenty years | ** ** | **65,265**                      | ** **  |   | **9.2** | ** ** |   |
| Due after twenty  years                   | ** ** | **20,419**                      | ** **  |   | **2.9** | ** ** |   |
| Asset-backed  securities                  | ** ** | **238,759**                     | ** **  |   | **33.5** | ** ** |   |
| Totals                                    | ** ** | **$**                           | **712,538** | ** ** |   | **100.0** | **%** |   |

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(1)          Actualmaturities of asset-backed securities differ from contractual maturitiesbecause borrowers may have the right to call or prepay obligations with orwithout call or prepayment penalties. Prepayment rates are influenced by anumber of factors that cannot be predicted with certainty, including: therelative sensitivity of the underlying mortgages or other collateral to changesin interest rates; a variety of economic, geographic and other factors; and therepayment priority of the securities in the overall securitization structures.

**N.**              Ratings

A.M. Best, which rates insurance companies based onfactors of concern to policyholders, currently assigns Safety Insurance an “A(Excellent)” rating. Our “A” rating was reaffirmed by A.M. Best on November 22,2004. Such rating is the third highest rating of 13 ratings that A.M. Bestassigns to solvent insurance companies, which currently range from “A++(Superior)” to “D (Very Vulnerable).” Publications of A.M. Best indicatethat the “A” rating is assigned to those companies that in A.M. Best’sopinion have a strong ability to meet their obligations to policyholders over along period of time. In 

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evaluating a company’sfinancial and operating performance, A.M. Best reviews the company’sprofitability, leverage and liquidity, as well as its book of business, theadequacy and soundness of its reinsurance, the quality and estimated marketvalue of its assets, the adequacy of its loss reserves, the adequacy of itssurplus, its capital structure, the experience and competence of its managementand its market presence. A.M. Best’s ratings reflect its opinion of aninsurance company’s financial strength, operating performance and ability tomeet its obligations to policyholders and are not evaluations directed topurchasers of an insurance company’s securities.

In reaffirming SafetyInsurance’s rating, A.M. Best recognized its excellent capitalization,sustained operating profitability, and favorable market position as anautomobile insurer in Massachusetts. A.M. Best also noted among ourpositive attributes: favorable operating earnings in recent years; ourdisciplined underwriting approach; and expertise in the highly regulatedMassachusetts automobile insurance industry. A.M. Best cited other factorsthat partially offset these positive attributes, including our geographicconcentration, elevated underwriting leverage and limited product scope. We aresubject to the competitive and highly regulated Massachusetts private passengerautomobile market, which is characterized by mandated rates set by theCommissioner.

**O.**              Supervision and Regulation

*Introduction.**  *Our principal operations areconducted through the Insurance Subsidiaries which are subject to comprehensiveregulation by the Division of Insurance, of which the Commissioner is thesenior official. The Commissioner is appointed by the Governor. We are subjectto the authority of the Commissioner in many areas of our business underMassachusetts law, including:

·       ourlicenses to transact insurance;

·       thepremium rates and policy forms we may use;

·       ourfinancial condition including the adequacy of our reserves and provisions forunearned premium;

·       thesolvency standards that we must maintain;

·       thetype and size of investments we may make;

·       theprescribed or permitted statutory accounting practices we must use; and

·       thenature of the transactions we may engage in with our affiliates.

In addition, the Commissioner periodically conducts afinancial examination of all licensees domiciled in Massachusetts. We were mostrecently examined for the five-year period ending December 31, 2003. TheDivision had no material findings as a result of this examination.

*InsuranceHolding Company Regulation.**  *Our principal operating subsidiaries are insurancecompanies, and therefore we are subject to certain laws in Massachusettsregulating insurance holding company systems. These laws require that wefile a registration statement with the Commissioner that discloses theidentity, financial condition, capital structure and ownership of each entitywithin our corporate structure and any transactions among the members of ourholding company system. In some instances, we must provide prior notice to theCommissioner for material transactions between our insurance companysubsidiaries and other affiliates in our holding company system. These holdingcompany statutes also require, among other things, prior approval of thepayment of extraordinary dividends or distributions and any acquisition of adomestic insurer.

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*InsuranceRegulation Concerning Dividends.**  *We rely on dividends from theInsurance Subsidiaries for our cash requirements. The insurance holding companylaw of Massachusetts requires notice to the Commissioner of any dividend to thestockholders of an insurance company. The Insurance Subsidiaries may not makean “extraordinary dividend” until thirty days after the Commissioner hasreceived notice of the intended dividend and has not objected in such time. Ashistorically administered by the Commissioner, this provision requires theprior approval by the Commissioner of an extraordinary dividend. Anextraordinary dividend is defined as any dividend or distribution that,together with other distributions made within the preceding twelve monthsexceeds the greater of 10% of the insurer’s surplus as of the preceding December 31,or the insurer’s net income for the twelve-month period ending thepreceding December 31, in each case determined in accordance withstatutory accounting practices. Under Massachusetts law, an insurer may paycash dividends only from its unassigned funds, also known as its earnedsurplus, and the insurer’s remaining surplus must be both reasonable inrelation to its outstanding liabilities and adequate to its financial needs. Atyear-end 2005, the statutory surplus of Safety Insurance was $350,833 and itsnet income for 2005 was $92,432. A maximum of $92,432 will be available by theend of 2006 for such dividends without prior approval of the Division.

*Acquisitionof Control of a Massachusetts Domiciled Insurance Company.**  *Massachusetts law requires advanceapproval by the Commissioner of any change in control of an insurance companythat is domiciled in Massachusetts. That law presumes that control exists whereany person, directly or indirectly, owns, controls, holds the power to vote orholds proxies representing 10% or more of our outstanding voting stock. Evenpersons who do not acquire beneficial ownership of more than 10% of theoutstanding shares of our common stock may be deemed to have acquired controlif the Commissioner determines that control exists in fact. Any purchaser ofshares of common stock representing 10% or more of the voting power of ourcapital stock will be presumed to have acquired control of the InsuranceSubsidiaries unless, following application by that purchaser the Commissionerdetermines that the acquisition does not constitute a change of control or isotherwise not subject to regulatory review. These requirements may deter, delayor prevent transactions affecting the control of or the ownership of our commonstock, including transactions that could be advantageous to our stockholders.

*ProtectionAgainst Insurer Insolvency.**  *Massachusetts law requires that insurers licensed todo business in Massachusetts participate in the Massachusetts InsurersInsolvency Fund. The Massachusetts Insurers Insolvency Fund must pay any claimup to $300 of a policyholder of an insolvent insurer if the claim existed priorto the declaration of insolvency or arose within sixty days after thedeclaration of insolvency. Members of the Massachusetts Insurers InsolvencyFund are assessed the amount the Massachusetts Insurers Insolvency Fund deemsnecessary to pay its obligations and expenses in connection with handlingcovered claims. Subject to certain exceptions, assessments are made in theproportion that each member’s net written premiums for the prior calendar yearfor all property and casualty lines bore to the corresponding net writtenpremiums for Massachusetts Insurers Insolvency Fund members for the sameperiod. As a matter of Massachusetts law, insurance rates and premiums includeamounts to recoup any amounts paid by insurers for the costs of theMassachusetts Insurers Insolvency Fund. With respect to private passengerautomobile insurance rates and premiums, the Commissioner has historically madean adjustment in his or her annual rate decision reflecting any MassachusettsInsurers Insolvency Fund-related costs reported by the industry in its ratefiling. By statute, no insurer in Massachusetts may be assessed in any year anamount greater than two percent of that insurer’s direct written premium forthe calendar year prior to the assessment. We account for allocations from theMassachusetts Insurers Insolvency Fund as underwriting expenses. In 2004 and2003 we incurred charges of $2,538 and $3,423, respectively, for our allocationfrom the Massachusetts Insurers Insolvency Fund for the insolvencies of otherinsurers. In 2005, we received a refund of prior years’ assessments of $50. CARalso assesses its members as a result of insurer insolvencies. Because CAR isnot able to recover an insolvent company’s share of the net CAR losses from theMassachusetts Insurers Insolvency Fund, CAR must increase each of its member’sshare of the deficit in order to compensate for the insolvent carrier’sinability to pay its deficit 

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assessment. It isanticipated that there will be additional assessments from time to timerelating to various insolvencies.

*TheInsurance Regulatory Information System.**  *The Insurance RegulatoryInformation System was developed to help state regulators identify companiesthat may require special financial attention. The Insurance RegulatoryInformation System consists of a statistical phase and an analytical phasewhereby financial examiners review annual statements and financial ratios. Thestatistical phase consists of 12 key financial ratios based on year-end datathat are generated from the National Association of Insurance Commissioners’database annually; each ratio has an established “usual range” of results.These ratios assist state insurance departments in executing their statutorymandate to oversee the financial condition of insurance companies.

A ratio result falling outside the usual range ofInsurance Regulatory Information System ratios is not considered a failingresult; rather, unusual values are viewed as part of the regulatory earlymonitoring system. Furthermore, in some years, it may not be unusual forfinancially sound companies to have several ratios with results outside theusual ranges. Generally, an insurance company will become subject to regulatoryscrutiny if it falls outside the usual ranges of four or more of the ratios. In2005, all our ratios for both the Insurance Subsidiaries were within the normalrange except for Net Change in Adjusted Policyholders’ Surplus whichexceeded  the range. In 2004 and 2003,all our ratios for both the Insurance Subsidiaries were within the normal rangeexcept for Investment Yield, which fell below the range primarily due to ourinvestment strategy to increase tax-exempt holdings in our portfolio.

*Risk Based CapitalRequirements.**  *TheNational Association of Insurance Commissioners (“NAIC”) has adopted a formulaand model law to implement risk based capital requirements for most propertyand casualty insurance companies, which are designed to determine minimumcapital requirements and to raise the level of protection that statutorysurplus provides for policyholder obligations. The risk based capital formulafor property and casualty insurance companies measures three major areas ofrisk facing property and casualty insurers:

·       underwriting,which encompasses the risk of adverse loss developments and inadequate pricing;

·       declinesin asset values arising from market and/or credit risk; and

·       off-balancesheet risk arising from adverse experience from non-controlled assets,guarantees for affiliates or other contingent liabilities and reserve andpremium growth.

Under Massachusetts law, insurers having less totaladjusted capital than that required by the risk based capital calculation willbe subject to varying degrees of regulatory action, depending on the level ofcapital inadequacy.

The risk based capital law provides for four levels ofregulatory action. The extent of regulatory intervention and action increasesas the level of total adjusted capital to risk based capital falls. The firstlevel, the company action level, as defined by the NAIC, requires an insurer tosubmit a plan of corrective actions to the Commissioner if total adjustedcapital falls below 200% of the risk based capital amount. The regulatoryaction level, as defined by the NAIC requires an insurer to submit a plancontaining corrective actions and requires the Commissioner to perform anexamination or other analysis and issue a corrective order if total adjustedcapital falls below 150% of the risk based capital amount. The authorizedcontrol level, as defined by the NAIC, authorizes the Commissioner to takewhatever regulatory actions he or she considers necessary to protect the bestinterest of the policyholders and creditors of the insurer which may include theactions necessary to cause the insurer to be placed under regulatory control,i.e., rehabilitation or liquidation, if total adjusted capital falls below 100%of the risk based capital amount. The fourth action level is the mandatorycontrol level, as defined by the NAIC, which requires the Commissioner to placethe insurer under regulatory control if total adjusted capital falls below 70%of the risk based capital amount.

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The formulas have not been designed to differentiateamong adequately capitalized companies that operate with higher levels ofcapital. Therefore, it is inappropriate and ineffective to use the formulas torate or to rank these companies. At December 31, 2005, our InsuranceSubsidiaries had total adjusted capital in excess of amounts requiring companyor regulatory action at any prescribed risk based capital action level.

*Regulationof Private Passenger Automobile Insurance in Massachusetts.**  *Our principal line of business isMassachusetts private passenger automobile insurance. As described in moredetail above under “B. The Massachusetts Property and Casualty Insurance Market,”regulation of private passenger automobile insurance in Massachusetts differssignificantly from how this line of insurance is regulated in other states.These differences include the requirements that the premium rate we and allinsurers must charge is fixed and established by the Commissioner, that ourability and that of our competitors to deviate from the rate set by theCommissioner is restricted, and that some of our insurance producers areassigned to us as a matter of law. See “B. The Massachusetts Property andCasualty Insurance Market,” as discussed above.

**ITEM 1A.**        RISKFACTORS

*An investment inour common stock involves a number of risks. Any of the risks described belowcould result in a significant or material adverse effect on our results ofoperations or financial condition, and a corresponding decline in the marketprice of our common stock.*

***Because we are primarily a private passengerautomobile insurance carrier, our business may be adversely affected byconditions in this industry.***

Approximately 80.3% of ourdirect written premiums for the year ended December 31, 2005 weregenerated from private passenger automobile insurance policies. As a result ofour focus on that line of business, negative developments in the economic,competitive or regulatory conditions affecting the private passenger automobileinsurance industry could have a material adverse effect on our results ofoperations and financial condition. In addition, these developments would havea disproportionate effect on us, compared to insurers which conduct operationsin multiple business lines.

***Because we write insurance only in Massachusetts, ourbusiness may be adversely affected by conditions in Massachusetts.***

All of our direct writtenpremiums are generated in Massachusetts. Our revenues and profitability aretherefore subject to prevailing regulatory, economic, demographic, competitiveand other conditions in Massachusetts. Changes in any of these conditions couldmake it more costly or difficult for us to conduct our business. Adverseregulatory developments in Massachusetts, which could include, among others,reductions in the maximum rates permitted to be charged, inadequate rateincreases or more fundamental changes in the design or implementation of theMassachusetts automobile insurance regulatory framework, could have a materialadverse effect on our results of operations and financial condition. Inaddition, these developments would have a disproportionate effect on us,compared to insurers which conduct operations in multiple states.

***We have exposure to claims related to severe weatherconditions, which may result in an increase in claims frequency and severity.***

We are subject to claims arising out of severe weatherconditions, such as rainstorms, snowstorms and ice storms, that may have asignificant effect on our results of operations and financial condition. Theincidence and severity of weather conditions are inherently unpredictable.There is generally an increase in claims frequency and severity under theprivate passenger automobile insurance we write when severe weather occurs becausea higher incidence of vehicular accidents and other insured losses tend tooccur as a result of severe weather conditions. In addition, we have exposureto an increase in claims frequency and 

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severity under thehomeowners and other property insurance we write because property damage mayresult from severe weather conditions.

Because some of ourinsureds live near the Massachusetts coastline, we also have a potentialexposure to losses from hurricanes and major coastal storms such as Nor’easters.Although we purchase catastrophe reinsurance to limit our exposure to thesetypes of natural catastrophes, in the event of a major catastrophe resulting inproperty losses to us in excess of $250.0 million, our losses would exceed thelimits of this reinsurance.

***If we are not able to attract and retain independentagents, it could adversely affect our business.***

We market our insurancesolely through independent agents. We must compete with other insurancecarriers for the business of independent agents. Some of our competitors offera larger variety of products, lower prices for insurance coverage or highercommissions. While we believe that the commissions and services we provide toour agents are competitive with other insurers, changes in commissions, servicesor products offered by our competitors could make it harder for us to attractand retain independent agents to sell our insurance products.

***Established competitors with greater resources maymake it difficult for us to market our products effectively and offer ourproducts at a profit.***

The property and casualtyinsurance business is highly competitive and many of our competitors havesubstantially greater financial and other resources than us. We compete withboth large national writers and smaller regional companies. Further, ourcompetitors include other companies which, like us, serve the independentagency market, as well as companies which sell insurance directly to customers.Direct writers may have certain competitive advantages over agency writers,including increased name recognition, loyalty of the customer base to theinsurer rather than to an independent agency and, potentially, lower coststructures. A material reduction in the amount of business independent agentssell would directly and negatively affect our profitability and our ability tocompete with insurers that do not rely solely on the independent agency marketto sell their products. In the past, competition in the Massachusetts personalauto insurance market has included offering significant discounts from themaximum permitted rates, and there can be no assurance that these conditionswill not recur. Further, our Company and others compete on the basis of thecommissions and other cash and non-cash incentives provided to agents. Althougha number of national insurers that are much larger than we are do not currentlycompete in a material way in the Massachusetts personal auto market, if one ormore of these companies decided to aggressively enter the market it couldreduce our share of the Massachusetts market and thereby have a materialadverse effect on us. These companies include some that would be able tosustain significant losses in order to acquire market share, as well as otherswhich use distribution methods that compete with the independent agent channel.

***As a holding company, Safety Insurance Group, Inc.is dependent on the results of operations of the Safety Insurance Company***.

Safety Insurance Group, Inc.is a company and a legal entity separate and distinct from Safety InsuranceCompany, our principal operating subsidiary. As a holding company withoutsignificant operations of its own, the principal sources of Safety InsuranceGroup, Inc.’s funds are dividends and other distributions from SafetyInsurance Company. Our rights to participate in any distribution of assets ofSafety Insurance Company are subject to prior claims of policyholders,creditors and preferred stockholders, if any, of Safety Insurance Company  (except to the extent that our rights, ifany, as a creditor are recognized). Consequently, our ability to pay debts,expenses and cash dividends to our stockholders may be limited. The ability ofSafety Insurance Company to pay dividends is subject to limits underMassachusetts insurance law. Further, the ability of Safety Insurance Group, Inc.to pay dividends, and our 

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subsidiaries’ability to incur indebtedness or to use the proceeds of equity offerings, willbe subject to limits under our revolving credit facility.

***We are subject to comprehensive regulation by Massachusettsand our ability to earn profits may be restricted by these regulations.***

General Regulation.We are subject to regulation by government agencies in Massachusetts, and wemust obtain prior approval for certain corporate actions. We must comply withregulations involving:

·       transactionsbetween an insurance company and any of its affiliates;

·       thepayment of dividends;

·       theacquisition of an insurance company or of any company controlling an insurancecompany;

·       approvalor filing of premium rates and policy forms;

·       solvencystandards;

·       minimumamounts of capital and surplus which must be maintained;

·       limitationson types and amounts of investments;

·       restrictionson the size of risks which may be insured by a single company;

·       limitationof the right to cancel or non-renew policies in some lines;

·       regulationof the right to withdraw from markets or terminate involvement with agencies;

·       requirementsto participate in residual markets;

·       licensingof insurers and agents;

·       depositsof securities for the benefit of policyholders; and

·       reportingwith respect to financial condition.

In addition, insurance department examiners fromMassachusetts perform periodic financial and market conduct examinations ofinsurance companies. Such regulation is generally intended for the protectionof policyholders rather than security holders.

Massachusetts requires that all licensed property andcasualty insurers bear a portion of the losses suffered by some insureds as aresult of impaired or insolvent insurance companies by participating in the Massachusetts Insurers Insolvency Fund (“InsolvencyFund”). Members of the Insolvency Fund are assessed a proportionate share ofthe obligations and expenses of the Insolvency Fund in connection with aninsolvent insurer. In 2005, the Company received a refund of prior years’assessments from the Insolvency Fund of $50. In 2004 and 2003, the Companyreceived notice of assessments from the Insolvency Fund amounting to $2,538 and$3,423. These assessments were made by the Insolvency Fund to cover thecost of paying eligible claims of policyholders of these insolvent insurers,and by CAR, to recover the shares of net CAR losses that would have beenassessed to the insolvent companies but for their insolvencies. In addition, Massachusettshas established an underwriting association in order to ensure that propertyinsurance is available for owners of high risk property who are not able toobtain insurance from private insurers. The losses of this underwritingassociation are shared by all insurers that write property and casualtyinsurance in Massachusetts. We are assessed from time to time to pay theselosses. The effect of these assessments could reduce our profitability in anygiven period and limit our ability to grow our business.

Because we are unable to predict with certaintychanges in the political, economic or regulatory environments in Massachusettsin the future, there can be no assurance that existing insurance-related laws 

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and regulations will notbecome more restrictive in the future or that new restrictive laws will not beenacted and, therefore, it is not possible to predict the potential effects ofthese laws and regulations on us.

Massachusetts Personal Auto Regulation. We are subjectto the extensive regulation of the private passenger automobile insuranceindustry in Massachusetts. Owners of registered automobiles are required tomaintain minimum automobile insurance coverages. Generally, we are required bylaw to issue a policy to any applicant who seeks it. We are assigned certainagents that have been unable to obtain a voluntary contract with anotherinsurer, on the basis of our market share. We call these agents ExclusiveRepresentative Producers or ERPs. In addition, we are required to participatein a state mandated reinsurance program run by CAR, to which we cede certainundesirable risks and from which we are allocated a portion of the program’soverall losses. This program operates at an underwriting deficit and results inexpense for us. Our ability to earn profits may be restricted by these requirements.

Our marketing andunderwriting strategies are limited by maximum premium rates and minimum agencycommission levels for personal automobile insurance, which are mandated by theCommissioner. The Commissioner mandated an average rate decrease in privatepassenger automobile premiums of 1.7% for 2005. The Commissioner mandatedaverage rate increases of 2.5% and 2.7% for 2004 and 2003, respectively, and norate change for 2002. The Commissioner announced on December 15, 2005, a8.7% statewide average rate decrease for 2006. In addition, the Commissionerannually establishes the minimum commission rate that insurers must pay theirauto insurance agents. The Commissioner approved a commission rate, as apercentage of premiums of 10.9%, 10.5%, 11.0%, and 11.7% in 2005, 2004, 2003,and 2002, respectively. The Commissioner approved a commission rate of 11.8%for 2006. Premium rates are set following a proceeding in which theCommissioner considers historic information relating to claims costs as well asoutside factors affecting insurance costs. If the information considered doesnot accurately predict the future benefit and expense costs of insurers, or ifthe Commissioner otherwise sets inadequate premium rates, our futureprofitability could be decreased. Future increases in commission rates wouldalso decrease our profitability.

***We may enter new markets and there can be no assurancethat our diversification strategy will be effective.***

Although we intend toconcentrate on our core businesses in Massachusetts, we also may seek to takeadvantage of prudent opportunities to expand our core businesses into otherstates where we believe the independent agent distribution channel is strong.As a result of a number of factors, including the difficulties of findingappropriate expansion opportunities and the challenges of operating in anunfamiliar market, we may not be successful in this diversification.Additionally, in order to carry out any such strategy we would need to obtainthe appropriate licenses from the insurance regulatory authority of any suchstate. Today, we do not possess any licenses outside of Massachusetts and wecould encounter unexpected regulatory obstacles that prevent us from obtainingthese licenses in a timely fashion, or at all.

***Our failure to maintain a commercially acceptablefinancial strength rating would significantly and negatively affect our abilityto implement our business strategy successfully.***

A.M. Best has currentlyassigned Safety Insurance an ‘‘A (Excellent)’’ rating. An ‘‘A’’ rating is A.M.Best’sthird highest rating, out of 13 possible rating classifications for solventcompanies. An ‘‘A’’ rating is assigned to insurers that in A.M. Best’sopinion have a strong ability to meet their ongoing obligations topolicyholders. Moreover, an ‘‘A’’ rating is assigned to companies that have, onbalance, excellent balance sheet strength, operating performance and businessprofile when compared to the standards established by A.M. Best. A.M.Best bases its ratings on factors that concern policyholders and not uponfactors concerning investor protection. Such ratings are subject to change andare not recommendations to buy, sell or hold securities. An important factor inan insurer’s ability to compete effectively is its A.M. Best rating. Our A.M.Best rating is lower than those of some of our competitors. Any future decreasein our rating could affect our competitive position.

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***Our losses and loss adjustment expenses may exceed ourreserves, which could significantly affect our business.***

The reserves for losses and loss adjustment expensesthat we have established are estimates of amounts needed to pay reported andunreported claims and related expenses based on facts and circumstances knownto us as of the time we established the reserves. Reserves are based onhistorical claims information, industry statistics and other factors. Theestablishment of appropriate reserves is an inherently uncertain process. Ifour reserves are inadequate and are strengthened, we would have to treat theamount of such increase as a charge to our earnings in the period that thedeficiency is recognized. As a result of these factors, there can be noassurance that our ultimate liability will not materially exceed our reservesand have a negative effect on our results of operations and financialcondition.

Due to the inherentuncertainty of estimating reserves, it has been necessary, and may over timecontinue to be necessary, to revise estimated future liabilities as reflectedin our reserves for claims and policy expenses. The historic development ofreserves for losses and loss adjustment expenses may not necessarily reflectfuture trends in the development of these amounts. Accordingly, it is notappropriate to extrapolate redundancies or deficiencies based on historicalinformation.

***If we lose key personnel, our ability to implement ourbusiness strategy could be delayed or hindered.***

Our future success dependssignificantly upon the efforts of certain key management personnel, includingDavid F. Brussard, our Chief Executive Officer and President. We maintain a$10.0 million key man life insurance policy on Mr. Brussard, the proceedsof which are payable to us, but do not maintain any key man insurance on anyother executive. We have entered into employment agreements with Messrs. Brussard,Begley, Kerton, Krupa, Loranger, Patrick , Murphy, and Berry, the eight membersof our Management Team. The loss of key personnel could prevent us from fullyimplementing our business strategy and could significantly and negativelyaffect our financial condition and results of operations. As we continue togrow, we will need to recruit and retain additional qualified managementpersonnel, and our ability to do so will depend upon a number of factors, suchas our results of operations and prospects and the level of competition thenprevailing in the market for qualified personnel.

***Market fluctuations and changes in interest rates canhave significant and negative effects on our investment portfolio.***

Our results of operationsdepend in part on the performance of our invested assets. As of December 31,2005, 99.7% of our investment portfolio was invested in fixed maturitysecurities and 0.3% in common equity securities. Certain risks are inherent inconnection with debt securities including loss upon default and pricevolatility in reaction to changes in interest rates and general market factors.

***We may not be able to successfully alleviate riskthrough reinsurance arrangements which could cause us to reduce our premiumswritten in certain lines or could result in losses.***

In order to reduce riskand to increase our underwriting capacity, we purchase reinsurance. Theavailability and the cost of reinsurance protection is subject to marketconditions, which are outside of our control. As a result, we may not be ableto successfully alleviate risk through these arrangements. For example, ifreinsurance capacity for homeowners risks were reduced as a result of terroristattacks or other causes, we would seek to reduce the amount of homeownersbusiness we write. In addition, we are subject to credit risk with respect toour reinsurance because the ceding of risk to reinsurers does not relieve us ofour liability to our policyholders. A significant reinsurer’s insolvency orinability to make payments under the terms of a reinsurance treaty could have amaterial adverse effect on our results of operations and financial condition.

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***There are anti-takeover provisions contained in ourorganizational documents and in laws of the State of Delaware and theCommonwealth of Massachusetts that could impede an attempt to replace or removeour management or prevent the sale of our company, which could diminish thevalue of our common stock.***

Our certificate of incorporation, bylaws and the lawsof Delaware contain provisions that may delay, deter or prevent a takeoverattempt that stockholders might consider in their best interests. For example,our organizational documents provide for a classified board of directors withstaggered terms, prevent stockholders from taking action by written consent,prevent stockholders from calling a special meeting of stockholders, providefor supermajority voting requirements to amend our certificate of incorporationand certain provisions of our bylaws and provide for the filling of vacancieson our board of directors by the vote of a majority of the directors then inoffice. These provisions will render the removal of the incumbent board ofdirectors or management more difficult. In addition, these provisions mayprevent stockholders from receiving the benefit of any premium over the marketprice of our common stock offered by a bidder in a potential takeover. Even inthe absence of a takeover attempt, the existence of these provisions mayadversely affect the prevailing market price of our common stock if they areviewed as discouraging takeover attempts in the future.

The Massachusetts insurance law prohibits any personfrom acquiring control of us, and thus indirect control of Safety Insurance,without the prior approval of the Commissioner. That law presumes that controlexists where any person, directly or indirectly, owns, controls, holds thepower to vote or holds proxies representing 10% or more of our outstandingvoting stock. Even persons who do not acquire beneficial ownership of more than10% of the outstanding shares of our common stock may be deemed to haveacquired such control if the Commissioner determines that such control existsin fact. Therefore, any person seeking to acquire a controlling interest in uswould face regulatory obstacles which could delay, deter or prevent anacquisition that stockholders might consider in their best interests.

Section 203 of theGeneral Corporation Law of Delaware, the jurisdiction in which Safety Group isorganized, may affect the ability of an “interested stockholder” to engage incertain business combinations including mergers, consolidations or acquisitionsof additional shares, for a period of three years following the time that the stockholderbecomes an interested stockholder. An interested stockholder is defined toinclude persons owning directly or indirectly 15% or more of the outstanding votingstock of the corporation.

***Future sales of shares of our common stock by ourexisting stockholders in the public market, or the possibility or perception ofsuch future sales, could adversely affect the market price of our stock.***

Investors currently knownto be the beneficial owners of greater than 5.0% of our outstanding commonstock, hold approximately 30% of the common stock of Safety Insurance Group, Inc.on a fully diluted basis. No prediction can be made as to the effect, if any,that future sales of shares by our existing stockholders, or the availabilityof shares for future sale, will have on the prevailing market price of ourcommon stock from time to time. Sales of substantial amounts of our commonstock in the public market by our existing stockholders, or the possibility orperception that such sales could occur, could cause the prevailing marketprices for our common stock to decrease. If such sales reduce the market priceof our common stock, our ability to raise additional capital in the equitymarkets may be adversely affected.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None

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**ITEM 2.**                PROPERTIES

We conduct almost all ofour operations in approximately 89,099 square feet of leased space at 20 CustomHouse Street in downtown Boston, Massachusetts. Our lease expires in December 2008.

**ITEM 3.**                LEGALPROCEEDINGS

Our Insurance Subsidiariesare parties to a number of lawsuits arising in the ordinary course of theirinsurance business. We believe that the ultimate resolution of these lawsuitswill not, individually or in the aggregate, have a material adverse effect onour financial condition. Other than these lawsuits, we are not involved in anylegal proceedings.

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

There were no matterssubmitted to a vote of the Company’s shareholders during the fourth quarter of2005.

**ITEM 4A.**        EXECUTIVEOFFICERS OF THE REGISTRANT

Thetable below sets forth certain information concerning our directors andexecutive officers as of the date of this annual report.

| ** **                   | ** ** | ** ** | ** ** | ** **                                                                        | ** ** | **Years**    | ** ** |
|------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------|------------|--------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** **                                                                        | ** ** | **Employed** | ** ** |
| **Name**                     | ** ** | ** ** | ** ** | **Age**                                                                           | ** ** | **Position** | ** ** | **by Safety** | ** ** |
| David F. Brussard            |       | 54         |       | President, Chief  Executive Officer and Chairman of the Board                     |       | 30           |       |
| William J.  Begley, Jr. |       | 51         |       | Vice President, Chief  Financial Officer and Secretary                            |       | 20           |       |
| James D. Berry               |       | 46         |       | Vice President—Insurance  Operations                                         |       | 23           |       |
| George M. Murphy             |       | 39         |       | Vice President—Marketing                                                     |       | 17           |       |
| Robert J. Kerton             |       | 59         |       | Vice President—Claims                                                        |       | 19           |       |
| David E. Krupa               |       | 45         |       | Vice President—Claims  Operations                                            |       | 23           |       |
| Daniel D. Loranger           |       | 66         |       | Vice President—Management  Information Systems and Chief Information Officer |       | 25           |       |
| Edward N. Patrick, Jr.  |       | 57         |       | Vice President—Underwriting                                                  |       | 32           |       |
| A. Richard  Caputo, Jr. |       | 40         |       | Director                                                                          |       | —       |       |
| Frederic H. Lindeberg.       |       | 65         |       | Director                                                                          |       | —       |       |
| Peter J. Manning             |       | 67         |       | Director                                                                          |       | —       |       |
| David K. McKown              |       | 68         |       | Director                                                                          |       | —       |       |
|                              |            |            |            |                                                                                   |            |              |            |  |  |

 

*DavidF. Brussard*was appointed Chairman of the Board in March 2004and President and Chief Executive Officer (“CEO”) in June 2001. Mr. Brussardhas served as a Director of the Company since October 2001. Since January 1999,Mr. Brussard has been the CEO and President of the Insurance Subsidiaries.Previously, Mr. Brussard served as Executive Vice President of theInsurance Subsidiaries from 1985 to 1999 and as Chief Financial Officer andTreasurer of the Insurance Subsidiaries from 1979 to 1999. Mr. Brussardhas been employed by one or more of our subsidiaries for over 30 years. Mr. Brussardis also Chairman of the Governing Committee and a member of the BudgetCommittee, Executive Committee and Nominating Committee of the AutomobileInsurers Bureau of Massachusetts and is Vice Chairman of the Governing Committee,Chairman of the Governing Committee Review Panel, and a member of the ActuarialCommittee of CAR. Mr. Brussard is also on the Board of Trustees of theInsurance Library Association of Boston.

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*WilliamJ. Begley, Jr.*was appointed Chief Financial Officer,Vice President and Secretary of the Company on March 4, 2002. Since January 1999,Mr. Begley has been the Chief Financial Officer and Treasurer of theInsurance Subsidiaries. Previously, Mr. Begley served as AssistantController of the Insurance Subsidiaries from 1985 to 1987, as Controller from1987 to 1990 and as Assistant Vice President/Controller from 1990 to 1999. Mr. Begleyhas been employed by the Insurance Subsidiaries for over 20 years. Mr. Begleyalso serves on the audit committee of CAR and is a member of the Board ofDirectors of the Massachusetts Insurers Insolvency Fund.

*JamesD. Berry*was appointed Vice President of InsuranceOperations of the Company on October 1, 2005. Mr. Berry has beenemployed by the Insurance Subsidiaries for over 23 years and has directed theCompany’s Massachusetts Private Passenger line of business since 2001.

*GeorgeM. Murphy*was appointed Vice President ofMarketing  on October 1, 2005. Mr. Murphyhas been employed by the Insurance Subsidiaries for over 17 years and mostrecently served as Director of Marketing.

*RobertJ. Kerton*was appointed Vice President of CasualtyClaims of the Company on March 4, 2002. Mr. Kerton has served as VicePresident of Casualty Claims of the Insurance Subsidiaries since 1986 and hasbeen employed by the Insurance Subsidiaries for over 19 years. Mr. Kertonpreviously served 18 years with Allstate Insurance Company in variousMassachusetts claim management assignments. Mr. Kerton serves as Chairmanof the Automobile Insurers Bureau claims committee, vice chairman of the CARclaims committee and on the governing board of the Massachusetts InsuranceFraud Bureau.

*DavidE. Krupa*was appointed Vice President of PropertyClaims of the Company on March 4, 2002. Mr. Krupa has served as VicePresident of Property Claims of the Insurance Subsidiaries since July 1990and has been employed by the Insurance Subsidiaries for over 23 years. Mr. Krupawas first employed by the Company in 1982 and held a series of managementpositions in the Claims Department before being appointed Vice President in1990. In addition, Mr. Krupa has been a member of several claimscommittees both at the Automobile Insurers Bureau and CAR.

*DanielD. Loranger*was appointed Vice President of ManagementInformation Systems of the Company on March 4, 2002. Mr. Loranger hasserved as Vice President of Management Information Systems and ChiefInformation Officer of the Insurance Subsidiaries since 1980 and has beenemployed by the Insurance Subsidiaries for over 25 years. Mr. Lorangerbegan his data processing career with Raytheon Manufacturing in 1960. BEYONDCOMPUTING MAGAZINE awarded Mr. Loranger the first place 2000 PartnershipAward for the strategic alliance of technology with the Company’s businessobjectives and for development of internal software for the Company.

*EdwardN. Patrick, Jr*was appointed Vice President ofUnderwriting of the Company on March 4, 2002. Mr. Patrick has servedas Vice President of Underwriting of the Insurance Subsidiaries since 1979 andas Secretary since 1999. He has been employed by one or more of oursubsidiaries for over 32 years. Mr. Patrick has served on severalcommittees of CAR, including the market review, servicing carrier, statistical,automation and reinsurance operations committees. Mr. Patrick has alsoserved on the CAR operations committee since 1984 and has served as itschairman since 1998.

*A.Richard Caputo, Jr.*has served as a director ofthe Company since June 2001. Mr. Caputo is a Senior Principal and wasa Managing Director of The Jordan Company L.P. and its predecessors, a privateinvestment firm, since 1990. Mr. Caputo is also a director of TALInternational, Inc., Universal Technical Institute, Inc. and variousprivately held companies.

*FredericH. Lindeberg*has served as a director of the Companysince August 2004. Mr. Lindeberg has had a consulting practiceproviding taxation, management and investment counsel since 1991, focusing onfinance, real estate, manufacturing and retail industries. Mr. Lindebergretired in 1991 as Partner-In-Charge of various KPMG tax offices, after24 years of service where he provided both accounting and tax 

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counsel to variousclients. Mr. Lindeberg was formerly an adjunct professor at Penn StateGraduate School of Business. Mr. Lindeberg is currently a director of TALInternational, Inc.

*PeterJ. Manning*has served as a director of the Companysince September 2003. Mr. Manning retired in 2003 as Vice Chairman ofFleetBoston Financial, after 31 years with FleetBoston Financial Corporation(formerly BankBoston) where he also held the positions of Comptroller andExecutive Vice President and Chief Financial Officer. Mr. Manning startedhis career with Coopers & Lybrand in 1962 prior to his 1972 employmentwith BankBoston. He currently is a director of Thermo Electron, and variousnon-profit companies and is Chairman of the Board of the Tournament PlayersClub of Boston.

*DavidK. McKown*has served as director of the Company since November 2002.Mr. McKown has been a Senior Advisor to Eaton Vance Management since 2000,focusing on business origination in real estate and asset-based loans. Mr. McKownretired in March 2000 having served as a Group Executive with BankBostonsince 1993, where he focused on acquisitions and high-yield bank debtfinancings. Mr. McKown has been in the banking industry for 41 years,worked for BankBoston for over 32 years and had previously been the headof BankBoston’s real estate department, corporate finance department, and amanaging director of BankBoston’s private equity unit. Mr. McKown iscurrently a trustee of Equity Office Properties Trust, and a director ofNewcastle Investment Corp. and various privately held companies.

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**PART II.**

**ITEM5.**                MARKET FOR THEREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES

As of March 10, 2006, there were 32 holders ofrecord of the Company’s common stock, par value $0.01 per share, and weestimate another 8,400 held in “Street Name.”

TheCompany’s common stock (symbol: SAFT) is listed on the NASDAQ National Market.The following table sets forth the high and low sales prices per share for eachfull quarterly period within the Company’s two most recent fiscal years.

| **2005**       | ** ** | ** ** | ** ** | **High**   | ** ** | **Low**   | ** ** |
|----------------|------------|------------|------------|------------|------------|-----------|------------|
| First Quarter  | ** ** | **$**      | **40.54**  | ** ** | **$**      | **30.13** | ** ** |
| Second Quarter | ** ** | **$**      | **34.61**  | ** ** | **$**      | **26.20** | ** ** |
| Third Quarter  | ** ** | **$**      | **37.23**  | ** ** | **$**      | **32.52** | ** ** |
| Fourth Quarter | ** ** | **$**      | **44.34**  | ** ** | **$**      | **34.27** | ** ** |

 

| **2004**       | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $          | 20.49      |     | $          | 17.00   |       |
| Second Quarter |       | $          | 22.55      |     | $          | 17.97   |       |
| Third Quarter  |       | $          | 22.89      |     | $          | 19.00   |       |
| Fourth Quarter |       | $          | 32.33      |     | $          | 20.56   |       |

 

The closing price of the Company’s common stock on March 10,2006 was $42.85 per share.

During 2005, the Company declared and paid fourquarterly cash dividends to stockholders, which totaled $9,409. The Company’sBoard of Directors declared a quarterly cash dividend on February 16, 2006of $0.18 per share to stockholders of record on March 1, 2006 payable on March 15,2006. The Company plans to continue to declare and pay quarterly cash dividendsin 2006, depending on the Company’s financial position and the regularity ofits cash flows. See 2005 and 2004 dividend information on page 60.

The Company relies on dividends from its InsuranceSubsidiaries for a portion of its cash requirements. The payment by the Companyof any cash dividends to the holders of common stock therefore depends on thereceipt of dividend payments from its Insurance Subsidiaries. The payment ofdividends by the Insurance Subsidiaries is subject to limitations imposed byMassachusetts law, as discussed in Item 1.O., Business, Supervision andRegulation, “Insurance Regulation Concerning Dividends,” and also in Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations,Liquidity and Capital Resources.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

The following table sets forth our selected historicalconsolidated financial data as of and for each of the five years ended December 31,2005. Prior to October 16, 2001, Thomas Black Corporation (“TBC”) was theultimate parent company of Safety Insurance. In the Acquisition, on October 16,2001, Safety Insurance Group, Inc. became the parent company of TBC.

The selected historical consolidated financial datafor the years ended December 31, 2005, 2004 and 2003 and as of December 31,2005 and 2004 have been derived from the financial statements of SafetyInsurance Group, Inc. included in this annual report which have beenaudited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm. The selected historical consolidated financial data as of andfor the year then ended December 31, 2002 and for the successor period October 16,2001 to December 31, 2001 and for the predecessor period January 1,2001 to October 15, 2001 have been derived from Safety Insurance Group, Inc.’sconsolidated financial statements not included in this annual report, whichhave been audited by PricewaterhouseCoopers LLP. As a result of theAcquisition, financial data for periods prior to the Acquisition may not becomparable with financial data for periods following the Acquisition.

We have prepared the selected historical consolidatedfinancial data, other than statutory data, in conformity with U. S. generallyaccepted accounting principles (“GAAP”). We have derived the statutory datafrom the annual statements of our Insurance Subsidiaries filed with insuranceregulatory authorities, which were prepared in accordance with statutoryaccounting practices, which vary in certain respects from GAAP.

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Theselected financial data presented below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements and the accompanying notes included inthis Form 10-K in order to more fully understand the historicalconsolidated financial data.

| ** **                                                              | ** ** | **Successor**         | ** **  | **Predecessor**       | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| ** **                                                              | ** ** | **Year Ended**   | ** **  | **October 16-**  | ** ** | **January 1-** | ** ** |
| ** **                                                              | ** ** | **December 31,** | ** **  | **December 31,** | ** ** | **October 16,** | ** ** |
| ** **                                                              | ** ** | **2005**              | ** **  | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** | **2001(1)** | ** ** | **2001(1)** | ** ** |
| Direct written  premiums                                                | ** ** | **$**                 | **649,113** |                  | $          | 628,295 |   | $ | 571,545 |   | $ | 516,556 |   |   | $ | 80,238 |   |   |   | $ | 391,628 |   |   |
| Net written  premiums                                                   | ** ** | **632,836**           |        | 618,923               |       | 566,970 |   | 517,614 |   |   | 82,980 |   |   |   | 382,486 |   |   |
| Net earned  premiums                                                    | ** ** | **622,831**           |        | 592,292               |       | 540,248 |   | 489,256 |   |   | 100,175 |   |   |   | 347,098 |   |   |
| Investment income                                                       | ** ** | **31,573**            |        | 27,259                |       | 26,086 |   | 26,142 |   |   | 5,359 |   |   |   | 22,246 |   |   |
| Net realized gains  (losses) on investments                             | ** ** | **305**               |        | 1,274                 |       | 10,051 |   | (277 | ) |   | (4,284 | ) |   |   | (766 | ) |   |
| Finance and other  service income                                       | ** ** | **16,748**            |        | 15,615                |       | 15,409 |   | 14,168 |   |   | 2,546 |   |   |   | 9,260 |   |   |
| Total revenue                                                           | ** ** | **671,457**           |        | 636,440               |       | 591,794 |   | 529,289 |   |   | 103,796 |   |   |   | 377,838 |   |   |
| Loss and loss  adjustment expenses                                      | ** ** | **385,593**           |        | 425,061               |       | 420,969 |   | 375,178 |   |   | 75,559 |   |   |   | 276,383 |   |   |
| Underwriting,  operating and related expenses                           | ** ** | **146,669**           |        | 145,075               |       | 130,636 |   | 128,866 |   |   | 29,808 |   |   |   | 87,998 |   |   |
| Transaction  expenses(2)                                                |       | **—**            |        | —                |       | — |   | — |   |   | 3,874 |   |   |   | 5,605 |   |   |
| Other expenses                                                          | ** ** | **—**            |        | —                |       | — |   | 6,250 |   |   | — |   |   |   | — |   |   |
| Interest expenses                                                       | ** ** | **948**               |        | 672                   |       | 646 |   | 7,254 |   |   | 1,823 |   |   |   | 550 |   |   |
| Total expenses                                                          | ** ** | **533,210**           |        | 570,808               |       | 552,251 |   | 517,548 |   |   | 111,064 |   |   |   | 370,536 |   |   |
| Income (loss)  before income taxes                                      | ** ** | **138,247**           |        | 65,632                |       | 39,543 |   | 11,741 |   |   | (7,268 | ) |   |   | 7,302 |   |   |
| Income tax expense  (benefit)                                           | ** ** | **43,065**            |        | 20,642                |       | 11,061 |   | 1,280 |   |   | (1,666 | ) |   |   | 1,678 |   |   |
| Income (loss)  before extraordinary item and preferred share  dividends | ** ** | **95,182**            |        | 44,990                |       | 28,482 |   | 10,461 |   |   | (5,602 | ) |   |   | 5,624 |   |   |
| Excess of fair  value of acquired net assets over purchase price   |       | **—**            |        | —                |       | — |   | — |   |   | 117,523 |   |   |   | — |   |   |
| Net income before  preferred share dividends                            | ** ** | **95,182**            |        | 44,990                |       | 28,482 |   | 10,461 |   |   | 111,921 |   |   |   | 5,624 |   |   |
| Dividends on  mandatorily redeemable preferred shares                   | ** ** | **—**            |        | —                |       | — |   | (1,219 | ) |   | (280 | ) |   |   | — |   |   |
| Net income  available to common shareholders                            | ** ** | **$**                 | **95,182**  |                  | $          | 44,990 |   | $ | 28,482 |   | $ | 9,242 |   |   | $ | 111,641 |   |   |   | $ | 5,624 |   |   |
| Net income (loss) per common share before  extraordinary item:          |       |                  |        |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                   | ** ** | **$**                 | **6.11**    |                  | $          | 2.94 |   | $ | 1.87 |   | $ | 1.44 |   |   | $ | (1.07 | ) |   |   | $ | 6.26 |   |   |
| Diluted                                                                 | ** ** | **$**                 | **5.97**    |                  | $          | 2.90 |   | $ | 1.86 |   | $ | 1.38 |   |   | $ | (1.07 | ) |   |   | $ | 6.26 |   |   |
| Extraordinary item per common share:                                    |       |                  |        |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                   | ** ** | **$**                 | **—**  |                  | $          | — |   | $ | — |   | $ | — |   |   | $ | 21.29 |   |   |   | $ | — |   |   |
| Diluted                                                                 | ** ** | **$**                 | **—**  |                  | $          | — |   | $ | — |   | $ | — |   |   | $ | 21.29 |   |   |   | $ | — |   |   |
| Net income per common share available to common  shareholders:          |       |                  |        |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                   | ** ** | **$**                 | **6.11**    |                  | $          | 2.94 |   | $ | 1.87 |   | $ | 1.44 |   |   | $ | 20.23 |   |   |   | $ | 6.26 |   |   |
| Diluted                                                                 | ** ** | **$**                 | **5.97**    |                  | $          | 2.90 |   | $ | 1.86 |   | $ | 1.38 |   |   | $ | 20.23 |   |   |   | $ | 6.26 |   |   |
| Cash dividends  paid per common share                                   | ** ** | **$**                 | **0.60**    |                  | $          | 0.44 |   | $ | 0.34 |   | $ | — |   |   | $ | — |   |   |   | $ | — |   |   |
| Weighted average number of common shares outstanding:                   |       |                  |        |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                   | ** ** | **15,578,039**        |        | 15,315,877            |       | 15,259,991 |   | 6,433,786 |   |   | 5,519,500 |   |   |   | 898,300 |   |   |
| Diluted                                                                 | ** ** | **15,953,737**        |        | 15,526,892            |       | 15,340,047 |   | 6,699,338 |   |   | 5,810,000 |   |   |   | 898,300 |   |   |

 

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| ** **                                   | ** ** | **As of and for the Year ended December 31,** | ** **  |
|----------------------------------------------|------------|---------------------------------------------------------------------------------------|-------------|
| ** **                                   | ** ** | **2005**                                                                              | ** **  | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001(1)** | ** ** |
| **Balance  Sheet Data:**                     |       |                                                                                  |        |   |   |   |   |   |   |   |   |
| Total cash & investment securities       | ** ** | **$**                                                                                 | **877,570** |   | $ | 820,269 |   | $ | 699,920 |   | $ | 638,663 |   | $ | 529,286 |   |
| Total assets                                 | ** ** | **1,257,675**                                                                         |        | 1,206,445 |   | 1,076,296 |   | 978,596 |   | 859,174 |   |
| Losses and loss adjustment expenses reserves | ** ** | **450,716**                                                                           |        | 450,897 |   | 383,551 |   | 333,297 |   | 302,556 |   |
| Total debt                                   | ** ** | **—**                                                                            |        | 19,956 |   | 19,956 |   | 19,956 |   | 99,500 |   |
| Total liabilities                            | ** ** | **869,726**                                                                           |        | 901,111 |   | 808,276 |   | 733,344 |   | 727,512 |   |
| Mandatorily redeemable preferred stock       | ** ** | **—**                                                                            |        | — |   | — |   | 22,680 |   | — |   |
| Total shareholders' equity                   | ** ** | **387,949**                                                                           |        | 305,334 |   | 268,020 |   | 245,252 |   | 108,982 |   |
| **Statutory  Data:**                         |       |                                                                                  |        |   |   |   |   |   |   |   |   |
| Policyholders' surplus (at period end)       | ** ** | **$**                                                                                 | **350,833** |   | $ | 278,161 |   | $ | 258,551 |   | $ | 234,204 |   | $ | 220,081 |   |
| Loss ratio(3)                                | ** ** | **61.9**                                                                              | **%**       | 71.7 | % | 78.0 | % | 77.5 | % | 78.8 | % |
| Expense ratio(3)                             | ** ** | **23.4**                                                                              |        | 23.7 |   | 23.5 |   | 24.9 |   | 25.0 |   |
| Combined ratio(3)                            | ** ** | **85.3**                                                                              | **%**       | 95.4 | % | 101.5 | % | 102.4 | % | 103.8 | % |
| **GAAP  Ratios:**                            |       |                                                                                  |        |   |   |   |   |   |   |   |   |
| Loss ratio(3)                                | ** ** | **61.9**                                                                              | **%**       | 71.8 | % | 77.9 | % | 76.7 | % | 78.7 | % |
| Expense ratio(3)                             | ** ** | **23.5**                                                                              |        | 24.5 |   | 24.2 |   | 26.3 |   | 26.3 |   |
| Combined ratio(3)                            | ** ** | **85.4**                                                                              | **%**       | 96.3 | % | 102.1 | % | 103.0 | % | 105.0 | % |

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(1)          In this financialpresentation, the financial data for 2001 has been split into a predecessorperiod from January 1, 2001 to October 15, 2001 and a successorperiod from October 16, 2001 to December 31, 2001.

(2)          Our transaction expensesreflect the costs we incurred in connection with our October 16, 2001acquisition of TBC. Please refer to our 2003 Annual Report on Form 10-K,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations—The Acquisition” for further information.

(3)          The loss ratio is theratio of losses and loss adjustment expenses to net earned premiums. Theexpense ratio, when calculated on a statutory accounting basis, is the ratio ofunderwriting expenses to net written premiums, and when calculated on a GAAPbasis is the ratio of underwriting expense to net earned premiums. The combinedratio is the sum of the loss ratio and the expense ratio. Please refer to page 41for a discussion on the comparison of the above statutory insurance ratios toour GAAP ratios.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The followingdiscussion should be read in conjunction with our accompanying consolidatedfinancial statements and notes thereto, which appear elsewhere in this document.In this discussion, all dollar amounts are presented in thousands, except shareand per share data.*

*The following discussion contains forward-lookingstatements. We intend statements which are not historical in nature to be, andare hereby identified as “forward-looking statements” to be covered bythe safe harbor provisions of the Private Securities Litigation Reform Act of1995. In addition, the Company’s senior management may make forward-lookingstatements orally to analysts, investors, the media and others. This safeharbor requires that we specify important factors that could cause actualresults to differ materially from those contained in forward-lookingstatements made by or on behalf of us. We cannot promise that our expectationsin such forward-looking statements will turn out to be correct. Ouractual results could be materially different from and worse than ourexpectations. See “Forward-Looking Statements” on page 61 forspecific important factors that could cause actual results to differ materiallyfrom those contained in forward-looking statements.*

**A. Executive Summary and Overview**

In this discussion, “Safety” refers to SafetyInsurance Group, Inc. and “our Company,” “we,” “us” and “our” refer toSafety Insurance Group, Inc. and its consolidated subsidiaries. Oursubsidiaries consist of Safety Insurance Company (“Safety Insurance”), SafetyIndemnity Insurance Company, Whiteshirts Asset Management Corporation (“WAMC”),f/k/a Thomas Black Insurance Agency, Inc., and Whiteshirts ManagementCorporation, f/k/a RBS, Inc., which is WAMC’s holding company.

We are a leading providerof private passenger automobile insurance in Massachusetts. In addition toprivate passenger automobile insurance (which represented 80.3% of our directwritten premiums in 2005), we offer a portfolio of other insurance products,including commercial automobile (10.8% of 2005 direct written premiums),homeowners (7.2% of 2005 direct written premiums), dwelling fire, umbrella andbusiness owner policies (totaling 1.7% of 2005 direct written premiums).Operating exclusively in Massachusetts through our insurance companysubsidiaries, Safety Insurance and Safety Indemnity Insurance Company (togetherreferred to as the “Insurance Subsidiaries”), we have established strong relationshipswith 637 independent insurance agents in 743 locations throughoutMassachusetts. We have used these relationships and our extensive knowledge ofthe Massachusetts market to become the second largest private passengerautomobile insurance carrier in Massachusetts, capturing an approximate 11.3%share of the Massachusetts private passenger automobile market in 2005,according to the CAR Cession Volume Analysis Report of February 27, 2006,based on automobile exposures. These statistics total, for each vehicleinsured, the number of months during the year insurance for that vehicle is ineffect, to arrive at an aggregate number of car-months for each insurer; thisaggregate number, divided by 12, equals the insurer’s number of car-years, ameasure we refer to in this discussion as automobile exposures.

*MassachusettsAutomobile Insurance Market*

We are subject to the extensive regulation of theprivate passenger automobile insurance industry in Massachusetts, whichrepresented 80.3% of our direct written premiums in 2005. Owners of registeredautomobiles in Massachusetts are required to maintain minimum automobileinsurance coverages. We are required to participate in a state-mandatedreinsurance program run by CAR to which we cede certain unprofitable risks andfrom which we are allocated a portion of the overall losses. As a servicingcarrier of CAR, we are required to issue a policy to all qualified applicants. Thisprogram operates at an underwriting deficit. This deficit is allocated amongevery Massachusetts automobile insurance company, including us, based on acomplex formula that takes into consideration a company’s voluntary marketshare, the rate at which it cedes business to CAR, and the company’sutilization of a credit system CAR has designed to encourage carriers to reducetheir use of CAR. In addition, based on our market share, we 

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are assigned certainlicensed producers by CAR that have been unable to obtain a voluntary contractwith another insurer. We call these agents Exclusive Representative Producers,or ERPs.

On December 31, 2004, the Commissioner approvednew rules for CAR, which became effective on January 1, 2005 (the “ApprovedRules”). On January 14, 2005, we filed, on Form 8-K, anestimate of the financial impact the Approved Rules may have on us and westated that a lawsuit had been filed in Suffolk Superior Court by CommerceInsurance Company against the Commissioner that seeks an order permanentlyenjoining implementation and/or enforcement of the Approved Rules. CertainERPs, Arbella Mutual Insurance Company and the Center for Insurance Researchintervened as plaintiffs and CAR intervened as a defendant in this lawsuit. On June 20,2005, the Massachusetts Superior Court ruled that the Commissioner lacked the statutoryauthority to implement the Approved Rules and ordered them vacated. As aresult, the Approved Rules did not go into effect. The Commissionerappealed the decision of the Massachusetts Superior Court. On October 26,2005, the Massachusetts Supreme Judicial Court agreed to take direct appellatereview of the Commissioner’s appeal. At the present time, we are unable topredict whether the Commissioner’s appeal will be successful.

On June 15, 2005, CAR approved rules tomodify the ERP subscription relief process, making the reassignment of ERPexposures from an oversubscribed servicing carrier more timely and responsive,while enhancing equity in the ERP distribution for all servicing carriers (the “ERPSubscription Rules”). Also, the current practice of two and three-partyagreements between ERPs and servicing carriers would be prohibited. On September 30,2005, the Commissioner approved the ERP Subscription Rules, and instructed CARto complete a redistribution of all ERPs that will establish for all servicingcarriers overall parity in the quantity and quality of their ERP exposures. Theredistribution plan for ERPs as adopted by the CAR Governing Committee on November 16and December 14, 2005, was approved by the Commissioner on January 27,2006. On January 31, 2006 CAR notified each reassigned ERP and allservicing carriers of the redistribution. According to the January 31,2006 CAR Private Passenger ERP Redistribution Summary, 18 Safety ERPs with25,590 exposures were assigned to other servicing carriers beginning with newbusiness effective March 1, 2006 and renewal business May 1, 2006. Inaddition, CAR assigned 29 ERPs with 24,670 exposures from other servicingcarriers to Safety, however 25 of these ERPs with 23,116 exposures were givenvoluntary contracts by their former servicing carrier or other carriers and areno longer eligible for assignment to Safety as ERPs. We expect that theredistribution of ERPs will eliminate our disproportionate share of high lossratio ERP business, and would therefore result in a reduction of the expense weincur because of our disproportionate share of high loss ratio ERPs. However,it is possible that other servicing carriers or ERPs could bring challenges,with regards to the redistribution of ERPs, and as a result there can be noassurances that our expenses will be reduced.

On June 1, 2005, the Governor filed legislationthat would introduce more competition into the Massachusetts automobileinsurance marketplace, reduce rates for good drivers, target fraud andexcessive personal injury costs, and allow insurers rate flexibility. At thistime we are unable to predict whether the Governor’s legislation will be enactedby the legislature.

Beginning January 1, 2006 CAR has implemented aLimited Servicing Carrier Program (“LSC”) for ceded commercial automobilepolicies. CAR approved Safety and five other servicing carriers through aRequest for Proposal to process approximately $200,000 of ceded commercialautomobile business based on CAR data as of December 31, 2005, which willbe spread equitably amongst the six servicing carriers.

Each year, the Commissioner sets maximum premium ratesthat may be charged and minimum commissions that must be paid to agents forprivate passenger automobile insurance. The Commissioner announced on December 15,2005, a 8.7% statewide average private passenger automobile insurance ratedecrease for 2006, compared to a 1.7% decrease for 2005. Coinciding with the2006 rate decision, the Commissioner also approved an 11.8% commission rateagents receive for selling private passenger automobile insurance, as apercentage of premiums, compared to a commission rate of 10.9% in 2005.

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While state-mandatedaverage maximum private passenger automobile insurance rates decreased 1.7% for2005, our average premium per automobile exposure in the year ended December 31,2005 increased from the year ended December 31, 2004 by approximately0.1%. This increase was primarily the result of purchases of new automobiles byour insureds. We believe that the continued benefits of our rate pursuitinitiative, which validates insured rating classifications and discounteligibility, also contributed to the increase in our average premiums receivedper automobile exposure. The table below shows average Massachusetts-mandatedprivate passenger automobile premium rate changes and changes in our averagepremium per automobile exposure from 1996-2005.

**MassachusettsPrivate Passenger Rate Decisions**

| ** ** | ** ** | **State Mandated** | ** ** | **Safety Change in**    | ** ** |
|------------|------------|-------------------------|------------|-----------------------------------|------------|
| ** ** | ** ** | **Average Rate**   | ** ** | **Average Premium per** | ** ** |
| ** ** | **Year**   | ** **              | ** ** | **Change(1)**                     | ** ** | **Automobile Exposure(2)** | ** ** |
| ** ** | **2005**   | ** **              | ** ** | ** **                        | **(1.7**   | **)%** | ** ** | ** ** | **0.1** | **%** | ** ** |
|       | 2004       | ** **              |       |                              | 2.5        | % |   |   | 6.1 | % |   |
|       | 2003       | ** **              |       |                              | 2.7        | % |   |   | 6.9 | % |   |
|       | 2002       | ** **              |       |                              | 0.0        | % |   |   | 5.2 | % |   |
|       | 2001       | ** **              |       |                              | (8.3       | )% |   |   | 0.0 | % |   |
|       | 2000       | ** **              |       |                              | 0.7        | % |   |   | 7.4 | % |   |
|       | 1999       | ** **              |       |                              | 0.7        | % |   |   | 10.9 | % |   |
|       | 1998       | ** **              |       |                              | (4.0       | )% |   |   | 2.8 | % |   |
|       | 1997       | ** **              |       |                              | (6.2       | )% |   |   | (5.1 | )% |   |
|       | 1996       | ** **              |       |                              | (4.5       | )% |   |   | (7.7 | )% |   |
|            |            |                         |            |                                   |            |  |  |  |  |  |  |  |  |

 

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(1)          Source: Commissionerrate decisions for 1996 - 2005.

(2)          Source: SafetyInsurance.

*StatutoryAccounting Principles*

Our results arereported in accordance with GAAP, which differ from amounts reported inaccordance with statutory accounting principles (“SAP”) as prescribed byinsurance regulatory authorities. Specifically, under GAAP:

·       Policyacquisition costs such as commissions, premium taxes and other variable costsincurred in connection with writing new and renewal business are capitalizedand amortized on a pro rata basis over the period in which the related premiumsare earned, rather than expensed as incurred, as required by SAP.

·       Certainassets are included in the consolidated balance sheets whereas, under SAP, suchassets are designated as “non admitted assets,” and charged directly againststatutory surplus. These assets consist primarily of premium receivables thatare outstanding over ninety days, federal deferred tax assets in excess ofstatutory limitations, furniture, equipment, leasehold improvements and prepaidexpenses.

·       Amountsrelated to ceded reinsurance are shown gross as prepaid reinsurance premiumsand reinsurance recoverables, rather than netted against unearned premiumreserves and loss and loss adjustment expense reserves, respectively, asrequired by SAP.

·       Fixedmaturities securities, which are classified as available-for-sale, are reportedat current market values, rather than at amortized cost, or the lower ofamortized cost or market, depending on the specific type of security, asrequired by SAP.

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·       Equitysecurities are reported at quoted market values, which may differ from theNational Association of Insurance Commissioners market values as required bySAP.

·       Thediffering treatment of income and expense items results in a correspondingdifference in federal income tax expense. Changes in deferred income taxes arereflected as an item of income tax benefit or expense, rather than recordeddirectly to surplus as regards policyholders, as required by SAP. Admittancetesting may result in a charge to unassigned surplus for non-admitted portionsof deferred tax assets. Under GAAP reporting, a valuation allowance may berecorded against the deferred tax asset and reflected as an expense.

*Insurance Ratios*

The property and casualty insurance industry uses thecombined ratio as a measure of underwriting profitability. The combined ratio isthe sum of the loss ratio (losses and loss adjustment expenses incurred as apercent of net earned premiums) plus the expense ratio (underwriting expensesas a percent of net written premiums, if calculated on a SAP basis, or netearned premiums, if calculated on a GAAP basis). The combined ratio reflectsonly underwriting results, and does not include income from investments orfinance and other service income. Underwriting profitability is subject tosignificant fluctuations due to competition, catastrophic events, weather,economic and social conditions and other factors.

Ourstatutory insurance ratios are outlined in the following table:

| ** **                 | ** ** | **For the Years   Ended December 31,** | ** ** |
|----------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Statutory Ratios:** | ** ** | ** **                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loss Ratio                 | ** ** | **61.9**                                                        | **%**      | 71.7 | % | 78.0 | % |
| Expense Ratio              | ** ** | **23.4**                                                        | **%**      | 23.7 | % | 23.5 | % |
| Combined Ratio             | ** ** | **85.3**                                                        | **%**      | 95.4 | % | 101.5 | % |

 

UnderGAAP, the loss ratio is computed in the same manner as under SAP, but theexpense ratio is determined by matching underwriting expenses to the periodover which net premiums were earned, rather than to the period that netpremiums were written. Our GAAP insurance ratios are outlined in the followingtable:

| ** **       | ** ** | **For the Years   Ended December 31,** | ** ** |
|------------------|------------|-----------------------------------------------------------------|------------|
| ** **       | ** ** | **2005**                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| **GAAP Ratios:** |       |                                                            |       |   |   |   |   |
| Loss Ratio       | ** ** | **61.9**                                                        | **%**      | 71.8 | % | 77.9 | % |
| Expense Ratio    | ** ** | **23.5**                                                        | **%**      | 24.5 | % | 24.2 | % |
| Combined Ratio   | ** ** | **85.4**                                                        | **%**      | 96.3 | % | 102.1 | % |

 

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*Stock-BasedCompensation*

On June 25,2002, the Board adopted the 2002 Management Omnibus Incentive Plan (the “IncentivePlan”). The Incentive Plan provides for a variety of awards, includingnonqualified stock options (“NQSOs”), stock appreciation rights and restrictedstock (“RS”) awards. On December 31, 2005, there were 225,958 sharesavailable for future grant. The Board and the Compensation Committee intend toissue more awards under the Incentive Plan in the future. Grants outstandingunder the Incentive Plan as of December 31, 2005 were comprised of 98,417restricted shares and 496,086 nonqualified stock options. Grants made under theIncentive Plan are as follows:

| ** **       | ** **  | ** **          | ** ** | ** **              | ** ** | **Exercise**           | ** ** | ** **         | ** ** | ** **             | ** ** |
|------------------|-------------|---------------------|------------|-------------------------|------------|------------------------|------------|--------------------|------------|------------------------|------------|
| **Type of** | ** **  | ** **          | ** ** | **Number of**      | ** ** | **Price(1) or**   | ** ** | ** **         | ** ** | ** **             | ** ** |
| **Equity**       | ** **  | ** **          | ** ** | **Awards**              | ** ** | **Fair Value(2)** | ** ** | ** **         | ** ** | ** **             | ** ** |
| ** **       | **Awarded** | ** **          | ** ** | **Effective Date** | ** ** | **Granted**            | ** ** | **per Share** | ** ** | **Vesting Terms** | ** ** | **Expiration Date** | ** ** |
| NQSOs            |        | November  27, 2002  |       |                    | 379,000    |                   |       |               | $12.00     | (1)                    |       | 5  years, 20% annually |   | November  27, 2012 |   |
| NQSOs            |        | February  20, 2003  |       |                    | 99,000     |                   |       |               | $13.30     | (1)                    |       | 5  years, 20% annually |   | February  20, 2013 |   |
| NQSOs            |        | March  31, 2003     |       |                    | 292,000    |                   |       |               | $13.03     | (1)                    |       | 3  years, 30%-30% - 40% |   | March  31, 2013 |   |
| NQSOs            |        | August  21, 2003    |       |                    | 10,000     |                   |       |               | $15.89     | (1)                    |       | 5  years, 20% annually |   | August  21, 2013 |   |
| NQSOs            |        | March  25, 2004     |       |                    | 111,000    |                   |       |               | $18.50     | (1)                    |       | 5  years, 20% annually |   | March  25, 2014 |   |
| RS               |        | March  25, 2004     |       |                    | 70,271     |                   |       |               | $18.50     | (2)                    |       | 3  years, 30%-30%- 40% |   | N/A |   |
| NQSOs            |        | August  30, 2004    |       |                    | 10,000     |                   |       |               | $21.40     | (1)                    |       | 5  years, 20% annually |   | August  30, 2014 |   |
| **NQSOs**        | ** **  | **March 16, 2005**  | ** ** | ** **              | **78,000** |                   | ** ** | ** **         | **$35.23** | **(1)**                | ** ** | **5 years, 20% annually** | ** ** | **March 16, 2015** | ** ** |
| **RS**           | ** **  | **March 16, 2005**  | ** ** | ** **              | **56,770** |                   | ** ** | ** **         | **$35.23** | **(2)**                | ** ** | **3 years, 30%-30% - 40%** | ** ** | **N/A** | ** ** |
| **RS**           | ** **  | **March  16, 2005** | ** ** | ** **              | **4,000**  |                   | ** ** | ** **         | **$35.23** | **(2)**                | ** ** | **No  vesting period(3)** | ** ** | **N/A** | ** ** |
|                  |             |                     |            |                         |            |                        |            |                    |            |                        |            |  |  |  |  |  |  |

----

(1)          Theexercise price of the options grant effective on November 27, 2002 isequal to the IPO price of our stock on that same day. The exercise price of theremaining option grants is equal to the closing price of our common stock onthe grant effective date.

(2)          Thefair value of the restricted stock grant is equal to the closing price of ourcommon stock on the grant effective date.

(3)          Theshares cannot be sold, assigned, pledged, or otherwise transferred, encumberedor disposed of until the recipient is no longer a member of our Board ofDirectors.

*Reinsurance*

We reinsure with other insurance companies a portionof our potential liability under the policies we have underwritten, therebyprotecting us against an unexpectedly large loss or a catastrophic occurrencethat could produce large losses, primarily in our homeowners line of business.As of January 1, 2006 our catastrophe reinsurance provides gross peroccurrence reinsurance coverage up to $250,000. Our catastrophe reinsuranceprotects us in the event of a “415-year storm” (that is, a storm of aseverity expected to occur once in a 415-year period). Swiss Re, ourprimary reinsurer, maintains an A.M. Best rating of “A+” (Superior). Allof our other reinsurers have an A.M. Best rating of “A” (Excellent) orbetter except for Montpelier Re, Endurance Re and Amlin Bermuda which are rated“A-”(Excellent). We are a participant in CAR, a state-established body thatruns the residual market reinsurance programs for both private passenger andcommercial automobile insurance in Massachusetts under which premiums,expenses, losses and loss adjustment expenses on ceded business are shared byall insurers writing automobile insurance in Massachusetts. We also participatein the Massachusetts Property Insurance Underwriting Association (“FAIR Plan”)in which premiums, expenses, losses and loss adjustment expenses on homeownersbusiness that cannot be placed in the voluntary market are shared by allinsurers writing homeowners insurance in Massachusetts. At December 31,2005, we had no material amounts recoverable from any reinsurer, excluding theresidual markets described above.

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On March 10, 2005,our Board of Directors adopted a resolution that prohibits Safety frompurchasing finite reinsurance without approval by the Board. To date, theCompany has never purchased a finite reinsurance contract.

*Effects ofInflation*

We do not believe thatinflation has had a material effect on our consolidated results of operations,except insofar as inflation may affect interest rates.

**B. CriticalAccounting Policies and Estimates**

*Loss and LossAdjustment Expense Reserves.*

Significant periods of time can elapse between theoccurrence of an insured loss, the reporting to us of that loss and our finalpayment of that loss. To recognize liabilities for unpaid losses, we establishreserves as balance sheet liabilities. Our reserves represent estimates ofamounts needed to pay reported and unreported losses and the expenses ofinvestigating and paying those losses, or loss adjustment expenses. Everyquarter, we review our previously established reserves and adjust them, ifnecessary.

When a claim is reported, claims personnel establish a“case reserve” for the estimated amount of the ultimate payment. The amount ofthe reserve is primarily based upon an evaluation of the type of claiminvolved, the circumstances surrounding each claim and the policy provisionsrelating to the loss. The estimate reflects the informed judgment of suchpersonnel based on general insurance reserving practices and on the experienceand knowledge of the claims person. During the loss adjustment period, theseestimates are revised as deemed necessary by our claims department based onsubsequent developments and periodic reviews of the cases.

In accordance with industry practice, we also maintainreserves for estimated losses incurred but not yet reported (“IBNR”). IBNRreserves are determined in accordance with commonly accepted actuarialreserving techniques on the basis of our historical information and experience.We review and make adjustments to incurred but not yet reported reservesquarterly.

When reviewing reserves, we analyze historical dataand estimate the impact of various loss development factors, such as ourhistorical loss experience and that of the industry, trends in claims frequencyand severity, our mix of business, our claims processing procedures, legislativeenactments, judicial decisions, legal developments in imposition of damages,and changes and trends in general economic conditions, including the effects ofinflation. A change in any of these factors from the assumption implicit in ourestimate can cause our actual loss experience to be better or worse than ourreserves, and the difference can be material. There is no precise method,however, for evaluating the impact of any specific factor on the adequacy ofreserves, because the eventual development of reserves is affected by manyfactors.

Managementdetermines the Company’s loss and LAE reserves estimate based upon the work ofthe Company’s actuaries and management’s own assessment of reasonable reserves.A reasonable estimate is derived primarily by considering a range ofindications calculated by the Company’s actuaries using generally acceptedactuarial techniques. Our key assumptions are the ultimate frequency andseverity of claims, based upon the most recent ten years of claims reported tothe Company and the data CAR reports to us to calculate our share of theresidual market, as of the date of the applicable balance sheet. For eachaccident year and each coverage within a line of business our actuariescalculate reserve ranges using actuarial techniques such as:

·       *Paid Loss Indications*: This method projects ultimate lossestimates based upon extrapolations of historic paid loss trends. This methodtends to be used on short tail lines such as automobile physical damage.

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·       *Incurred Loss Indications*: This method projects ultimateloss estimates based upon extrapolations of historic incurred loss trends. Thismethod tends to be used on long tail lines of business such as automobileliability and homeowner’s liability.

·       *Bornhuetter-Ferguson Indications*: This method projectsultimate loss estimates based upon extrapolations of an expected amount ofIBNR, which is added to current incurred losses or paid losses. This methodtends to be used on small, immature, or volatile lines of business, such as ourBOP and umbrella lines of business.

·       *Bodily Injury Code Indications*: This method projectsultimate loss estimates for our private passenger and commercial automobilebodily injury coverage based upon extrapolations of the historic number ofaccidents and the historic number of bodily injury claims per accident.Projected ultimate bodily injury claims are then segregated into expected claimsby type of injury (e.g. soft tissue injury vs. hard tissue injury) based onpast experience. An ultimate severity, or average paid loss amounts, isestimated based upon extrapolating historic trends. Projected ultimate lossestimates using this method are the aggregate of estimated losses by injurytype.

Such techniques assumethat past experience, adjusted for the effects of current developments andanticipated trends, are an appropriate basis for predicting future events. Itis possible that the final outcome may fall above or below these amounts as aresult of a number of factors, including immature data, sparse data, orsignificant growth in a line of business. Using these methodologies ouractuaries established a range of reasonable possible estimations for netreserves of approximately $332,266 to $382,506 as of December 31, 2005, ascompared to a range of $329,403 to $384,536 for 2004. In general, the low andhigh values of the ranges represent reasonable minimum and maximum values ofthe indications based on the techniques described above.

Thefollowing tables present the recorded reserves and the range of estimations byline of business for net loss and LAE reserves as of December 31, 2005 andDecember 31, 2004.

**Range of Net Reserves for Losses and LAE as of December 31, 2005**

| **Line of Business** | ** ** | ** ** | ** ** | **Low** | ** ** | **Recorded** | ** ** | **High** | ** ** |
|--------------------------------|------------|------------|------------|---------|------------|--------------|------------|----------|------------|
| **Private  Passenger Auto**    |       | $          | 253,277    |    | $          | 278,415      |       | $        | 288,410    |   |
| **Commercial  Auto**           |       | 47,135     |       | 51,946  |       | 52,772       |       |
| **Homeowners**                 |       | 25,185     |       | 30,745  |       | 31,750       |       |
| **All  Other**                 |       | 6,669      |       | 9,060   |       | 9,574        |       |
| **Total**                      |       | $          | 332,266    |    | $          | 370,166      |       | $        | 382,506    |   |

 

**Range of Net Reserves for Losses and LAE as ofDecember 31, 2004**

| **Line of Business** | ** ** | ** ** | ** ** | **Low** | ** ** | **Recorded** | ** ** | **High** | ** ** |
|--------------------------------|------------|------------|------------|---------|------------|--------------|------------|----------|------------|
| **Private  Passenger Auto**    |       | $          | 269,766    |    | $          | 288,557      |       | $        | 309,590    |   |
| **Commercial  Auto**           |       | 39,397     |       | 48,793  |       | 47,666       |       |
| **Homeowners**                 |       | 18,401     |       | 24,085  |       | 20,854       |       |
| **All  Other**                 |       | 1,839      |       | 5,295   |       | 6,426        |       |
| **Total**                      |       | $          | 329,403    |    | $          | 366,730      |       | $        | 384,536    |   |

 

The Company’s net loss and LAE reserves, based onmanagement’s best estimate, were set at $370,166 as of December 31, 2005,as compared to $366,730 for 2004.

For our private passenger and commercial auto lines ofbusiness as of December 31, 2005, due to the relatively long time we havebeen writing these lines of insurance, and our stable long-term trends infrequency and severity, the range of reserves are relatively narrow compared tothe mid-point estimation 

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and we recorded reservesslightly higher than the mid-point of the range. For our private passenger lineas of December 31, 2004 we recorded reserves at the mid-point of therange, and for our commercial automobile line of business we recorded reserveshigher than the range due to our rapid growth in this line over the years priorto 2004.

For our homeowners and all other lines of business asof December 31, 2005, due to the relatively short time we have beenwriting these lines of business, and the resulting immature data available forour analysis, the range of reserves are relatively wide compared to themid-point estimation and we recorded reserves closer to the high of the rangeof projections. For our homeowners and all other lines of business as of December 31,2004, we recorded reserves higher than the range for homeowners and we recordedreserves very close to the high of the range of projections for all other linesof business.

The following tablespresent information by line of business for our net reserves for losses and LAEas of December 31, 2005 and December 31, 2004.

**Net Reserves for Losses and LAE as of December 31,2005**

| **Line of Business**             | ** ** | ** ** | ** ** | **Direct less Ceded** | ** ** | **Assumed** | ** ** | **Net** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------------|------------|-------------|------------|---------|------------|
| **Private  Passenger Auto**                |       |       | $          | 211,327                         |       |        |       |    |       |   |
| **CAR assumed Private Passenger**          |       |       |       |                            |       | $           | 67,088     |    |       |   |
| **Net Private Passenger Auto**             |       |       |       |                            |       |        |       | $       | 278,415    |   |
| **Commercial  Auto**                       |       |       | 36,982     |                            |       |        |       |    |       |
| **CAR assumed Commercial Auto**            |       |       |       |                            |       | 14,964      |       |    |       |
| **Net Commercial Auto**                    |       |       |       |                            |       |        |       | 51,946  |       |
| **Homeowners**                             |       |       | 23,497     |                            |       |        |       |    |       |
| **FAIR Plan assumed Homeowners**           |       |       |       |                            |       | 7,248       |       |    |       |
| **Net Homeowners**                         |       |       |       |                            |       |        |       | 30,745  |       |
| **All  Other**                             |       |       | 9,060      |                            |       | —      |       | 9,060   |       |
| **Total Net Reserves for Losses  and LAE** |       |       | $          | 280,866                         |       |        | $          | 89,300  |       | $ | 370,166 |   |

 

**Net Reserves for Losses and LAE as ofDecember 31, 2004**

| **Line of Business**             | ** ** | ** ** | ** ** | **Direct less Ceded** | ** ** | **Assumed** | ** ** | **Net** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------------|------------|-------------|------------|---------|------------|
| **Private  Passenger Auto**                |       |       | $          | 203,892                         |       |        |       |    |       |   |
| **CAR assumed Private Passenger**          |       |       |       |                            |       | $           | 84,665     |    |       |   |
| **Net Private Passenger Auto**             |       |       |       |                            |       |        |       | $       | 288,557    |   |
| **Commercial  Auto**                       |       |       | 34,653     |                            |       |        |       |    |       |
| **CAR assumed Commercial Auto**            |       |       |       |                            |       | 14,141      |       |    |       |
| **Net Commercial Auto**                    |       |       |       |                            |       |        |       | 48,794  |       |
| **Homeowners**                             |       |       | 17,892     |                            |       |        |       |    |       |
| **FAIR Plan assumed Homeowners**           |       |       |       |                            |       | 6,193       |       |    |       |
| **Net Homeowners**                         |       |       |       |                            |       |        |       | 24,085  |       |
| **All  Other**                             |       |       | 5,295      |                            |       | —      |       | 5,295   |       |
| **Total Net Reserves for Losses  and LAE** |       |       | $          | 261,732                         |       |        | $          | 104,999 |       | $ | 366,731 |   |

 

*CAR Loss and Loss Adjustment Expense Reserves*

We are a participant inCAR and assume a significant portion of losses and LAE on business ceded by theindustry participants to CAR. We estimate reserves for assumed losses and LAEthat have not yet been reported to us by CAR. Our estimations are based uponthe same factors we use for our own reserves, plus additional factors due tothe nature of and the information we receive from CAR.

The CAR deficit, whichconsists of premium ceded to CAR less CAR losses and LAE, is allocated amongevery automobile insurance company writing business in Massachusetts based on acomplex formula (the “Participation Ratio”) that takes into consideration acompany’s voluntary market share, the 

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amountof business it cedes to CAR and credits the company earns under a system CARhas designed to encourage carriers to voluntarily write business in selectedunder-priced classes and territories.

We receive a Settlement ofBalances report from CAR that reports our share of CAR premium, losses and LAE,on a lagged basis, seventy-five days after the end of every quarter.CAR-published financial data is always at least one quarter behind thefinancial data we report. For example, when we reported our financial resultsfor the year ended December 31, 2005, we had nine months of reported 2005CAR financial data, and we had to estimate what CAR would report to us for thelast three months of the year.

We receive our finalcalendar year Participation Ratio report from CAR eight months after the end ofthat year, and thus we have to estimate for six quarters our share of the CARdeficit. For example, for the year ended December 31, 2004 we had toestimate our 2004 policy year CAR Participation Ratio beginning with the firstquarter of 2004 through the second quarter of 2005.

Because of the lag in CARestimates, and in order to try to validate to the extent possible theinformation CAR does provide, we must try to estimate the effects of theactions of our competitors in order to establish our Participation Ratio.Before final Participation Ratios are available, we estimate the size of CARand the resulting deficit based on historical analysis of CAR results, andestimations of our competitors’ current cession strategies. Even after ourfinal Participation Ratio is available from CAR, we must continue to estimatethe size of CAR, and the resulting deficit based upon data published by CAR andour own continuing analysis. As a result, changes in our reserves for CAR maycontinue to occur until all claims are finally settled. The Loss ReservingCommittee at CAR meets 70 days after the end of each quarter to estimate theCAR deficit for all active policy years and publishes estimations, which we useto estimate our share of the deficit. The estimation that CAR calculates isbased on data it collects from 19 servicing carriers which settle, reserve andreport claims using a variety of methods. Any delays or errors in thecollection of this data could have a significant impact on the accuracy of CAR’sestimations.

Although we rely to asignificant extent in setting our reserves on the information CAR provides, weare cautious in our use of that information, both because of the delaysdescribed above and because the CAR estimates incorporate data CAR receivesfrom all other CAR servicing carriers in Massachusetts. We do not have directaccess to that data or firsthand knowledge of how those carriers are currentlyconducting their operations. As a result, we are cautious in recording CARreserves for the calendar years that we have to estimate our ParticipationRatio and these reserves are subject to significant judgments and estimates.

*Sensitivity Analysis*

Establishment of appropriate reserves is an inherentlyuncertain process. There can be no certainty that currently establishedreserves based on our key assumptions regarding frequency and severity in ourlines of business, or our assumptions regarding our share of the CAR loss willprove adequate in light of subsequent actual experience. To the extent that reservesare inadequate and are strengthened, the amount of such increase is treated asa charge to earnings in the period that the deficiency is recognized. To theextent that reserves are redundant and are released, the amount of the releaseis a credit to earnings in the period the redundancy is recognized. For theyear ended December 31, 2005 a 1 percentage-point change in the loss andLAE ratio would result in a change in reserves of $6,228. Each 1percentage-point change in the loss and loss expense ratio would have a $4,048effect on net income, or $0.25 per diluted share.

Our assumptions consider that past experience,adjusted for the effects of current developments and anticipated trends, are anappropriate basis for establishing our reserves. Our key assumptions could havea reasonable possible range of plus or minus 5 percentage-points for eachestimation. However, as 2005 demonstrates, there is no guarantee that ourassumptions will not have more than a 5 percentage-point variation. Thefollowing sensitivity tables present information for each of our primary linesof business on the effect each 1 percentage-point change in each of our keyassumptions on unpaid frequency and severity 

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could have on our directminus ceded loss and LAE reserves and net income for the year ended December 31,2005. In evaluating the information in the table, it should be noted that a 1percentage-point change in a single assumption would change estimated reservesby 1 percentage-point. A 1 percentage-point change in both our key assumptionswould change estimated reserves within a range of plus or minus 2percentage-points.

| ** **                                                                 | ** ** | **-1 Percent** | ** ** | **No**             | ** ** | **+1 Percent** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                                                 | ** ** | **Change in**  | ** ** | **Change in** | ** ** | **Change in**  | ** ** |
| ** **                                                                 | ** ** | **Frequency**       | ** ** | **Frequency**      | ** ** | **Frequency**       | ** ** |
| **Private  Passenger Automobile Direct minus Ceded Loss and LAE Reserves** |       |                |       |               |       |                |       |   |   |   |   |   |   |
| -1 Percent Change in Severity                                              |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated decrease in reserves                                             |       |                | $          | (4,227             | )          |                |       | $ | (2,113 | ) |   |   | $ | — |   |   |
| Estimated increase in net income                                           |       |                | 2,747      |               |       |                | 1,374      |   |   |   | — |   |   |
| No Change in  Severity                                                     |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves                                  |       |                | (2,113     | )                  |       |                | —     |   |   |   | 2,113 |   |   |
| Estimated increase (decrease) in net income                                |       |                | 1,374      |               |       |                | —     |   |   |   | (1,374 | ) |   |
| +1 Percent Change  in Severity                                             |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated increase in reserves                                             |       |                | —     |               |       |                | 2,113      |   |   |   | 4,227 |   |   |
| Estimated decrease in net income                                           |       |                | —     |               |       |                | (1,374     | ) |   |   | (2,747 | ) |   |
| **Commercial Automobile Direct minus Ceded Loss  and LAE Reserves**        |       |                |       |               |       |                |       |   |   |   |   |   |   |
| -1 Percent Change in Severity                                              |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated decrease in reserves                                             |       |                | (740       | )                  |       |                | (370       | ) |   |   | — |   |   |
| Estimated increase in net income                                           |       |                | 481        |               |       |                | 240        |   |   |   | — |   |   |
| No Change in  Severity                                                     |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves                                  |       |                | (370       | )                  |       |                | —     |   |   |   | 370 |   |   |
| Estimated increase (decrease) in net income                                |       |                | 240        |               |       |                | —     |   |   |   | (240 | ) |   |
| +1 Percent Change  in Severity                                             |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated increase in reserves                                             |       |                | —     |               |       |                | 370        |   |   |   | 740 |   |   |
| Estimated decrease in net income                                           |       |                | —     |               |       |                | (240       | ) |   |   | (481 | ) |   |
| **Homeowners Direct minus Ceded Loss and LAE  Reserves**                   |       |                |       |               |       |                |       |   |   |   |   |   |   |
| -1 Percent Change in Severity                                              |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated decrease in reserves                                             |       |                | (470       | )                  |       |                | (235       | ) |   |   | — |   |   |
| Estimated increase in net income                                           |       |                | 305        |               |       |                | 153        |   |   |   | — |   |   |
| No Change in  Severity                                                     |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves                                  |       |                | (235       | )                  |       |                | —     |   |   |   | 235 |   |   |
| Estimated increase (decrease) in net income                                |       |                | 153        |               |       |                | —     |   |   |   | (153 | ) |   |
| +1 Percent Change  in Severity                                             |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated increase in reserves                                             |       |                | —     |               |       |                | 235        |   |   |   | 470 |   |   |
| Estimated decrease in net income                                           |       |                | —     |               |       |                | (153       | ) |   |   | (305 | ) |   |
| **All Other Direct minus Ceded Loss and LAE  Reserves**                    |       |                |       |               |       |                |       |   |   |   |   |   |   |
| -1 Percent Change in Severity                                              |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated decrease in reserves                                             |       |                | (181       | )                  |       |                | (91        | ) |   |   | — |   |   |
| Estimated increase in net income                                           |       |                | 118        |               |       |                | 59         |   |   |   | — |   |   |
| No Change in  Severity                                                     |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves                                  |       |                | (91        | )                  |       |                | —     |   |   |   | 91 |   |   |
| Estimated increase (decrease) in net income                                |       |                | 59         |               |       |                | —     |   |   |   | (59 | ) |   |
| +1 Percent Change  in Severity                                             |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated increase in reserves                                             |       |                | —     |               |       |                | 91         |   |   |   | 181 |   |   |
| Estimated decrease  in net income                                          |       |                | —     |               |       |                | (59        | ) |   |   | (118 | ) |   |
|                                                                            |            |                     |            |                    |            |                     |            |  |  |  |  |  |  |  |  |  |

 

Ourestimated share of CAR loss and LAE reserves is based on assumptions about ourParticipation Ratio, the size of CAR, and the resulting deficit (similarassumptions apply with respect to the FAIR Plan). Our assumptions consider thatpast experience, adjusted for the effects of current developments andanticipated trends, are an appropriate basis for establishing our CAR reserves.Our assumptions could 

47

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have a reasonable possible range of plus or minus 5percentage-points for each estimation. The following sensitivity table presentsinformation of the effect each 1 percentage-point change in our assumptions onour share of reserves for CAR and other residual markets could have on ourassumed loss and LAE reserves and net income for the year ended December 31,2005. In evaluating the information in the table, it should be noted that a 1percentage-point change in our assumptions would change estimated reserves by 1percentage-point.

| ** **                                    | ** ** | **-1 Percent** | ** ** | **No**             | ** ** | **+1 Percent** | ** ** |
|-----------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                    | ** ** | **Change in**  | ** ** | **Change in** | ** ** | **Change in**  | ** ** |
| ** **                                    | ** ** | **Estimation**      | ** ** | **Estimation**     | ** ** | **Estimation**      | ** ** |
| **CAR Assumed Private Passenger  Automobile** |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves     |       |                | $          | (671               | )          |                |       | $ | — |   |   |   | $ | 671 |   |   |
| Estimated increase (decrease) in net income   |       |                | 436        |               |       |                | —     |   |   |   | (436 | ) |   |
| **CAR Assumed Commercial  Automobile**        |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves     |       |                | (150       | )                  |       |                | —     |   |   |   | 150 |   |   |
| Estimated increase (decrease) in net income   |       |                | 97         |               |       |                | —     |   |   |   | (97 | ) |   |
| **FAIR Plan Assumed Homeowners**              |       |                |       |               |       |                |       |   |   |   |   |   |   |
| Estimated (decrease) increase in reserves     |       |                | (72        | )                  |       |                | —     |   |   |   | 72 |   |   |
| Estimated increase  (decrease) in net income  |       |                | 47         |               |       |                | —     |   |   |   | (47 | ) |   |
|                                               |            |                     |            |                    |            |                     |            |  |  |  |  |  |  |  |  |  |

 

*Reserve Development Summary*

The changes we haverecorded in our reserves in the past illustrate the uncertainty of estimatingreserves. Primarily due to an improvement in CAR results, the Company’s prioryear reserves decreased by $39,620 and $6,778 for the years ended December 31,2005 and 2004, respectively. The company’s prior year reserves increased by$181 for the year ended December 31, 2003.

Thefollowing table presents a comparison of prior year development of our net reservesfor losses and LAE for the years ended December 31, 2005, 2004 and 2003.

**PriorYear Net Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **For the years ended December 31,** | ** ** |
|------------------------|------------|---------------------------------------------------------------|------------|
| **Accident Year**      | ** ** | ** **                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| 1995 &  Prior |       | $                                                             | (45        | ) | $ | (176 | ) | $ | (152 | ) |
| 1996                   |       | 34                                                            |       | 47 |   | (19 | ) |
| 1997                   |       | (5                                                            | )          | (11 | ) | 110 |   |
| 1998                   |       | 7                                                             |       | (504 | ) | 105 |   |
| 1999                   |       | (892                                                          | )          | (12 | ) | 115 |   |
| 2000                   |       | (276                                                          | )          | 1,588 |   | 2,090 |   |
| 2001                   |       | (317                                                          | )          | 2,495 |   | 401 |   |
| 2002                   |       | (3,489                                                        | )          | (304 | ) | (2,469 | ) |
| 2003                   |       | (7,155                                                        | )          | (9,901 | ) | — |   |
| 2004                   |       | (27,482                                                       | )          | — |   | — |   |
| All Prior Years        |       | $                                                             | (39,620    | ) | $ | (6,778 | ) | $ | 181 |   |
|                        |            |                                                               |            |  |  |  |  |  |  |  |  |  |

 

The decrease in prior yearreserves during the 2005 period resulted from re-estimations of prior yearultimate loss and LAE liabilities and is composed primarily of a reduction of$22,162 in CAR assumed reserves and a reduction of $14,600 in the Company’sautomobile reserves. The decrease in prior year reserves during the 2004 periodis composed primarily of a reduction of $6,854 in CAR assumed reserves, areduction of $2,523 in our homeowners line of business, and an increase of $2,928in the Company’s automobile reserves. The increase in prior year reservesduring the 2003 period is composed primarily of a reduction of $1,894 in ourautomobile reserves, and an increase of $1,915 in CAR assumed reserves. It isnot appropriate to extrapolate future favorable or unfavorable development ofreserves from this past experience.

48

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Thefollowing table presents information by line of business for prior yeardevelopment of our net reserves for losses and LAE for the year ended December 31,2005. Each accident year represents all claims for an annual calendaraccounting period in which loss events occurred, regardless of when the lossesare actually reported, booked or paid. Our financial statements reflect theaggregate results of the current and all prior accident years.

**PriorYear Net Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **Private Passenger** | ** ** | **Commercial** | ** ** | ** **     | ** ** | ** **     | ** ** | ** **         | ** ** |
|------------------------|------------|----------------------------|------------|----------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| **Accident Year**      | ** ** | ** **                 | ** ** | **Automobile** | ** ** | **Automobile** | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total** | ** ** |
| 1995 &  Prior |       |                       | $          | (32            | )          |           |       | $              | (13        | )                  |       |   | $ | — |   |   |   | $ | — |   |   | $ | (45 | ) |
| 1996                   |       |                       | 51         |           |       |           | (17        | )              |       |               | —     |   |   |   | — |   |   | 34 |   |
| 1997                   |       |                       | 13         |           |       |           | (18        | )              |       |               | —     |   |   |   | — |   |   | (5 | ) |
| 1998                   |       |                       | 20         |           |       |           | (13        | )              |       |               | —     |   |   |   | — |   |   | 7 |   |
| 1999                   |       |                       | (771       | )              |       |           | (25        | )              |       |               | (96        | ) |   |   | — |   |   | (892 | ) |
| 2000                   |       |                       | (351       | )              |       |           | 193        |           |       |               | (84        | ) |   |   | (34 | ) |   | (276 | ) |
| 2001                   |       |                       | 133        |           |       |           | 91         |           |       |               | (495       | ) |   |   | (46 | ) |   | (317 | ) |
| 2002                   |       |                       | (1,370     | )              |       |           | (806       | )              |       |               | (1,306     | ) |   |   | (7 | ) |   | (3,489 | ) |
| 2003                   |       |                       | (4,416     | )              |       |           | (1,404     | )              |       |               | (1,438     | ) |   |   | 103 |   |   | (7,155 | ) |
| 2004                   |       |                       | (25,031    | )              |       |           | (2,995     | )              |       |               | 470        |   |   |   | 74 |   |   | (27,482 | ) |
| All Prior Years        |       |                       | $          | (31,754        | )          |           |       | $              | (5,007     | )                  |       |   | $ | (2,949 | ) |   |   | $ | 90 |   |   | $ | (39,620 | ) |
|                        |            |                            |            |                |            |                |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

To further clarify the effects of changes in ourreserve estimates for CAR and other residual markets, the next two tables breakout the information in the table above by source of the business (i.e.,non-residual market vs. residual market).

Thefollowing table presents information by line of business for prior yeardevelopment of direct minus ceded reserves for losses and LAE for the yearended December 31, 2005; that is, all our reserves except for businessceded or assumed from CAR and other residual markets.

**Prior Year Net Direct minus Ceded Loss and LAE ReserveDevelopment Summary**

| ** **             | ** ** | **Retained  Private Passenger** | ** ** | **Retained  Commercial** | ** ** | **Retained**   | ** ** | **Retained**   | ** ** | ** **         | ** ** |
|------------------------|------------|--------------------------------------|------------|--------------------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| **Accident Year** | ** ** | ** **                           | ** ** | **Automobile**           | ** ** | **Automobile** | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total** | ** ** |
| 1995 &  Prior |       |                                 | $          | (46                      | )          |           |       | $              | —     |               |       |   | $ | — |   |   |   | $ | — |   |   | $ | (46 | ) |
| 1996                   |       |                                 | 50         |                     |       |           | (17        | )              |       |               | —     |   |   |   | — |   |   | 33 |   |
| 1997                   |       |                                 | (4         | )                        |       |           | —     |           |       |               | —     |   |   |   | — |   |   | (4 | ) |
| 1998                   |       |                                 | 12         |                     |       |           | (1         | )              |       |               | —     |   |   |   | — |   |   | 11 |   |
| 1999                   |       |                                 | (345       | )                        |       |           | (64        | )              |       |               | (91        | ) |   |   | — |   |   | (500 | ) |
| 2000                   |       |                                 | (37        | )                        |       |           | 18         |           |       |               | (41        | ) |   |   | (34 | ) |   | (94 | ) |
| 2001                   |       |                                 | (54        | )                        |       |           | —     |           |       |               | (337       | ) |   |   | (46 | ) |   | (437 | ) |
| 2002                   |       |                                 | (1,883     | )                        |       |           | (120       | )              |       |               | (983       | ) |   |   | (7 | ) |   | (2,993 | ) |
| 2003                   |       |                                 | (200       | )                        |       |           | (470       | )              |       |               | (751       | ) |   |   | 103 |   |   | (1,318 | ) |
| 2004                   |       |                                 | (9,768     | )                        |       |           | (1,670     | )              |       |               | 1,126      |   |   |   | 74 |   |   | (10,238 | ) |
| All Prior Years        |       |                                 | $          | (12,275                  | )          |           |       | $              | (2,324     | )                  |       |   | $ | (1,077 | ) |   |   | $ | 90 |   |   | $ | (15,586 | ) |
|                        |            |                                      |            |                          |            |                |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

49

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Thefollowing table presents information by line of business for prior yeardevelopment of reserves assumed from CAR and other residual markets for lossesand LAE for the year ended December 31, 2005.

**PriorYear assumed Loss and LAE Reserve Development Summary**

| ** **             | ** ** | **CAR Assumed  Private Passenger** | ** ** | **CAR Assumed  Commercial** | ** ** | **FAIR Plan** | ** ** | ** **     | ** ** | ** **         | ** ** |
|------------------------|------------|----------------------------------------------|------------|----------------------------------|------------|--------------------|------------|----------------|------------|--------------------|------------|
| **Accident Year**      | ** ** | ** **                                   | ** ** | **Automobile**                   | ** ** | **Automobile**     | ** ** | **Homeowners** | ** ** | **All Other** | ** ** | **Total** | ** ** |
| 1995 &  Prior |       |                                         | $          | 14                               |       |               |       | $              | (13        | )                  |       |   | $ | — |   |   |   | $ | — |   |   | $ | 1 |   |
| 1996                   |       |                                         | 1          |                             |       |               | —     |           |       |               | —     |   |   |   | — |   |   | 1 |   |
| 1997                   |       |                                         | 17         |                             |       |               | (18        | )              |       |               | —     |   |   |   | — |   |   | (1 | ) |
| 1998                   |       |                                         | 8          |                             |       |               | (12        | )              |       |               | —     |   |   |   | — |   |   | (4 | ) |
| 1999                   |       |                                         | (426       | )                                |       |               | 39         |           |       |               | (5         | ) |   |   | — |   |   | (392 | ) |
| 2000                   |       |                                         | (314       | )                                |       |               | 175        |           |       |               | (43        | ) |   |   | — |   |   | (182 | ) |
| 2001                   |       |                                         | 187        |                             |       |               | 91         |           |       |               | (158       | ) |   |   | — |   |   | 120 |   |
| 2002                   |       |                                         | 513        |                             |       |               | (686       | )              |       |               | (323       | ) |   |   | — |   |   | (496 | ) |
| 2003                   |       |                                         | (4,216     | )                                |       |               | (934       | )              |       |               | (687       | ) |   |   | — |   |   | (5,837 | ) |
| 2004                   |       |                                         | (15,263    | )                                |       |               | (1,325     | )              |       |               | (656       | ) |   |   | — |   |   | (17,244 | ) |
| All Prior Years        |       |                                         | $          | (19,479                          | )          |               |       | $              | (2,683     | )                  |       |   | $ | (1,872 | ) |   |   | $ | — |   |   | $ | (24,034 | ) |
|                        |            |                                              |            |                                  |            |                    |            |                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our private passenger automobile line of businessprior year reserves decreased by $31,754 for the year ended December 31,2005. The decrease was primarily due to improved assumed CAR results for theprivate passenger automobile pool for the 2004 accident year of $15,263 and forthe 2003 accident year of $4,216. The improved CAR results were due primarilyto improved CAR private passenger loss ratios for 2004 and 2003 as publishedand reported by the CAR Loss Reserving Committee at the November 30, 2005meeting, as compared to the published results at the December 1, 2004meeting. In addition, we reduced our retained private passenger automobilereserves for the 2004 and 2002 accident years by $9,768 and $1,883,respectively, primarily due to better than previously estimated severity on ourestablished bodily injury case reserves during 2005.

Our commercial automobile line of business prior yearreserves decreased by $5,007 for the year ended December 31, 2005. Thedecrease was primarily due to more favorable commercial automobile bodilyinjury severity than previously estimated on our established case reservesduring 2005.

Our Homeowners line of business prior year reservesdecreased by $2,949 for the year ended December 31, 2005. The decrease wasdue to improved FAIR Plan results for the 2004, 2003 and 2002 accident years of$656, $687 and $323 respectively, and better than previously estimated severityon property reserves on our established case reserves for 2003 and 2002 of $751and $983, respectively, partially offset by increased severity on ourestablished case reserves for 2004 of $1,077. The improved FAIR Plan resultswere due primarily to the increase in business written by the FAIR Plan inMassachusetts coastal territories such as Cape Cod without the occurrence of acatastrophe.

In estimating all our loss reserves, including CAR, wefollow the guidance prescribed by Statement of Financial Accounting Standards (“FAS”)No. 60, “Accounting and Reporting by Insurance Enterprises” and FAS No. 113,“Accounting and Reporting for Reinsurance of Short-Duration and Long-DurationContracts.”

For further information, see “Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations: *Losses and Loss Adjustment Expenses.”*

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*Other-Than-TemporaryImpairments.*

We use a systematic methodology to evaluate declinesin market values below cost or amortized cost of our investments. Thismethodology ensures that we evaluate available evidence concerning any declinesin a disciplined manner.

In our determination of whether a decline in marketvalue below amortized cost is an other-than-temporary impairment, we considerand evaluate several factors and circumstances including the issuer’s overallfinancial condition, the issuer’s credit and financial strength ratings, aweakening of the general market conditions in the industry or geographic regionin which the issuer operates, a prolonged period (typically six months orlonger) in which the fair value of an issuer’s securities remains below ouramortized cost, our ability and intent to hold these investments for a periodof time sufficient to allow for recovery of our costs, and any other factorsthat may raise doubt about the issuer’s ability to continue as a going concern.

We record other-than-temporary impairments as realizedlosses, which serve to reduce net income and earnings per share. We recordtemporary losses as unrealized losses, which do not impact net income andearnings per share but reduce other comprehensive net income. The risksinherent in our assessment of other-than-temporary impairments include the riskthat market factors may differ from our expectations, or that the creditassessment could change in the near term, resulting in a charge to earnings.

For further information,see “Item 7—Management’s Discussion and Analysis of Financial Condition andResults of Operations: *Net RealizedInvestment Losses.”*

**C.**                                       Resultsof Operations

Thefollowing table shows certain of our selected financial results:

| ** **                                    | ** ** | **For the Year Ended December 31,** | ** **  |
|-----------------------------------------------|------------|--------------------------------------------------------------|-------------|
| ** **                                    | ** ** | **2005**                                                     | ** **  | **2004** | ** ** | **2003** | ** ** |
| Direct written  premiums                      | ** ** | **$**                                                        | **649,113** |   | $ | 628,295 |   | $ | 571,545 |   |
| Net written  premiums                         | ** ** | **632,836**                                                  |        | 618,923 |   | 566,970 |   |
| Net earned  premiums                          | ** ** | **622,831**                                                  |        | 592,292 |   | 540,248 |   |
| Net investment  income                        | ** ** | **31,573**                                                   |        | 27,259 |   | 26,086 |   |
| Net realized  gains on investments            | ** ** | **305**                                                      |        | 1,274 |   | 10,051 |   |
| Finance and other  service income             | ** ** | **16,748**                                                   |        | 15,615 |   | 15,409 |   |
| Total revenue                                 | ** ** | **671,457**                                                  |        | 636,440 |   | 591,794 |   |
| Loss and loss  adjustment expenses            | ** ** | **385,593**                                                  |        | 425,061 |   | 420,969 |   |
| Underwriting,  operating and related expenses | ** ** | **146,669**                                                  |        | 145,075 |   | 130,636 |   |
| Interest expenses                             | ** ** | **948**                                                      |        | 672 |   | 646 |   |
| Total expenses                                | ** ** | **533,210**                                                  |        | 570,808 |   | 552,251 |   |
| Income before  income taxes                   | ** ** | **138,247**                                                  |        | 65,632 |   | 39,543 |   |
| Income tax  expense                           | ** ** | **43,065**                                                   |        | 20,642 |   | 11,061 |   |
| Net income                                    | ** ** | **$**                                                        | **95,182**  |   | $ | 44,990 |   | $ | 28,482 |   |

 

**YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDEDDECEMBER 31, 2004**

*DirectWritten Premiums.**  *Directwritten premiums for the year ended December 31, 2005 increased by$20,818, or 3.3%  to $649,113 from$628,295 for 2004. The 2005 increase occurred primarily in our personalautomobile line, which experienced a 0.1% increase in average written premiumand a 2.4% increase in written exposures. In addition, our commercialautomobile line’s average written premium decreased by 0.3%, with a 7.6%increase in written exposures. Our homeowners line average written premiumincreased by 7.3%, with a 2.9% decrease in written exposures.

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*NetWritten Premiums.**  *Netwritten premiums for the year ended December 31, 2005 increased by $13,913or 2.2% to $632,836 from $618,923 for 2004. This was primarily due to thefactors that increased direct written premiums combined with a decrease inpremiums ceded to CAR.

*Net EarnedPremiums.**  *Netearned premiums for the year ended December 31, 2005 increased by $30,539,or 5.2%, to $622,831 from $592,292 for 2004. This was primarily due to thefactors that increased direct written premiums combined with a decrease inpremiums ceded to CAR.

*NetInvestment Income.**  *Investmentincome for the year ended December 31, 2005 was $31,573 compared to$27,259 for 2004. Average cash and investment securities (at cost) increased by$102,624, or 14.0%, to $837,200 for the year ended December 31, 2005 from$734,576 for 2004 due to a $72,871 increase in average cash and a $29,753increase in average securities. Net effective yield on the investment portfolioremained relatively unchanged at 3.8% during the year ended December 31,2005 compared to 3.7% during 2004. Our duration decreased to 3.2 years at December 31,2005 from 3.4 years at December 31, 2004.

*NetRealized Gains on Investments.**  *Net realized gains on investmentsdecreased to $305 for the year ended December 31, 2005 from $1,274 for2004.

Thegross unrealized appreciation (depreciation) of investments in fixed maturitysecurities, including redeemable preferred stocks that have characteristics offixed maturities, and equity securities, was as follows:

| ** **                                                               | ** ** | **December 31, 2005** | ** **  |
|--------------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                               | ** ** | ** **                      | ** **  | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | ** **                      | ** **  | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** **  | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) | ** ** | **$**                           | **127,764** | ** ** |   | **$** | **142** | ** ** |   |   | **$** | **(2,686** | **)** |   | **$** | **125,220** | ** ** |
| Obligations of  states and political subdivisions                        | ** ** | **321,250**                     | ** **  |   | **4,385** | ** ** |   |   | **(3,026** | **)** |   | **322,609** | ** ** |
| Asset-backed  securities(1)                                              | ** ** | **124,531**                     | ** **  |   | **293** | ** ** |   |   | **(1,349** | **)** |   | **123,475** | ** ** |
| Corporate and  other securities                                          | ** ** | **140,385**                     | ** **  |   | **2,309** | ** ** |   |   | **(1,460** | **)** |   | **141,234** | ** ** |
| Subtotal, fixed  maturity securities                                     | ** ** | **713,930**                     | ** **  |   | **7,129** | ** ** |   |   | **(8,521** | **)** |   | **712,538** | ** ** |
| Equity securities                                                        | ** ** | **1,895**                       | ** **  |   | **110** | ** ** |   |   | **—** | ** ** |   | **2,005** | ** ** |
| Totals                                                                   | ** ** | **$**                           | **715,825** | ** ** |   | **$** | **7,239** | ** ** |   |   | **$** | **(8,521** | **)** |   | **$** | **714,543** | ** ** |

----

(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) andFederal National Mortgage Association (FNMA). The total of these fixed maturitysecurities was $115,284 at fair value and $117,766 at amortized cost as of December 31,2005. As such, the asset-backed securities presented exclude such issuersalready presented under U.S. Treasury securities and obligations of U.S.Government Agencies.

As of December 31, 2005, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’sInvestors Service, Inc. of Baa or higher, except the few securities notrated by Moody’s which received Standard & Poor’s ratings of A- orhigher, as well as a rating assigned by the Securities Valuation Office of theNational Association of Insurance Commissioners of 1 or 2).

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Thecomposition of our fixed income security portfolio by Moody’s rating was asfollows:

| ** **                                                            | ** ** | **December 31, 2005** | ** **  |
|-----------------------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                                            | ** ** | **Estimated**                   | ** **  | ** ** | ** ** |
| ** **                                                            | ** ** | **Fair Value**             | ** **  | **Percent** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                           | **122,237** | ** ** |   | **17.2** | **%** |   |
| Aaa/Aa                                                                | ** ** | **443,200**                     | ** **  |   | **62.1** | ** ** |   |
| A                                                                | ** ** | **86,179**                      | ** **  |   | **12.1** | ** ** |   |
| Baa                                                                   | ** ** | **46,183**                      | ** **  |   | **6.5** | ** ** |   |
| Not rated  (Standard & Poor’s rating of A-  or higher)  | ** ** | **14,739**                      | ** **  |   | **2.1** | ** ** |   |
| Total                                                                 | ** ** | **$**                           | **712,538** | ** ** |   | **100.0** | **%** |   |

 

Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

In our determination of other-than-temporaryimpairments, we consider several factors and circumstances including theissuer’s overall financial condition, the issuer’s credit and financialstrength ratings, a weakening of the general market conditions in the industryor geographic region in which the issuer operates, a prolonged period(typically six months or longer) in which the fair value of an issuer’ssecurities remains below our amortized cost, our ability and intent to holdthese investments for a period of time sufficient to allow for recovery of ourcosts, and any other factors that may raise doubt about the issuer’s ability tocontinue as a going concern.

Other-than-temporary impairments are recorded asrealized losses, which serve to reduce net income and earnings per share.Temporary losses are recorded as unrealized losses, which do not impact netincome and earnings per share but reduce other comprehensive net income. Therisks inherent in the assessment of other-than-temporary impairments includethe risk that market factors may differ from our expectations; we may decide tosubsequently sell a security for unforeseen business needs; or the creditassessment could change in the near term, resulting in a charge to earnings.

Thefollowing table illustrates the gross unrealized losses included in theCompany’s investment portfolio and the fair value of those securities,aggregated by investment category. The table also illustrates the length oftime that they have been in a continuous unrealized loss position as ofDecember 31, 2005.

| ** **                                                            | ** ** | **As of December 31, 2005** | ** **  |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** **  | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | ** **                                      | ** **  | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** **  | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$**                                           | **52,119**  | ** ** | ** ** | **$** | **581** |   | ** ** | **$** | **65,746** | ** ** | ** ** | **$** | **2,105** |   | ** ** | **$** | **117,865** | ** ** | ** ** | **$** | **2,686** |   |   |
| Obligations of  states and political subdivisions                     | ** ** | **53,872**                                      | ** **  | ** ** | **872** |   | ** ** | **97,361** | ** ** | ** ** | **2,154** |   | ** ** | **151,233** | ** ** | ** ** | **3,026** |   |   |
| Asset-backed  securities                                              | ** ** | **54,816**                                      | ** **  | ** ** | **526** |   | ** ** | **37,560** | ** ** | ** ** | **823** |   | ** ** | **92,376** | ** ** | ** ** | **1,349** |   |   |
| Corporate and  other securities                                       | ** ** | **38,830**                                      | ** **  | ** ** | **603** |   | ** ** | **31,707** | ** ** | ** ** | **857** |   | ** ** | **70,537** | ** ** | ** ** | **1,460** |   |   |
| Total temporarily  impaired securities                                | ** ** | **$**                                           | **199,637** | ** ** | ** ** | **$** | **2,582** |   | ** ** | **$** | **232,374** | ** ** | ** ** | **$** | **5,939** |   | ** ** | **$** | **432,011** | ** ** | ** ** | **$** | **8,521** |   |   |

 

The unrealized losses recorded on the fixed maturityinvestment portfolio at December 31, 2005 resulted from fluctuations inmarket interest rates as opposed to fundamental changes in the credit qualityof the issuers of such securities. Therefore, these decreases in values areviewed as being temporary as we 

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have the intent andability to retain such investments for a period of time sufficient to allow forrecovery in market value.

Of the $8,521 gross unrealized losses as ofDecember 31, 2005, $5,712 relates to fixed maturity obligations of U.S.government agencies and obligations of states and political subdivisions. Theremaining $2,809 of gross unrealized losses relates primarily to holdings ofinvestment grade asset-backed, corporate and other fixed maturitysecurities.

During the years ended December 31, 2005 and2004, there was no significant deterioration in the credit quality of any ofthe Company’s holdings and no other-than-temporary impairment charges wererecorded related to the Company’s portfolio of investment securities

*Financeand Other Service Income.**  *Finance and other service income includes revenuesfrom premium installment charges, which we recognize when earned, and othermiscellaneous income and fees. Finance and other service income for the yearended December 31, 2005 were $16,748 compared to $15,615 for the 2004period. This resulted from increases in premium installment billing feesprimarily due to growth in the number of policies combined with an increase inmiscellaneous income from CAR.

*Lossesand Loss Adjustment Expenses.**  *Losses and loss adjustment expensesincurred for the year ended December 31, 2005 decreased by $39,468, or9.3%, to $385,593 from $425,061 for the comparable 2004 period. Our GAAP lossratio for the year ended December 31, 2005 decreased to 61.9% compared to71.8% for the comparable 2004 period. Our GAAP loss ratio excluding lossadjustment expenses for the year ended December 31, 2005 decreased to54.9% from 64.6% for the comparable 2004 period. The loss ratio improved as aresult of favorable loss development of $22,162 in CAR assumed prior yearsreserves, favorable loss development of $14,600 in the Company’s prior yearsautomobile reserves, a decrease in personal and commercial bodily injury claimfrequency in our automobile lines of business, favorable loss development of$1,872 in FAIR Plan assumed prior years reserves, and favorable lossdevelopment of $986 in homeowners prior years reserves in 2005 compared tofavorable loss development of $6,854 in CAR assumed prior years reserves,$2,523in homeowner prior years reserves, $329 in FAIR Plan assumed prior yearsreserves, and an increase of $2,928 in the Company’s automobile prior yearsreserves in 2004.

*Underwriting,Operating and Related Expenses.**  *Underwriting, operating and relatedexpense for the year ended December 31, 2005 increased by $1,594, or 1.1%,to $146,669 from $145,075 for the comparable 2004 period. Our GAAP expenseratios for the year ended December 31, 2005 decreased to 23.5% compared to24.5% for the comparable 2004 periods and is partly due to a decrease inexpenses related to assessments from the Massachusetts Insurers InsolvencyFund.  The Company received a $50assessment refund of prior years assessments in 2005 compared to a $2,538assessment paid and expensed in 2004.

*InterestExpenses.**  *Interestexpense for the year ended December 31, 2005 was $948 compared to $672 forthe comparable 2004 period due to increased LIBOR rates on our credit facilityadvances in 2005.

*IncomeTax Expense.**  *Oureffective tax rates were 31.2% and 31.5% for the year ended December 31,2005 and 2004, respectively.  Theseeffective rates were lower than the statutory rate of 35% primarily due toadjustments for tax-exempt investment income and a $1,161 tax benefit recordedas a reduction to income tax expense for the year ended December 31, 2005.This tax benefit represents a reduction in federal income tax reserves for taxyears 2001 through 2003 during 2005 upon completion of an examination of theCompany’s federal income tax returns for the tax periods ended December 31,2003, 2002, and 2001 by the Internal Revenue Service.

*Net Income.**  *Net income for the year ended December 31,2005 increased by $50,192, or 111.6%, to $95,182 from $44,990 for thecomparable 2004 period. This increase was primarily due to the increase inpremiums and decrease in the loss ratio, as discussed above.

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**YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDEDDECEMBER 31, 2003**

*DirectWritten Premiums.**  *Directwritten premiums for the year ended December 31, 2004 increased by$56,750, or 9.9%, to $628,295 from $571,545 for 2003. The 2004 increaseoccurred primarily in our personal automobile line, which experienced a 6.1%increase in average written premium and a 3.5% increase in written exposures.In addition, our commercial automobile line’s average written premium increasedby 6.0%, while we had a 5.6% increase in written exposures. Our homeowners lineaverage written premium increased by 8.3%, which was partly offset by a 1.7%decrease in written exposures.

*NetWritten Premiums.**  *Netwritten premiums for the year ended December 31, 2004 increased by$51,953, or 9.2%, to $618,923 from $566,970 for 2003. This was primarily due tothe increase in direct written premiums.

*NetEarned Premiums.**  *Netearned premiums for the year ended December 31, 2004 increased by $52,044,or 9.6%, to $592,292 from $540,248 for 2003. This was primarily due to thefactors that increased direct written premiums, including increased premiumrates on personal automobile, commercial automobile and homeowners productlines.

*NetInvestment Income.**  *Investmentincome for the year ended December 31, 2004 was $27,259 compared to$26,086 for 2003. Average cash and investment securities (at amortized cost)increased by $95,645, or 15.0%, to $734,576 for the year ended December 31,2004 from $638,931 for 2003 due to a $53,491 increase in average cash and a$42,154 increase in average securities. Net effective yield on the investmentportfolio decreased to 3.7% during the year ended December 31, 2004 from4.1% during 2003 due to management’s investment strategy to shorten theportfolio duration, shift to higher rated securities, and increase tax-exemptholdings. Our duration decreased to 3.4 years at December 31, 2004from 4.2 years at December 31, 2003.

*NetRealized Gains on Investments.**  *Net realized gains on investmentsdecreased to $1,274 for the year ended December 31, 2004 from $10,051 for2003.

Thegross unrealized appreciation (depreciation) of investments in fixed maturitysecurities, including redeemable preferred stocks that have characteristics offixed maturities, and equity securities, was as follows:

| ** **                                                               | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | ** **                      | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) |       | $                               | 124,209    |   |   | $ | 972 |   |   |   | $ | (1,019 | ) |   | $ | 124,162 |   |
| Obligations of  states and political subdivisions                        |       | 320,414                         |       |   | 8,761 |   |   |   | (1,250 | ) |   | 327,925 |   |
| Asset-backed  securities(1)                                              |       | 78,958                          |       |   | 1,356 |   |   |   | (374 | ) |   | 79,940 |   |
| Corporate and  other securities                                          |       | 126,578                         |       |   | 5,228 |   |   |   | (324 | ) |   | 131,482 |   |
| Subtotal, fixed  maturity securities                                     |       | 650,159                         |       |   | 16,317 |   |   |   | (2,967 | ) |   | 663,509 |   |
| Equity securities                                                        |       | 1,037                           |       |   | 50 |   |   |   | — |   |   | 1,087 |   |
| Totals                                                                   |       | $                               | 651,196    |   |   | $ | 16,367 |   |   |   | $ | (2,967 | ) |   | $ | 664,596 |   |

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(1)          Obligations of U.S.Government agencies include collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) andFederal National Mortgage Association (FNMA). The total of these fixed maturitysecurities was $120,636 at fair value and $120,729 at amortized cost as of December 31,2004. As such, the asset-backed securities presented exclude such issuersalready presented under U.S. Treasury securities and obligations of U.S.Government Agencies.

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As of December 31, 2004, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities (i.e., all our securities received a rating assigned by Moody’sInvestors Service, Inc. of Baa or higher, except the few securities notrated by Moody’s which received S&P ratings of AA/A or higher, as well as arating assigned by the Securities Valuation Office of the National Associationof Insurance Commissioners of 1 or 2).

The composition ofour fixed income security portfolio by Moody’s rating was as follows:

| ** **                                                            | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **Estimated**                   | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Fair Value**             | ** ** | **Percent** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $                               | 124,162    |   |   | 18.7 | % |   |
| Aaa/Aa                                                                |       | 416,305                         |       |   | 62.7 | % |   |
| A                                                                     |       | 78,615                          |       |   | 11.9 | % |   |
| Baa                                                                   |       | 44,427                          |       |   | 6.7 | % |   |
| Total                                                                 |       | $                               | 663,509    |   |   | 100.0 | % |   |

 

Ratings are assigned by Moody’s, or the equivalent, asdiscussed above. Such ratings are generally assigned upon the issuance of thesecurities and are subject to revision on the basis of ongoing evaluations.Ratings in the table are as of the date indicated.

In our determination of other-than-temporaryimpairments, we consider several factors and circumstances including the issuer’soverall financial condition, the issuer’s credit and financial strengthratings, a weakening of the general market conditions in the industry orgeographic region in which the issuer operates, a prolonged period (typicallysix months or longer) in which the fair value of an issuer’s securities remainsbelow our amortized cost, our ability and intent to hold these investments fora period of time sufficient to allow for recovery of our costs, and any otherfactors that may raise doubt about the issuer’s ability to continue as a goingconcern.

Other-than-temporary impairments are recorded asrealized losses, which serve to reduce net income and earnings per share.Temporary losses are recorded as unrealized losses, which do not impact netincome and earnings per share but reduce other comprehensive net income. Therisks inherent in the assessment of other-than-temporary impairments includethe risk that market factors may differ from our expectations; we may decide tosubsequently sell a security for unforeseen business needs; or the creditassessment could change in the near term, resulting in a charge to earnings.

The following tableillustrates the gross unrealized losses included in the Company’s investmentportfolio and the fair value of those securities, aggregated by investmentcategory. The table also illustrates the length of time that they have been ina continuous unrealized loss position as of December 31, 2004.

| ** **                                                            | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $                                               | 37,187     |   |   | $ | 96 |   |   |   | $ | 29,151 |   |   |   | $ | 923 |   |   | $ | 66,338 |   |   | $ | 1,019 |   |   |
| Obligations of states  and political subdivisions                     |       | 61,509                                          |       |   | 394 |   |   |   | 60,748 |   |   |   | 856 |   |   | 122,257 |   |   | 1,250 |   |   |
| Asset-backed  securities                                              |       | 22,516                                          |       |   | 231 |   |   |   | 4,690 |   |   |   | 143 |   |   | 27,206 |   |   | 374 |   |   |
| Corporate and  other securities                                       |       | 20,346                                          |       |   | 272 |   |   |   | 1,475 |   |   |   | 52 |   |   | 21,821 |   |   | 324 |   |   |
| Total temporarily  impaired securities                                |       | $                                               | 141,558    |   |   | $ | 993 |   |   |   | $ | 96,064 |   |   |   | $ | 1,974 |   |   | $ | 237,622 |   |   | $ | 2,967 |   |   |

 

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The unrealized losses recorded on the fixed maturityinvestment portfolio at December 31, 2004 resulted from fluctuations inmarket interest rates as opposed to fundamental changes in the credit qualityof the issuers of such securities. Therefore, these decreases in values areviewed as being temporary as we have the intent and ability to retain suchinvestments for a period of time sufficient to allow for recovery in marketvalue.

Of the $2,967 gross unrealized losses as of December 31,2004, $2,269 relates to fixed maturity obligations of states and politicalsubdivisions and U.S. government agencies. The remaining $698 of grossunrealized losses relates primarily to holdings of investment grade asset-backed,corporate and other fixed maturity securities.

During the year ended December 31, 2004, therewas no significant deterioration in the credit quality of any of the Company’sholdings and no other-than-temporary impairment charges were recorded relatedto the Company’s portfolio of investment securities. However, during the yearended December 31, 2003, there was a significant deterioration in thecredit quality of one of the Company’s holdings, Continental Airlines.Accordingly, during the first quarter of 2003, the Company recorded another-than-temporary impairment of $837 for this security. During May 2003,this security was sold at a realized gain of $426.

*Financeand Other Service Income.**  *Finance and other service income includes revenuesfrom premium installment charges, which we recognize when earned, and othermiscellaneous income and fees. Finance and other service income for the yearended December 31, 2004 remained constant at $15,615 compared to $15,409for the 2003 period. This resulted from increases in premium installmentbilling fees due to growth in the number of policies and the fee charged perpolicy, offset by decreases in miscellaneous income from CAR.

*Lossesand Loss Adjustment Expenses.**  *Losses and loss adjustment expensesincurred for the year ended December 31, 2004 increased $4,092, or 1.0%,to $425,061 from $420,969 for the comparable 2003 period. Our GAAP loss ratiofor the year ended December 31, 2004 decreased to 71.8% compared to 77.9%for the comparable 2003 period. Our GAAP loss ratio excluding loss adjustmentexpenses for the year ended December 31, 2004 decreased to 64.6% from70.2% for the comparable 2003 period. The 2004 decrease in our GAAP loss ratiosis primarily due to an increase in average written premium, a decrease in claimfrequency in our personal automobile, commercial automobile and homeownerslines of business and favorable loss development primarily due to animprovement in prior year CAR results.

*Underwriting,Operating and Related Expenses.**  *Underwriting, operating and relatedexpense for the year ended December 31, 2004 increased by $14,439, or11.1%, to $145,075 from $130,636 for the comparable 2003 period. Our GAAPexpense ratios for the year ended December 31, 2004 increased to 24.5%compared to 24.2% for the comparable 2003 periods.

*InterestExpenses.**  *Interestexpense for the year ended December 31, 2004 was $672 compared to $646 forthe comparable 2003 period.

*IncomeTax Expense.**  *Oureffective tax rates were 31.5% and 28.0% for the year ended December 31,2004 and 2003, respectively. These effective rates were lower than thestatutory rate of 35% primarily due to adjustments for tax-exempt investmentincome. The increase in the effective tax rate during 2004 was due to a reducedlevel of annual estimated tax-exempt interest relative to annual estimatedincome before taxes in the current period. Additionally, our effective tax ratefor the year ended December 31, 2004 was adversely impacted by anadjustment of $544 related to an increase in a previously established valuationallowance against state deferred tax assets from 80% to a full 100% of theasset.

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*Net Income.**  *Net income for the year endedDecember 31, 2004 increased by $16,508, or 58.0%, to $44,990 from $28,482for the comparable 2003 period. These increases in net income during 2004 are aresult of decreases in the loss ratios, which are due to an increase in averagewritten premium and a decrease in claim frequency in our personal automobile,commercial automobile and homeowners lines of business.

**D.   Liquidityand Capital Resources**

As a holding company, Safety’s assets consistprimarily of the stock of our direct and indirect subsidiaries. Our principalsource of funds to meet our obligations and pay dividends to shareholders,therefore, is dividends and other permitted payments from our subsidiaries,principally Safety Insurance. Safety is the borrower under our creditfacilities.

Safety Insurance’s sources of funds primarily includepremiums received, investment income and proceeds from sales and redemptions ofinvestments. Safety Insurance’s principal uses of cash are the payment ofclaims, operating expenses and taxes, the purchase of investments and paymentof dividends to Safety.

Net cash provided by operating activities was$116,417, $126,176, and $85,185 during the years ended December 31, 2005,2004 and 2003, respectively. Our operations typically generate substantialpositive cash flows from operations as most premiums are received in advance ofthe time when claim and benefit payments are required. These positive operatingcash flows are expected to continue to meet our liquidity requirements.

Net cash used for investing activities was $82,770during the year ended December 31, 2005, which resulted primarily frompurchases of fixed maturities in excess of sales and maturities of fixedmaturities. Net cash provided by investing activities was $7,820 during theyear ended December 31, 2004, which resulted primarily from sales andmaturities of fixed maturities in excess of purchases of fixed maturities. Netcash used for investing activities was $89,205 during the year ended December 31,2003, which resulted primarily from purchases of fixed maturities in excess ofsales and maturities of fixed maturities.

Net cash used forfinancing activities was $26,293 during the year ended December 31, 2005and resulted primarily from the pay down of the revolving credit facility andfrom dividends paid to shareholders. Net cash used for financing activities was$4,607 and $4,473 during the years ended December 31, 2004 and 2003,respectively, and resulted primarily from dividends paid to shareholders.

*Credit Facility*

Concurrent with the closing of our November 27,2002 initial public offering (“IPO”) and repayment of the old credit facility,Safety obtained a new $30,000 revolving credit facility. Safety borrowed theentire $30,000 under this credit facility at the closing of the IPO and paiddown the balance to $19,956 on December 5, 2002 with the approximately$10,000 net proceeds from the exercise of the underwriter’s over-allotmentoption for 900,000 shares of our common stock. Loans under the credit facilitybear interest at our option at either (i) the LIBOR rate plus 1.5% perannum or (ii) the higher of Citizens Bank of Massachusetts’ prime rate or0.5% above the federal funds rate plus 1.5% per annum. Interest only is payableprior to maturity. The obligations of Safety under the credit facility aresecured by pledges of the assets of Safety and the capital stock of Safety’soperating subsidiaries. The credit facility is guaranteed by the non-insurancecompany subsidiaries of Safety. The credit facility contains covenantsincluding requirements to maintain minimum risk based capital ratios andstatutory surplus of Safety Insurance as well as limitations or restrictions onindebtedness, liens, dividends, and other matters. As of December 31,2005, we were in compliance with all such covenants.

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Bank of America was the lender under this creditfacility. Under an agreement effective on June 17, 2005, Bank of Americaassigned the $30,000 credit facility to Citizens Bank of Massachusetts. Thecredit facility was due and payable at maturity on November 27, 2005,which was three years from the closing of the IPO. Under a June 17, 2005amendment to the credit facility, the maturity date was extended toJune 17, 2008. Other terms of the revolving credit facility remainunchanged.

The Company paid down thebalance of $19,956 on December 8, 2005 and had no amounts outstanding on itscredit facility at December 31, 2005. At December 31, 2004, the Company hadutilized advances of $19,956. The interest rate on the $30,000 commitment was..25% at December 31, 2005 and 2004.  Theinterest rate on the amounts advanced was 4.26% at December 31, 2004. Theaverage interest rate during 2005 and 2004 was 4.59% and 3.27%, respectively.

*Regulatory Matters*

Our insurance subsidiaries are subject to variousregulatory restrictions that limit the maximum amount of dividends available tobe paid to their parent without prior approval of the Commissioner. TheMassachusetts statute limits the dividends an insurer may pay in any twelve-monthperiod, without the prior permission of the Commissioner, to the greater of (i) 10%of the insurer’s surplus as of the preceding December 31 or (ii) theinsurer’s net income for the twelve-month period ending the preceding December 31,in each case determined in accordance with statutory accounting practices. Ourinsurance company subsidiaries may not declare an “extraordinary dividend”(defined as any dividend or distribution that, together with otherdistributions made within the preceding twelve months, exceeds the limitsestablished by Massachusetts statute) until thirty days after the Commissionerhas received notice of the intended dividend and has not objected. Ashistorically administered by the Commissioner, this provision requires theCommissioner’s prior approval of an extraordinary dividend. Under Massachusettslaw, an insurer may pay cash dividends only from its unassigned funds, alsoknown as earned surplus, and the insurer’s remaining surplus must be bothreasonable in relation to its outstanding liabilities and adequate to itsfinancial needs. At year-end 2005, the statutory surplus of Safety Insurancewas $350,833, and its net income for 2005 was $92,432. As a result, a maximumof $92,432 is available in 2006 for such dividends without prior approval ofthe Division. During the year ended December 31, 2005, Safety Insurancerecorded dividends to Safety of $24,900.

The maximum dividend permitted by law is notindicative of an insurer’s actual ability to pay dividends, which may beconstrained by business and regulatory considerations, such as the impact ofdividends on surplus, which could affect an insurer’s ratings or competitiveposition, the amount of premiums that can be written and the ability to payfuture dividends.

On February 16, 2006, our Board approved aquarterly cash dividend on our common stock of $0.18 per share, or $2,844,payable on March 15, 2006 to shareholders of record on March 1, 2006.On November 3, 2005, our Board approved a quarterly cash dividend on ourcommon stock of $0.18 per share, or $2,835, which was paid on December 15,2005. On August 18, 2005, our Board approved a quarterly cash dividend onour common stock of $0.18 per share, or $2,832, which was paid on September 15,2005. On May 19, 2005, our Board approved a quarterly cash dividend on ourcommon stock of $0.12 per share, or $1,881, which was paid on June 15,2005. On February 17, 2005, our Board approved a quarterly cash dividendon our common stock of $0.12 per share, or $1,861, which was paid on March 15,2005. We plan to continue to declare and pay quarterly cash dividends in 2006,depending on our financial position and the regularity of our cash flows.

Management believes thatthe current level of cash flow from operations provides us with sufficientliquidity to meet our operating needs over the next 12 months. We expectto be able to continue to meet our operating needs after the next12 months from internally generated funds. Since our ability to meet ourobligations in the long term (beyond such twelve-month period) isdependent upon such factors as market 

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changes,insurance regulatory changes and economic conditions, no assurance can be giventhat the available net cash flow will be sufficient to meet our operatingneeds. We expect that we would need to borrow or issue capital stock if weneeded additional funds, for example, to pay for an acquisition or asignificant expansion of our operations. There can be no assurance thatsufficient funds for any of the foregoing purposes would be available to us atsuch time.

*Off-Balance SheetArrangements*

We have no materialobligations under a guarantee contract meeting the characteristics identifiedin paragraph 3 of Financial Accounting Standards Board (“FASB”)Interpretation No. (“FIN”) 45, “Guarantor’s Accounting and DisclosureRequirements, Including Indirect Guarantees of Indebtedness of Others”. We haveno material retained or contingent interests in assets transferred to anunconsolidated entity. We have no material obligations, including contingentobligations, under contracts that would be accounted for as derivativeinstruments. We have no obligation, including contingent obligations, arisingout of a variable interest in an unconsolidated entity held by, and materialto, us, where such entity provides financing, liquidity, market risk or creditrisk support to, or engages in leasing, hedging or research and developmentservices with us. We have no direct investments in real estate and no holdingsof mortgages secured by commercial real estate. Accordingly, we have nomaterial off-balance sheet arrangements.

*ContractualObligations*

Wehave obligations to make future payments under contracts and credit-relatedfinancial instruments and commitments. At December 31, 2005, certainlong-term aggregate contractual obligations and credit-relatedcommitments are summarized as follows:

| ** **                     | ** ** | **Payments Due by Period** | ** **  |
|--------------------------------|------------|-------------------------------------------|-------------|
| ** **                     | ** ** | **Within**                                | ** **  | **Two to Three** | ** ** | **Four to Five** | ** ** | **After five** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **One Year**                         | ** **  | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Total** | ** ** |
| Loss and LAE  reserves         | ** ** | **$**                                     | **220,851** | ** ** |   | **$** | **198,315** | ** ** |   |   | **$** | **27,043** | ** ** |   |   | **$** | **4,507** | ** ** |   | **$** | **450,716** | ** ** |
| Capital lease  obligations     | ** ** | **233**                                   | ** **  |   | **39** | ** ** |   |   | **—** | ** ** |   |   | **—** | ** ** |   | **272** | ** ** |
| Operating leases               | ** ** | **2,888**                                 | ** **  |   | **5,954** | ** ** |   |   | **44** | ** ** |   |   | **—** | ** ** |   | **8,886** | ** ** |
| Total contractual  obligations | ** ** | **$**                                     | **223,972** | ** ** |   | **$** | **204,308** | ** ** |   |   | **$** | **27,087** | ** ** |   |   | **$** | **4,507** | ** ** |   | **$** | **459,874** | ** ** |

 

As of December 31,2005, the Company had loss and LAE reserves of $450,716, reinsurancerecoverables of $80,550 and net loss and LAE reserves of $370,166. Our loss andLAE reserves are estimates as described in more detail under “CriticalAccounting Policies and Estimates”. The specific amounts and timing ofobligations related to case reserves, IBNR reserves and related LAE reservesare not set contractually, and the amounts and timing of these obligations areunknown. Based upon our cumulative claims paid over the last ten years, theCompany estimates that its loss and LAE reserves will be paid in the periodshown above. While management believes that historical performance of losspayment patterns is a reasonable source for projecting future claims payments,there is inherent uncertainty in this estimated projected settlement of lossand LAE reserves, and as a result these estimates will differ, perhapssignificantly, from actual future payments. Our operations typically generatesubstantial positive cash flows from operations as most premiums are receivedin advance of the time when claim and benefit payments are required. Thesepositive operating cash flows are expected to continue to meet our liquidityrequirements, including any unexpected variations in the timing of claimsettlements.

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**E. Forward-Looking Statements**

Forward-lookingstatements might include one or more of the following, among others:

·       Projectionsof revenues, income, earnings per share, capital expenditures, dividends,capital structure or other financial items;

·       Descriptionsof plans or objectives of management for future operations, products orservices;

·       Forecastsof future economic performance, liquidity, need for funding and income; and

·       Descriptionsof assumptions underlying or relating to any of the foregoing.

Forward-looking statements can be identified bythe fact that they do not relate strictly to historical or current facts. Theyoften include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,”“estimate,” “aim,” “projects,” or words of similar meaning and expressions thatindicate future events and trends, or future or conditional verbs such as “will,”“would,” “should,” “could,” or “may”. All statements that address expectationsor projections about the future, including statements about the Company’sstrategy for growth, product development, market position, expenditures andfinancial results, are forward-looking statements.

Forward-looking statements are not guarantees offuture performance. By their nature, forward-looking statements aresubject to risks and uncertainties. There are a number of factors, many ofwhich are beyond our control, that could cause actual future conditions,events, results or trends to differ significantly and/or materially fromhistorical results or those projected in the forward-looking statements.These factors include but are not limited to the competitive nature of our industryand the possible adverse effects of such competition. Although a number ofnational insurers that are much larger than we are do not currently compete ina material way in the Massachusetts private passenger automobile market, if oneor more of these companies decided to aggressively enter the market it couldhave a material adverse effect on us. Other significant factors includeconditions for business operations and restrictive regulations inMassachusetts, the possibility of losses due to claims resulting from severeweather, the possibility that the Commissioner may approve future Rule changesthat change the operation of the residual market, our possible need for andavailability of additional financing, and our dependence on strategicrelationships, among others, and other risks and factors identified from timeto time in our reports filed with the SEC. Refer to Part 1, Item 1A—RiskFactors.

Some other factors, such as market, operational,liquidity, interest rate, equity and other risks, are described elsewhere inthis Annual Report on Form 10-K. Factors relating to the regulationand supervision of our Company are also described or incorporated in thisreport. There are other factors besides those described or incorporated in thisreport that could cause actual conditions, events or results to differ fromthose in the forward-looking statements.

Readers are cautioned notto place undue reliance on these forward-looking statements, which speakonly as of the date on which they are made. We do not undertake any obligationto update publicly or revise any forward-looking statements to reflectcircumstances or events that occur after the date the forward-lookingstatements are made.

***ITEM 7A.****         QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK*

*MarketRisk.**  *Marketrisk is the risk that we will incur losses due to adverse changes in marketrates and prices. We have exposure to market risk through our investmentactivities and our financing activities. Our primary market risk exposure is tochanges in interest rates. We use both fixed and variable rate debt as sourcesof financing. We have not entered, and do not plan to enter, into anyderivative financial instruments for trading or speculative purposes.

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*InterestRate Risk.**  *Interestrate risk is the risk that we will incur economic losses due to adverse changesin interest rates. Our exposure to interest rate changes primarily results fromour significant holdings of fixed rate investments and from our financingactivities. Our fixed maturity investments include U.S. and foreign governmentbonds, securities issued by government agencies, obligations of state and localgovernments and governmental authorities, corporate bonds and asset-backedsecurities, most of which are exposed to changes in prevailing interest rates.

We manage our exposure to risks associated withinterest rate fluctuations through active review of our investment portfolio byour management and Board and consultation with third-party financialadvisors. As a general matter, we do not attempt to match the durations of ourassets with the durations of our liabilities, and the majority of ourliabilities are “short tail.” Our goal is to maximize the total after-taxreturn on all of our investments. An important strategy that we employ toachieve this goal is to try to hold enough in cash and short-term investmentsin order to avoid liquidating longer-term investments to pay claims.

Basedupon the results of interest rate sensitivity analysis, the following tablesshow the interest rate risk of our investments in fixed maturities, includingpreferred stocks with characteristics of fixed maturities, measured in terms offair value (which is equal to the carrying value for all our fixed maturitysecurities).

| ** **                                   | ** ** | **-100 Basis**   | ** ** | ** **         | ** ** | **+100 Basis**   | ** ** |
|----------------------------------------------|------------|-----------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **Point Change** | ** ** | **No Change** | ** ** | **Point Change** | ** ** |
| **As of December 31, 2005**             |       |                  |       |               |       |                  |       |   |   |   |   |   |   |
| Estimated fair  value                        | ** ** | ** **            | **$**      | **740,163**        |       | ** **            | ** ** | **$** | **712,538** |   | ** ** | ** ** | **$** | **684,924** | ** ** | ** ** |
| Estimated  increase (decrease) in fair value | ** ** | ** **            | **$**      | **27,625**         |       | ** **            | ** ** | **$** | **—** |   | ** ** | ** ** | **$** | **(27,614** | **)** | ** ** |
| **As of December 31,  2004**            |       |                  |       |               |       |                  |       |   |   |   |   |   |   |
| Estimated fair  value                        |       |                  | $          | 692,271            |       |                  |       | $ | 663,509 |   |   |   | $ | 635,052 |   |   |
| Estimated increase  (decrease) in fair value |       |                  | $          | 28,762             |       |                  |       | $ | — |   |   |   | $ | (28,457 | ) |   |

 

An important market risk for all of our long-term debtis interest rate risk. We continue to monitor the interest rate environment andto evaluate refinancing opportunities as maturity dates approach. With respectto floating rate debt, we are also exposed to the effects of changes inprevailing interest rates. At December 31, 2005 we had no debt outstandingunder our credit facility. During the year, the weighted average variableinterest rate on our credit facility was 4.4%. A 2.0% change in the prevailinginterest rate on our variable rate debt would result in interest expense fluctuatingapproximately $400 for 2006, assuming that all of such debt is outstanding forthe entire year.

*EquityRisk.**  *Equityrisk is the risk that we will incur economic losses due to adverse changes inequity prices. In the past, our exposure to changes in equity prices primarilyresulted from our holdings of common stocks, mutual funds and other equities.While we have in the past held common equity securities in our investmentportfolio, presently we hold none, except for interests in mutual funds to fundthe executive deferred compensation plan. We continuously evaluate marketconditions and we expect in the future to purchase equity securities. Weprincipally managed equity price risk through industry and issuerdiversification and asset allocation techniques.

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***ITEM 8.****                 FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA*

**SAFETY INSURANCEGROUP, INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                          | ** ** | **Page(s)** | ** ** |
|----------------------------------------------------------|------------|-------------|------------|
| **Consolidated Financial  Statements:**                  |       |        |       |   |   |
| Report of Independent Registered Public Accounting  Firm |       |        | 65         |   |   |
| Balance Sheets                                           |       |        | 67         |   |   |
| Statements of Operations                                 |       |        | 68         |   |   |
| Statements of Changes in Shareholders’ Equity       |       |        | 69         |   |   |
| Statements of Comprehensive Income                       |       |        | 70         |   |   |
| Statements of Cash Flows                                 |       |        | 71         |   |   |
| Notes to  Consolidated Financial Statements              |       |        | 72         |   |   |

 

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**Reportof Independent Registered Public Accounting Firm**

To the Board of Directors and Shareholders of SafetyInsurance Group, Inc.:

We have completedintegrated audits of Safety Insurance Group, Inc.’s 2005 and 2004consolidated financial statements and of its internal control over financialreporting as of December 31, 2005, and an audit of its 2003 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on our audits,are presented below.

*Consolidatedfinancial statements and financial statement schedules*

In our opinion, theconsolidated financial statements listed in the accompanying index presentfairly, in all material respects, the financial position of Safety InsuranceGroup, Inc. at December 31, 2005 and 2004, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2005 in conformity with accounting principles generallyaccepted in the United States of America. In addition, in our opinion, thefinancial statement schedules listed in the index appearing under 15(a)(2) presentfairly, in all material respects, the information set forth therein when readin conjunction with the related consolidated financial statements. Thesefinancial statements and financial statement schedules are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese financial statements and financial statement schedules based on ouraudits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2005 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2005, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for 

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external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that (i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLPBoston, MassachusettsMarch 16, 2006

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**Safety Insurance Group, Inc. and Subsidiaries**

**Consolidated Balance Sheets(Dollars in thousands, except share data)**

| ** **                                                                                                                            | ** ** | **December 31,** | ** **    |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|---------------|
| ** **                                                                                                                            | ** ** | **2005**              | ** **    | **2004** | ** ** |
| **Assets**                                                                                                                            | ** ** | ** **            | ** **    | ** ** | ** ** |
| Investment securities  available for sale:                                                                                            | ** ** | ** **            | ** **    | ** ** | ** ** |
| Fixed maturities, at fair value (amortized cost:  $713,930 and $650,159)                                                              | ** ** | **$**                 | **712,538**   |   | $ | 663,509 |   |
| Equity securities, at fair value (cost: $1,895 and  $1,037)                                                                           | ** ** | **2,005**             |          | 1,087 |   |
| Total investment securities                                                                                                           | ** ** | **714,543**           |          | 664,596 |   |
| Cash and cash  equivalents                                                                                                            | ** ** | **163,027**           |          | 155,673 |   |
| Accounts  receivable, net of allowance for doubtful accounts                                                                          | ** ** | **154,421**           |          | 150,451 |   |
| Accrued  investment income                                                                                                            | ** ** | **7,856**             |          | 7,008 |   |
| Taxes recoverable                                                                                                                     | ** ** | **318**               |          | — |   |
| Receivable from  reinsurers related to paid loss and loss adjustment expenses                                                         | ** ** | **18,750**            |          | 18,980 |   |
| Receivable from  reinsurers related to unpaid loss and loss adjustment   expenses                                                     | ** ** | **80,550**            |          | 84,167 |   |
| Prepaid  reinsurance premiums                                                                                                         | ** ** | **37,174**            |          | 43,402 |   |
| Deferred policy  acquisition costs                                                                                                    | ** ** | **45,480**            |          | 42,919 |   |
| Deferred income  taxes                                                                                                                | ** ** | **18,120**            |          | 12,679 |   |
| Equity and  deposits in pools                                                                                                         | ** ** | **14,631**            |          | 23,678 |   |
| Other assets                                                                                                                          | ** ** | **2,805**             |          | 2,892 |   |
| **Total assets**                                                                                                                      | ** ** | **$**                 | **1,257,675** |   | $ | 1,206,445 |   |
| **Liabilities**                                                                                                                       |       |                  |          |   |   |
| Loss and loss  adjustment expense reserves                                                                                            | ** ** | **$**                 | **450,716**   |   | $ | 450,897 |   |
| Unearned premium  reserves                                                                                                            | ** ** | **341,562**           |          | 337,786 |   |
| Accounts payable  and accrued liabilities                                                                                             | ** ** | **44,372**            |          | 43,684 |   |
| Taxes payable                                                                                                                         | ** ** | **—**            |          | 3,509 |   |
| Outstanding  claims drafts                                                                                                            | ** ** | **19,825**            |          | 16,832 |   |
| Payable to  reinsurers                                                                                                                | ** ** | **12,985**            |          | 16,990 |   |
| Payable for  securities purchased                                                                                                     | ** ** | **—**            |          | 10,972 |   |
| Capital lease  obligations                                                                                                            | ** ** | **266**               |          | 485 |   |
| Debt                                                                                                                                  | ** ** | **—**            |          | 19,956 |   |
| **Total liabilities**                                                                                                                 | ** ** | **869,726**           |          | 901,111 |   |
| **Commitments  and contingencies (Note 7)**                                                                                           |       |                  |          |   |   |
| **Shareholders’  equity**                                                                                                        |       |                  |          |   |   |
| Common stock:  $0.01 par value; 30,000,000 shares authorized; 15,787,947 and 15,500,052  shares issued and outstanding , respectively | ** ** | **158**               |          | 155 |   |
| Additional  paid-in capital                                                                                                           | ** ** | **120,451**           |          | 114,070 |   |
| Accumulated other  comprehensive (loss) income, net of taxes                                                                          | ** ** | **(833**              | **)**         | 8,709 |   |
| Retained earnings                                                                                                                     | ** ** | **268,173**           |          | 182,400 |   |
| **Total shareholders’ equity**                                                                                                   | ** ** | **387,949**           |          | 305,334 |   |
| **Total liabilities and  shareholders’ equity**                                                                                  | ** ** | **$**                 | **1,257,675** |   | $ | 1,206,445 |   |

 

The accompanying notes are an integral part of these financial statements.

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**SafetyInsurance Group, Inc. and Subsidiaries**

**ConsolidatedStatements of Operations(Dollars in thousands, except per share and share data)**

| ** **                                                 | ** ** | **For the Years Ended December 31,** | ** **  |
|------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                                 | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Net earned  premiums                                       | ** ** | **$**                                                         | **622,831** |   | $ | 592,292 |   | $ | 540,248 |   |
| Net investment  income                                     | ** ** | **31,573**                                                    |        | 27,259 |   | 26,086 |   |
| Net realized  gains on investments                         | ** ** | **305**                                                       |        | 1,274 |   | 10,051 |   |
| Finance and other  service income                          | ** ** | **16,748**                                                    |        | 15,615 |   | 15,409 |   |
| Total revenue                                              | ** ** | **671,457**                                                   |        | 636,440 |   | 591,794 |   |
| Losses and loss adjustment expenses                        | ** ** | **385,593**                                                   |        | 425,061 |   | 420,969 |   |
| Underwriting,  operating and related expenses              | ** ** | **146,669**                                                   |        | 145,075 |   | 130,636 |   |
| Interest expenses                                          | ** ** | **948**                                                       |        | 672 |   | 646 |   |
| Total expenses                                             | ** ** | **533,210**                                                   |        | 570,808 |   | 552,251 |   |
| Income before income taxes                                 | ** ** | **138,247**                                                   |        | 65,632 |   | 39,543 |   |
| Income tax  expense                                        | ** ** | **43,065**                                                    |        | 20,642 |   | 11,061 |   |
| **Net income**                                             | ** ** | **$**                                                         | **95,182**  |   | $ | 44,990 |   | $ | 28,482 |   |
| **Earnings  per weighted average common share:**           |       |                                                          |        |   |   |   |   |
| Basic                                                      | ** ** | **$**                                                         | **6.11**    |   | $ | 2.94 |   | $ | 1.87 |   |
| Diluted                                                    | ** ** | **$**                                                         | **5.97**    |   | $ | 2.90 |   | $ | 1.86 |   |
| **Cash dividends paid per common share**                   | ** ** | **$**                                                         | **0.60**    |   | $ | 0.44 |   | $ | 0.34 |   |
| **Weighted  average number of common shares outstanding:** | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Basic                                                      | ** ** | **15,578,039**                                                |        | 15,315,877 |   | 15,259,991 |   |
| Diluted                                                    | ** ** | **15,953,737**                                                |        | 15,526,892 |   | 15,340,047 |   |

 

The accompanying notes are an integral part of these financial statements.

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**SafetyInsurance Group, Inc. and Subsidiaries**

**ConsolidatedStatements of Changes in Shareholders’ Equity(Dollars in thousands)**

| ** **                                                                                                  | ** ** | ** ** | ** ** | ** **     | ** ** | **Accumulated**            | ** ** | **Promissory** | ** **  | ** **   | ** ** | ** **             | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|----------------------------|------------|----------------|-------------|--------------|------------|------------------------|------------|
| ** **                                                                                                  | ** ** | ** ** | ** ** | ** **     | ** ** | **Other**                  | ** ** | **Notes**      | ** **  | ** **   | ** ** | ** **             | ** ** |
| ** **                                                                                                  | ** ** | ** ** | ** ** | **Additional** | ** ** | **Comprehensive**          | ** ** | **Receivable** | ** **  | ** **   | ** ** | **Total**              | ** ** |
| ** **                                                                                                  | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Income/(Loss),**         | ** ** | **From**       | ** **  | **Retained** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                                  | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Net of Taxes** | ** ** | **Management** | ** **  | **Earnings** | ** ** | **Equity**             | ** ** |
| Balance at December 31, 2002                                                                           |       |       | $          | 153            |       |                       |       | $              | 110,632     |         |       |                   | $          | 14,321 |   |   |   | $ | (737 | ) |   | $ | 120,883 |   |   | $ | 245,252 |   |   |
| Net income                                                                                                  |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | 28,482 |   |   | 28,482 |   |   |
| Accrued interest on promissory notes from management                                                        |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   | (12 | ) |   |   |   |   | (12 | ) |   |
| Payments on promissory notes from management                                                                |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   | 715 |   |   |   |   |   | 715 |   |   |
| Other comprehensive loss, net of deferred federal  income taxes                                             |       |       |       |           |       |                       |       |           |        |         | (1,671     | )                      |       |   |   |   |   |   |   |   | (1,671 | ) |   |
| Other adjustments, net of deferred federal income  taxes                                                    |       |       |       |           |       |                       | 442        |           |        |         |       |                   |       |   |   |   |   |   |   |   | 442 |   |   |
| Dividends paid                                                                                              |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | (5,188 | ) |   | (5,188 | ) |   |
| Balance at December 31, 2003                                                                           |       |       | 153        |           |       |                       | 111,074    |           |        |         | 12,650     |                   |       |   | (34 | ) |   | 144,177 |   |   | 268,020 |   |   |
| Net income                                                                                                  |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | 44,990 |   |   | 44,990 |   |   |
| Payments on promissory notes from management                                                                |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   | 34 |   |   |   |   |   | 34 |   |   |
| Other comprehensive loss, net of deferred federal  income taxes                                             |       |       |       |           |       |                       |       |           |        |         | (3,941     | )                      |       |   |   |   |   |   |   |   | (3,941 | ) |   |
| Exercise of options and unearned compensation on  restricted stock net of deferred federal income taxes     |       |       | 2          |           |       |                       | 2,996      |           |        |         |       |                   |       |   |   |   |   |   |   |   | 2,998 |   |   |
| Dividends paid                                                                                              |       |       |       |           |       |                       |       |           |        |         |       |                   |       |   |   |   |   | (6,767 | ) |   | (6,767 | ) |   |
| Balance at December 31, 2004                                                                           |       |       | 155        |           |       |                       | 114,070    |           |        |         | 8,709      |                   |       |   | — |   |   | 182,400 |   |   | 305,334 |   |   |
| **Net income**                                                                                              | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           |        |         |       |                   |       |   |   |   | ** ** | **95,182** |   | ** ** | **95,182** |   |   |
| **Other comprehensive loss, net of deferred  federal income taxes**                                         | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           | ** **  | ** **   | **(9,542** | **)**                  | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | **(9,542** | **)** | ** ** |
| **compensation Exercise of options and unearned on  restricted stock net of deferred feceral income taxes** | ** ** | ** ** | **3**      |           | ** ** | ** **                 | **5,926**  |           | ** **  | ** **   | ** ** |                   |       |   |   |   |   |   |   | ** ** | **5,929** |   |   |
| **Tax contingency reserve adjustment**                                                                      | ** ** | ** ** | ** ** |           | ** ** | ** **                 | **455**    |           | ** **  | ** **   | ** ** | ** **             | ** ** | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** | **455** | ** ** | ** ** |
| **Dividends paid**                                                                                          | ** ** | ** ** | ** ** |           | ** ** | ** **                 | ** ** |           |        |         |       |                   |       |   |   |   | ** ** | **(9,409** | **)** | ** ** | **(9,409** | **)** | ** ** |
| **Balance  at December 31, 2005**                                                                      | ** ** | ** ** | **$**      | **158**        |       | ** **                 | ** ** | **$**          | **120,451** |         | ** ** | ** **             | **$**      | **(833** | **)** | ** ** | ** ** | **$** | **—** |   | ** ** | **$** | **268,173** | ** ** | ** ** | **$** | **387,949** | ** ** | ** ** |

 

The accompanying notes are an integral part of these financial statements.

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**SafetyInsurance Group, Inc. and Subsidiaries**

**ConsolidatedStatements of Comprehensive Income(Dollars in thousands)**

| ** **                                                                                                        | ** ** | **For the Years Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                        | ** ** | **December 31,**                  | ** ** |
| ** **                                                                                                        | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Net  income**                                                                                                   | ** ** | **$**                                  | **95,182** |   | $ | 44,990 |   | $ | 28,482 |   |
| **Other comprehensive loss, net  of tax:**                                                                        |       |                                   |       |   |   |   |   |
| Change in unrealized holding gains, net of tax  (benefit) expense of $(5,031), $(1,676), and $2,618               | ** ** | **(9,344**                             | **)**      | (3,113 | ) | 4,862 |   |
| Reclassification adjustment for gains included in net  income, net of tax benefit of $(107), $(446), and $(3,518) | ** ** | **(198**                               | **)**      | (828 | ) | (6,533 | ) |
| Unrealized losses on securities available for sale                                                                | ** ** | **(9,542**                             | **)**      | (3,941 | ) | (1,671 | ) |
| **Comprehensive income**                                                                                          | ** ** | **$**                                  | **85,640** |   | $ | 41,049 |   | $ | 26,811 |   |

 

The accompanying notes are an integral part of these financial statements.

70

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**SafetyInsurance Group, Inc. and Subsidiaries**

**ConsolidatedStatements of Cash Flows(Dollars in thousands)**

| ** **                                                                         | ** ** | **For the Years Ended,** | ** **  |
|------------------------------------------------------------------------------------|------------|-----------------------------------------|-------------|
| ** **                                                                         | ** ** | **December 31,**                   | ** **  |
| ** **                                                                         | ** ** | **2005**                                | ** **  | **2004** | ** ** | **2003** | ** ** |
| **Cash flows from operating activities:**                                          |       |                                    |        |   |   |   |   |
| Net income                                                                         | ** ** | **$**                                   | **95,182**  |   | $ | 44,990 |   | $ | 28,482 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                    |        |   |   |   |   |
| Depreciation and  amortization, net                                                | ** ** | **8,312**                               |        | 8,041 |   | 7,479 |   |
| Benefit for deferred  income taxes                                                 | ** ** | **(303**                                | **)**       | (1,865 | ) | (1,510 | ) |
| Gains on sale of fixed  assets                                                     | ** ** | **—**                              |        | (4 | ) | (35 | ) |
| Net realized gains on  investments                                                 | ** ** | **(305**                                | **)**       | (1,274 | ) | (10,051 | ) |
| Changes in assets and liabilities:                                                 |       |                                    |        |   |   |   |   |
| Accounts receivable                                                                | ** ** | **(3,970**                              | **)**       | (16,306 | ) | (12,140 | ) |
| Accrued investment  income                                                         | ** ** | **(848**                                | **)**       | 216 |   | (412 | ) |
| Receivable from  reinsurers                                                        | ** ** | **3,847**                               |        | 17,895 |   | (13,495 | ) |
| Prepaid reinsurance  premiums                                                      | ** ** | **6,228**                               |        | (9,928 | ) | (2,507 | ) |
| Deferred policy  acquisition costs                                                 | ** ** | **(2,561**                              | **)**       | (2,742 | ) | (3,185 | ) |
| Other assets                                                                       | ** ** | **8,883**                               |        | 4,717 |   | (1,187 | ) |
| Loss and loss adjustment  expense reserves                                         | ** ** | **(181**                                | **)**       | 67,346 |   | 50,254 |   |
| Unearned premium  reserves                                                         | ** ** | **3,776**                               |        | 36,559 |   | 29,229 |   |
| Accounts payable and  accrued liabilities                                          | ** ** | **688**                                 |        | 6,187 |   | 4,275 |   |
| Payable to reinsurers                                                              | ** ** | **(4,005**                              | **)**       | (28,348 | ) | 8,672 |   |
| Other liabilities                                                                  | ** ** | **1,674**                               |        | 692 |   | 1,316 |   |
| Net cash provided by  operating activities                                         | ** ** | **116,417**                             |        | 126,176 |   | 85,185 |   |
| **Cash flows from investing activities:**                                          |       |                                    |        |   |   |   |   |
| Fixed maturities  purchased                                                        | ** ** | **(155,647**                            | **)**       | (101,281 | ) | (281,783 | ) |
| Equity securities  purchased                                                       | ** ** | **(1,290**                              | **)**       | (1,279 | ) | — |   |
| Proceeds from sales of  fixed maturities                                           | ** ** | **63,365**                              |        | 103,043 |   | 193,541 |   |
| Proceeds from maturities  of fixed maturities                                      | ** ** | **11,125**                              |        | 7,520 |   | — |   |
| Proceed from sales of  equity securities                                           | ** ** | **443**                                 |        | 245 |   | — |   |
| Fixed assets purchased                                                             | ** ** | **(766**                                | **)**       | (432 | ) | (998 | ) |
| Proceeds from sales of  fixed assets                                               | ** ** | **—**                              |        | 4 |   | 35 |   |
| Net cash (used for)  provided by investing activities                              | ** ** | **(82,770**                             | **)**       | 7,820 |   | (89,205 | ) |
| **Cash flows from financing activities:**                                          |       |                                    |        |   |   |   |   |
| Payments on revolving  credit facility                                             | ** ** | **(19,956**                             | **)**       | — |   | — |   |
| Payments on promissory  notes from management                                      | ** ** | **—**                              |        | 34 |   | 715 |   |
| Proceeds from exercise  of stock options                                           | ** ** | **3,072**                               |        | 2,126 |   | — |   |
| Dividends paid to  shareholders                                                    | ** ** | **(9,409**                              | **)**       | (6,767 | ) | (5,188 | ) |
| Net cash used for  financing activities                                            | ** ** | **(26,293**                             | **)**       | (4,607 | ) | (4,473 | ) |
| **Net  increase (decrease) in cash and cash equivalents**                          | ** ** | **7,354**                               |        | 129,389 |   | (8,493 | ) |
| Cash and cash  equivalents, beginning of year                                      | ** ** | **155,673**                             |        | 26,284 |   | 34,777 |   |
| **Cash and cash equivalents, end  of year**                                        | ** ** | **$**                                   | **163,027** |   | $ | 155,673 |   | $ | 26,284 |   |
| **Supplemental disclosure of cash flow  information:**                             |       |                                    |        |   |   |   |   |
| Cash paid during the year for:                                                     |       |                                    |        |   |   |   |   |
| Federal and state income  taxes                                                    | ** ** | **$**                                   | **44,776**  |   | $ | 16,900 |   | $ | 12,120 |   |
| Interest                                                                           | ** ** | **$**                                   | **1,030**   |   | $ | 785 |   | $ | 515 |   |

 

The accompanying notes are an integral part of these financial statements.

71

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**1.**                 Basisof Presentation

The consolidated financial statements have beenprepared on the basis of accounting principles generally accepted in the UnitedStates of America (“GAAP”). The consolidated financial statements includeSafety Insurance Group, Inc. and its subsidiaries (the “Company”). Thesubsidiaries consist of Safety Insurance Company, Safety Indemnity InsuranceCompany, Whiteshirts Asset Management Corporation (“WAMC”), f/k/a Thomas BlackInsurance Agency, Inc., and Whiteshirts Management Corporation, f/k/a RBS, Inc.,which is WAMC’s holding company. All intercompany transactions have beeneliminated.

The Company was incorporated on June 25, 2001, inthe State of Delaware. On October 16, 2001, the Company acquired (the “Acquisition”)all of the issued and outstanding common stock of Thomas Black Corporation (“TBC”)and its property and casualty subsidiaries. TBC subsequently merged with andinto Safety Insurance Group, Inc. with Safety Insurance Group, Inc.being the corporation surviving the merger.

The Company is a leadingprovider of personal lines property and casualty insurance focused exclusivelyon the Massachusetts market. Its principal product line is private passengerautomobile insurance, which accounted for 80.3% of its direct written premiumsin 2005. The Company operates through its insurance company subsidiaries,Safety Insurance Company and Safety Indemnity Insurance Company (togetherreferred to as the “Insurance Subsidiaries”).

**2.**                 Summaryof Significant Accounting Policies

**Investments**

Investments in fixed maturities available for sale,which include taxable and non-taxable bonds and redeemable preferred stocks,are reported at fair value. Investments in equity securities available forsale, which include interests in mutual funds, are reported at fair value. Fairvalues are derived from external market quotations. Unrealized gains or losseson fixed maturity and equity securities, reported at fair value, are excludedfrom earnings and reported in a separate component of shareholders’ equity,known as “Accumulated other comprehensive income (loss), net of federal incometaxes”, until realized. Realized gains or losses on the sale or maturity ofinvestments are determined on the basis of the specific cost identificationmethod. Fixed maturities and equity securities that experience declines invalue that are other-than-temporary are written down to fair value with acorresponding charge to net realized losses on investments.

Investment income isrecognized on an accrual basis of accounting. Bonds not backed by other loansare amortized using the interest method. Loan-backed bonds and structuredsecurities are amortized using the interest method and significant changes inestimated cash flows from the original purchase assumptions are accounted forusing the retrospective method.

**Cash Equivalents**

Cash equivalents,consisting of money market accounts and United States (“U.S.”) Treasury billswith original maturities of three months or less, are stated at cost, whichapproximates fair value.

72

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Accounts Receivable**

Amounts included inaccounts receivable represent premiums as well as finance charges, which arebilled on a monthly installment basis. A majority of the Company’s premiums arebilled on a monthly installment basis. Accounts receivable are stated net ofallowances for doubtful accounts. At December 31, 2005 and 2004, theseallowances were $220 and $183, respectively. Uncollected premium balances overninety days past due are written off.

**Deferred Policy Acquisition Costs**

Amounts that vary with andare primarily related to acquiring new and renewal business, principallycommissions and premium taxes, are deferred and amortized ratably over theeffective period of the policies. All other acquisition expenses are charged toexpenses as incurred. Deferred policy acquisition costs are reviewed todetermine if they are recoverable from future income, and if not, are chargedto expense. Future investment income attributable to related premiums is takeninto account in measuring the recoverability of the carrying value of thisasset. All other acquisition expenses are charged to expense as incurred.Amortization of acquisition costs in the amount of $93,515, $88,425 and $82,203were charged to underwriting expenses for the years ended December 31, 2005,2004 and 2003, respectively.

**Equity and Deposits in Pools**

Equity and deposits inpools represents the net receivable cash amounts due from the residual marketmechanisms, Commonwealth Automobile Reinsurers (“CAR”), for automobile andMassachusetts Property Insurance Underwriting Association (“FAIR Plan”), forhomeowner insurance in Massachusetts. See Note 8 for a discussion of theCompany’s accounting for amounts assumed from residual markets.

**Equipmentand Leasehold Improvements**

Purchases of equipment and leasehold improvements arecarried at cost less accumulated depreciation. Maintenance and repairs arecharged to expense as incurred; improvements are capitalized.

Methodsof depreciation and useful lives by asset category are as follows:

| ** **                 | ** ** | **Life**                    | ** ** | **Depreciation Method**  | ** ** |
|----------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Automobiles                |       | 3 years                     |       | Straight-line            |       |
| Data processing  equipment |       | 3-5 years                   |       | Double-declining balance |       |
| Equipment                  |       | 5 years                     |       | Straight-line            |       |
| Furniture and fixtures     |       | 7 years                     |       | Straight-line            |       |
| Leasehold improvements     |       | 10 years or over lease term |       | Straight-line            |       |

 

**Losses and Loss Adjustment Expenses**

Liabilities for losses andloss adjustment expenses (“LAE”) include case basis estimates for open claimsreported prior to year-end and estimates of unreported claims and claim adjustmentexpenses. The estimates are continually reviewed and modified to reflectcurrent conditions, and any resulting adjustments are reflected in currentoperating results. Adjustments for anticipated salvage and subrogation arerecorded on incurred and reported and incurred but not reported losses.

73

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Premiums and Unearned Premiums**

Premiums are earned over the terms of the respectivepolicies, which are generally one year. Unearned premiums represent the portionof premiums written applicable to the unexpired terms of the policies.

Ceded premiums are charged to income over the terms ofthe respective policies and the applicable term of the reinsurance contractswith third party reinsurers. Prepaid reinsurance premiums represent theunexpired portion of premiums ceded to CAR and other reinsurers.

Advance premiums arerecorded as a liability and not recognized as income until earned. Such amountsare included in accounts payable and accrued liabilities and totaled $20,437and $21,207 at December 31, 2005 and 2004, respectively.

**Reinsurance**

Liabilities for unearned premiums and unpaid lossesare stated before deductions for ceded reinsurance. The ceded amounts arecarried as receivables. Earned premiums are stated net of deductions for cededreinsurance.

The Company, as primaryinsurer, will be required to pay losses in their entirety in the event that thereinsurers are unable to discharge their obligations under the reinsuranceagreements.

**PromissoryNotes Received From Management**

In connection with the Acquisition, the Companyobtained promissory notes from the executive management team to financemanagement’s purchase of the Company’s common stock, including the restrictedstock purchased by management.

In accordance with the provisions of the FinancialAccounting Standards Board’s Emerging Issues Task Force (“EITF”) No. 85-1,“Classifying Notes Received for Capital Stock,” all outstanding principal andaccrued interest related to these notes are recorded as contra-equity inthe consolidated financial statements.

See Note 10 for termsof promissory notes received from management.

**Finance and Other Service Income**

Finance and other serviceincome includes revenues from premium installment charges, which are recognizedwhen earned.

**Income Taxes**

The Company and its subsidiaries file aconsolidated U.S. federal income tax return. The method of allocation amongmembers of the consolidated group is subject to a written agreement approved bythe Board. The consolidated tax liability is allocated on the basis of the members’proportionate contribution to consolidated taxable income.

Deferred income taxes aregenerally recognized when assets and liabilities have different values forfinancial statement and tax reporting purposes, and for other temporary taxableand deductible differences 

74

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

asdefined by Statement of Financial Accounting Standards (“FAS”) No. 109, “Accountingfor Income Taxes”. A valuation allowance is established where management hasassessed that it is more likely than not that the Company will not be able toutilize the full deferred tax asset.

**Earningsper Weighted Average Common Share**

Basicearnings per weighted average common share (“EPS”) are calculated by dividingnet income by the weighted average number of basic common shares outstandingduring the period. Diluted EPS are calculated by dividing net income by theweighted average number of basic common shares outstanding and the net effectof potentially dilutive common shares. At December 31,2005, 2004 and 2003, the Company’s potentially dilutive instruments were commonshares under options of 496,086, 711,410 and 771,000, respectively, and commonshares under restriction of 94,417, 70,271and 0, respectively.

| ** **                                             | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Earnings per weighted  average common share:           |       |                                                          |       |   |   |   |   |
| Basic                                                  | ** ** | **$**                                                         | **6.11**   |   | $ | 2.94 |   | $ | 1.87 |   |
| Diluted                                                | ** ** | **$**                                                         | **5.97**   |   | $ | 2.90 |   | $ | 1.86 |   |
| Weighted average  number of common shares outstanding: |       |                                                          |       |   |   |   |   |
| Basic                                                  | ** ** | **15,578,039**                                                |       | 15,315,877 |   | 15,259,991 |   |
| Effect of  dilutive securities                         |       |                                                          |       |   |   |   |   |
| Stock options                                          | ** ** | **351,681**                                                   |       | 196,655 |   | 80,056 |   |
| Restricted stock                                       | ** ** | **24,017**                                                    |       | 14,360 |   | — |   |
| Weighted average  number of common shares outstanding: |       |                                                          |       |   |   |   |   |
| Diluted                                                | ** ** | **15,953,737**                                                |       | 15,526,892 |   | 15,340,047 |   |

 

Diluted EPS excludes stockoptions with exercise prices greater than the average market price of theCompany’s common stock during the period because their inclusion would beanti-dilutive. There were no anti-dilutive stock options for the years ended December 31,2005, 2004 and 2003.

**Stock-Based Compensation**

On June 25, 2002, the Board adopted the 2002Management Omnibus Incentive Plan (“the Incentive Plan”). The Incentive Planprovides for a variety of awards, including nonqualified stock options, StockAppreciation Rights, and restricted stock awards. The Company has grantedcertain stock option awards under this Incentive Plan and follows theaccounting for these options under the recognition and measurement principlesof Accounting Principles Board (“APB”) Opinion No. 25, “Accounting forStock Issued to Employees”, as allowed by FAS 123, “Accounting for Stock-BasedCompensation” and as amended by FAS 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure”.

No employee compensation cost related to stock optionsis reflected in net income, as all options granted under this plan had anexercise price equal to the market value of the underlying common stock on thedate of grant.

75

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of FAS 123to these stock options.

| ** **                                                                                                                           | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as  reported                                                                                                             | ** ** | **$**                                                         | **95,182** |   | $ | 44,990 |   | $ | 28,482 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects | ** ** | **(537**                                                      | **)**      | (457 | ) | (348 | ) |
| Pro forma net  income                                                                                                                | ** ** | **$**                                                         | **94,645** |   | $ | 44,533 |   | $ | 28,134 |   |
| Earnings per weighted  average share:                                                                                                |       |                                                          |       |   |   |   |   |
| Basic—as reported                                                                                                               | ** ** | **$**                                                         | **6.11**   |   | $ | 2.94 |   | $ | 1.87 |   |
| Basic—pro forma                                                                                                                 | ** ** | **$**                                                         | **6.08**   |   | $ | 2.91 |   | $ | 1.84 |   |
| Diluted—as reported                                                                                                             | ** ** | **$**                                                         | **5.97**   |   | $ | 2.90 |   | $ | 1.86 |   |
| Diluted—proforma                                                                                                                | ** ** | **$**                                                         | **5.95**   |   | $ | 2.90 |   | $ | 1.83 |   |

 

Thefair value of stock options used to compute pro forma net income and earningsper share disclosures for the years ended December 31, 2005, 2004 and 2003is the estimated fair value at grant date using the Black-Scholes option-pricingmodel with the following assumptions:

| ** **                         | ** ** | **For the Years Ended December 31,** |
|------------------------------------|------------|-------------------------------------------|
| ** **                         | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2003** |
| Dividend yield                     | ** ** | **1.36%-2.52%**                           |   | 1.87%-2.52% |   | 2.15%-2.52% |
| Expected volatility                | ** ** | **.20-.31**                               |   | .20-.31 |   | .20 |
| Risk-free interest rate            | ** ** | **3.23%-4.35%**                           |   | 3.23%-4.07% |   | 3.35%-4.07% |
| Expected holding period (in years) | ** ** | **7**                                     |   | 7 |   | 7 |

 

**Use of Estimates**

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

**Financial Instruments**

In the normal course ofbusiness, the Company enters into transactions involving various types offinancial instruments, including investments in fixed maturities and equitysecurities. Investment transactions have credit exposure to the extent that acounter party may default on an obligation to the Company. Credit risk is aconsequence of carrying, trading and investing in securities. To manage creditrisk, the Company focuses on higher quality fixed income securities, reviewsthe credit strength of all companies in which it invests, limits its exposurein any one investment and monitors the portfolio quality, taking into accountcredit ratings assigned by recognized statistical rating organizations.

76

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Statutory Accounting Practices**

The Company’s insurancesubsidiaries, domiciled in the Commonwealth of Massachusetts, prepare statutoryfinancial statements in accordance with the accounting practices prescribed orpermitted by the Commonwealth of Massachusetts Division of Insurance (“theDivision”). Prescribed statutory accounting practices are those practices thatare incorporated directly or by reference in state laws, regulations, andgeneral administrative rules applicable to all insurance enterprisesdomiciled in a particular state. Permitted statutory accounting practicesinclude practices not prescribed by the Division, but allowed by the Division.See Note 12.

**New Accounting Pronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard No. (“FAS”)123R (revised 2004), “Share-Based Payment” was issued. This statement requirescompanies to measure and recognize the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair value.FAS 123R replaces FAS 123, “Accounting for Stock-Based Compensation”, andsupersedes Accounting Principles Board No. (“APB”) 25, “Accounting forStock Issued to Employees”. In April 2005, the SEC postponed the effectivedate of FAS 123R until the fiscal year beginning after June 15, 2005. TheCompany is currently evaluating the effects of FAS 123R.

In May 2005, the FASBissued FAS No. 154, “Accounting Changes and Error Corrections”. FAS No. 154establishes, unless impracticable, retrospective application as the requiredmethod for reporting a change in accounting principle in the absence ofexplicit transition requirements specific to a newly adopted accountingprinciple. The statement will be effective for the Company for all accountingchanges and any error corrections occurring after January 1, 2006.

**Reclassifications**

Prior period amounts havebeen reclassified to conform to the current year presentation.

**Segments**

The Company comprises one business segment: propertyand casualty insurance operations. Management organizes the business aroundprivate passenger automobile insurance in Massachusetts sold exclusivelythrough independent agents and offers other personal and commercial insuranceas complementary products. In accordance with FAS 131, “Disclosures About Segments of an Enterpriseand Related Information”, the financial information of the segment ispresented consistent with the way results are regularly evaluated by the chiefoperating decision maker in deciding how to allocate resources and in assessingperformance.

77

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**3.**                 Investments

The gross unrealized appreciation (depreciation) ofinvestments in fixed maturity securities, including redeemable preferred stocksthat have characteristics of fixed maturities, and equity securities, includinginterests in mutual funds, was as follows:

| ** **                                                               | ** ** | **December 31, 2005** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | ** **                      | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) | ** ** | **$127,764**                    | ** ** |   | **$142** | ** ** |   |   | **$(2,686** | **)** |   | **$125,220** | ** ** |
| Obligations of  states and political subdivisions                        | ** ** | **321,250**                     | ** ** |   | **4,385** | ** ** |   |   | **(3,026** | **)** |   | **322,609** | ** ** |
| Asset-backed  securities(1)                                              | ** ** | **124,531**                     | ** ** |   | **293** | ** ** |   |   | **(1,349** | **)** |   | **123,475** | ** ** |
| Corporate and  other securities                                          | ** ** | **140,385**                     | ** ** |   | **2,309** | ** ** |   |   | **(1,460** | **)** |   | **141,234** | ** ** |
| Subtotal, fixed maturity securities                                      | ** ** | **713,930**                     | ** ** |   | **7,129** | ** ** |   |   | **(8,521** | **)** |   | **712,538** | ** ** |
| Equity securities                                                        | ** ** | **1,895**                       | ** ** |   | **110** | ** ** |   |   | **—** | ** ** |   | **2,005** | ** ** |
| Totals                                                                   | ** ** | **$715,825**                    | ** ** |   | **$7,239** | ** ** |   |   | **$(8,521** | **)** |   | **$714,543** | ** ** |

 

| ** **                                                               | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                               | ** ** | ** **                      | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                               | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies(1) |       | $124,209                        |       |   | $972 |   |   |   | $(1,019 | ) |   | $124,162 |   |
| Obligations of  states and political subdivisions                        |       | 320,414                         |       |   | 8,761 |   |   |   | (1,250 | ) |   | 327,925 |   |
| Asset-backed  securities(1)                                              |       | 78,958                          |       |   | 1,356 |   |   |   | (374 | ) |   | 79,940 |   |
| Corporate and  other securities                                          |       | 126,578                         |       |   | 5,228 |   |   |   | (324 | ) |   | 131,482 |   |
| Subtotal, fixed maturity securities                                      |       | 650,159                         |       |   | 16,317 |   |   |   | (2,967 | ) |   | 663,509 |   |
| Equity securities                                                        |       | 1,037                           |       |   | 50 |   |   |   | — |   |   | 1,087 |   |
| Totals                                                                   |       | $651,196                        |       |   | $16,367 |   |   |   | $(2,967 | ) |   | $664,596 |   |

----

(1)          Obligations of U.S.Government agencies includes collateralized mortgage obligations issued,guaranteed and/or insured by the following issuers: Government NationalMortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC) andFederal National Mortgage Association (FNMA). The total of these fixed maturitysecurities was $115,284 and $120,636 at fair value and $117,766 and $120,729 atamortized cost as of December 31, 2005 and 2004, respectively. As such,the asset-backed securities presented exclude such issuers alreadypresented under U.S. Treasury securities and obligations of U.S. GovernmentAgencies.

78

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Theamortized cost and the estimated fair value of fixed maturity securities, bymaturity, at December 31, 2005 are shown below. Expected maturities willdiffer from contractual maturities because borrowers may have the right to callor prepay obligations with or without call or prepayment penalties.

| ** **                                | ** ** | **December 31, 2005** | ** **   |
|-------------------------------------------|------------|---------------------------------|--------------|
| ** **                                | ** ** | **Amortized Cost**         | ** **   | **Fair Value** | ** ** |
| Due in one year  or less                  | ** ** |                            | **$26,402**  | ** ** |   | **$26,235** | ** ** |
| Due after one  year through five years    | ** ** |                            | **173,345**  | ** ** |   | **172,606** | ** ** |
| Due after five  years through ten years   | ** ** |                            | **187,823**  | ** ** |   | **189,254** | ** ** |
| Due after ten  years through twenty years | ** ** |                            | **64,846**   | ** ** |   | **65,265** | ** ** |
| Due after twenty  years                   | ** ** |                            | **19,217**   | ** ** |   | **20,419** | ** ** |
| Asset-backed  securities                  | ** ** |                            | **242,297**  | ** ** |   | **238,759** | ** ** |
| Totals                                    | ** ** |                            | **$713,930** | ** ** |   | **$712,538** | ** ** |

 

Gross gains of $478, $1,535 and $11,141 and grosslosses of $185, $263 and $253 were realized on sales of fixed maturities foryears ended December 31, 2005, 2004 and 2003, respectively. Gross gains of$12, $2 and $0 were realized on the sales of equity securities for the yearsended December 31, 2005, 2004 and 2003, respectively. Proceeds from fixedmaturities maturing were $11,125, $7,520, and $0 for the years ended December 31,2005, 2004 and 2003, respectively.

Thefollowing tables illustrate the gross unrealized losses included in the Company’sinvestment portfolio and the fair value of those securities aggregated byinvestment category. The tables also illustrate the length of time that theyhave been in a continuous unrealized loss position.

| ** **                                                            | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | ** **                                      | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies | ** ** | **$52,119**                                     | ** ** | ** ** | **$581** |   | ** ** | **$65,746** | ** ** | ** ** | **$2,105** |   | ** ** | **$117,865** | ** ** | ** ** | **$2,686** |   |   |
| Obligations of  states and political subdivisions                     | ** ** | **53,872**                                      | ** ** | ** ** | **872** |   | ** ** | **97,361** | ** ** | ** ** | **2,154** |   | ** ** | **151,233** | ** ** | ** ** | **3,026** |   |   |
| Asset-backed  securities                                              | ** ** | **54,816**                                      | ** ** | ** ** | **526** |   | ** ** | **37,560** | ** ** | ** ** | **823** |   | ** ** | **92,376** | ** ** | ** ** | **1,349** |   |   |
| Corporate and  other securities                                       | ** ** | **38,830**                                      | ** ** | ** ** | **603** |   | ** ** | **31,707** | ** ** | ** ** | **857** |   | ** ** | **70,537** | ** ** | ** ** | **1,460** |   |   |
| Total temporarily  impaired securities                                | ** ** | **$199,637**                                    | ** ** | ** ** | **$2,582** |   | ** ** | **$232,374** | ** ** | ** ** | **$5,939** |   | ** ** | **$432,011** | ** ** | ** ** | **$8,521** |   |   |

 

79

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

 

| ** **                                                            | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **Less than 12 Months**          | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                                            | ** ** | ** **                                      | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| ** **                                                            | ** ** | **Fair Value**                             | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** | **Losses** | ** ** |
| U.S. Treasury  securities and obligations of U.S. Government agencies |       | $37,187                                         |       |   | $96 |   |   |   | $29,151 |   |   |   | $923 |   |   | $66,338 |   |   | $1,019 |   |   |
| Obligations of  states and political subdivisions                     |       | 61,509                                          |       |   | 394 |   |   |   | 60,748 |   |   |   | 856 |   |   | 122,257 |   |   | 1,250 |   |   |
| Asset-backed  securities                                              |       | 22,516                                          |       |   | 231 |   |   |   | 4,690 |   |   |   | 143 |   |   | 27,206 |   |   | 374 |   |   |
| Corporate and  other securities                                       |       | 20,346                                          |       |   | 272 |   |   |   | 1,475 |   |   |   | 52 |   |   | 21,821 |   |   | 324 |   |   |
| Total temporarily impaired securities                                 |       | $141,558                                        |       |   | $993 |   |   |   | $96,064 |   |   |   | $1,974 |   |   | $237,622 |   |   | $2,967 |   |   |

 

The Company’s investment portfolio included 185securities in an unrealized loss position at December 31, 2005. TheCompany’s methodology of assessing other-than-temporary impairment is basedupon analysis of each security as of the balance sheet date and considersvarious factors including the length of time and the extent to which fair valuehas been less than the cost, the financial condition and the near termprospects of the issuer, whether the debtor is current on its contractuallyobligated interest and principal payments, and the Company’s intent to hold theinvestment for a period of time sufficient to allow for recovery of its costs.

As of December 31, 2005, our portfolio of fixedmaturity investments was comprised entirely of investment grade corporate fixedmaturity securities, U.S. government and agency securities and asset-backedsecurities. The unrealized losses recorded on the fixed maturity investmentportfolio at December 31, 2005 resulted from fluctuations in marketinterest rates as opposed to fundamental changes in the credit quality of theissuers of such securities. Therefore, these decreases in values are viewed asbeing temporary as the Company has the intent and ability to retain suchinvestments for a period of time sufficient to allow for recovery in marketvalue.

During the years ended December 31,2005 and 2004, there was no significant deterioration in the credit quality ofany of the Company’s holdings and no other-than-temporary impairment chargeswere recorded related to the Company’s portfolio of investment securities.However, during the year ended December 31, 2003, there was a significantdeterioration in the credit quality of one of the Company’s holdings,Continental Airlines. Accordingly, the Company recorded an other-than-temporaryimpairment of $837 for this security. During May 2003, this security wassold at a realized gain of $426.

80

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Net Investment Income**

Thecomponents of net investment income were as follows:

| ** **                                  | ** ** | **For the Years Ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Interest and  dividends on fixed maturities | ** ** | **$28,201**                                                   |       | $27,161 |   | $26,806 |   |
| Dividends on  equity securities             | ** ** | **44**                                                        |       | 23 |   | — |   |
| Interest on cash  and cash equivalents      | ** ** | **4,400**                                                     |       | 1,078 |   | 234 |   |
| Other                                       | ** ** | **—**                                                    |       | — |   | 11 |   |
| Total investment  income                    | ** ** | **32,645**                                                    |       | 28,262 |   | 27,051 |   |
| Investment  expenses                        | ** ** | **1,072**                                                     |       | 1,003 |   | 965 |   |
| Net investment  income                      | ** ** | **$31,573**                                                   |       | $27,259 |   | $26,086 |   |

 

**4.**                 Equipmentand Leasehold Improvements

At December 31, 2005and 2004, the Company held equipment and leasehold improvements with a carryingvalue of $1,041 and $973, which is net of accumulated depreciation of $1,881and $1,182, respectively. Depreciation and amortization expense for the yearsended December 31, 2005, 2004 and 2003 was $699, $767 and $331,respectively.

**5.**                 Employee BenefitPlans

**TheSafety Insurance 401(k) Retirement Plan**

The Company sponsors theSafety Insurance Company 401(k) qualified defined contribution retirementplan (the “Retirement Plan”). The Retirement Plan is available to all eligibleemployees of the Company. An employee must be 21 years of age to beeligible to participate in the Retirement Plan, and is allowed to contribute ona pre-tax basis up to the maximum allowed under federal law. The RetirementPlan is administered by the Company and is subject to the provisions of theEmployee Retirement Income Security Act of 1974 (“ERISA”). At the close of eachRetirement Plan year, the Company makes a matching contribution equal to 75% ofthe amount each participant contributed during the plan year from their totalpay, up to a maximum amount of 8% of the participant’s base salary, to thoseparticipants who have contributed to the Retirement Plan and were employed onthe last day of the Retirement Plan year. Compensation expense related to theRetirement Plan was $1,066, $1,074, and $969 for the years ended December 31,2005, 2004 and 2003, respectively.

81

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Management Omnibus Incentive Plan**

On June 25, 2002, the Board adopted the 2002Management Omnibus Incentive Plan (“the Incentive Plan”). The IncentivePlan provides for a variety of awards, including nonqualified stock options (“NQSOs”),stock appreciation rights and restricted stock (“RS”) awards. On December 31, 2005, there were 225,958shares available for future grant. The Board and the Compensation Committeeintend to issue more awards under the Incentive Plan in the future. Grants madeunder the Incentive Plan are as follows:

| **Type of  Equity  Awarded** | ** ** | **Effective Date**  | ** ** | **Number of  Awards  Granted** | ** ** | **Exercise  Price(1) or  Fair  Value(2)  per Share** | ** ** | **Vesting Terms** | ** ** | **Expiration Date** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-------------------------------------|------------|--------------------------------------------------------------------------|------------|------------------------|------------|--------------------------|------------|
| NQSOs                             |       | November 27,  2002  |       |                                | 379,000    |                                                                     |       |                   | $          | 12.00(1)                 |       |   | 5  years, 20% annually |   | November 27,  2012 |   |
| NQSOs                             |       | February 20,  2003  |       |                                | 99,000     |                                                                     |       |                   | $          | 13.30(1)                 |       |   | 5  years, 20% annually |   | February 20,  2013 |   |
| NQSOs                             |       | March 31,  2003     |       |                                | 292,000    |                                                                     |       |                   | $          | 13.03(1)                 |       |   | 3  years, 30%-30%-40% |   | March 31,  2013 |   |
| NQSOs                             |       | August 21,  2003    |       |                                | 10,000     |                                                                     |       |                   | $          | 15.89(1)                 |       |   | 5  years, 20% annually |   | August 21,  2013 |   |
| NQSOs                             |       | March 25,  2004     |       |                                | 111,000    |                                                                     |       |                   | $          | 18.50(1)                 |       |   | 5  years, 20% annually |   | March 25,  2014 |   |
| RS                                |       | March 25,  2004     |       |                                | 70,271     |                                                                     |       |                   | $          | 18.50(2)                 |       |   | 3  years, 30%-30%-40% |   | N/A |   |
| NQSOs                             |       | August 30,  2004    |       |                                | 10,000     |                                                                     |       |                   | $          | 21.40(1)                 |       |   | 5  years, 20% annually |   | August 30,  2014 |   |
| **NQSOs**                         | ** ** | **March 16, 2005**  | ** ** | ** **                          | **78,000** |                                                                     | ** ** | ** **             | **$**      | **35.23(1)**             |       | ** ** | **5 years, 20% annually** | ** ** | **March 16, 2015** | ** ** |
| **RS**                            | ** ** | **March 16, 2005**  | ** ** | ** **                          | **56,770** |                                                                     | ** ** | ** **             | **$**      | **35.23(2)**             |       | ** ** | **3 years, 30%-30%**-40% | ** ** | **N/A** | ** ** |
| **RS**                            | ** ** | **March 16,  2005** | ** ** | ** **                          | **4,000**  |                                                                     | ** ** | ** **             | **$**      | **35.23(2)**             |       | ** ** | **No  vesting period (3)** | ** ** | **N/A** | ** ** |

----

(1)          The exercise price ofthe options grant effective on November 27, 2002 is equal to the IPO priceof the Company’s stock on that same day. The exercise price of the remainingoption grants is equal to the closing price of the Company’s common stock onthe grant effective date.

(2)          The fair value of therestricted stock grant is equal to the closing price of the Company’s commonstock on the grant effective     date.

(3)          The shares cannot besold, assigned, pledged, or otherwise transferred, encumbered or disposed ofuntil the recipient is no longer a member of the Board.

The following table summarizes stock option activityunder the Incentive Plan:

| ** **                        | ** ** | **2005**                  | ** ** | **2004**                                   | ** ** |
|-----------------------------------|------------|---------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **Shares  Under  Option** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares  Under  Option** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding at  beginning of year | ** ** | **711,410**               | ** ** |                                       | **$**      | **13.60** |   |   | 771,000 |   |   | $ | 12.59 |   |   |
| Granted during  the year          | ** ** | **78,000**                | ** ** |                                       | **35.23**  |   |   | 121,000 |   |   | 18.74 |   |   |
| Forfeited during  the year        | ** ** | **(54,656**               | **)**      |                                       | **16.38**  |   |   | (10,800 | ) |   | 16.19 |   |   |
| Exercised during  the year        | ** ** | **(238,668**              | **)**      |                                       | **12.87**  |   |   | (169,790 | ) |   | 12.52 |   |   |
| Outstanding at end of  year       | ** ** | **496,086**               | ** ** |                                       | **17.04**  |   |   | 711,410 |   |   | 13.60 |   |   |

 

The range of exercise prices on stock optionsoutstanding under the Incentive Plan was $12.00 to $35.23 at December 31,2005 and $12.00 to $21.40 at December 31, 2004.

82

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Thefollowing table summarizes restricted stock activity under the Incentive Plan:

| ** **                               | ** ** | **Shares  Under  Restriction** | ** **  | **Weighted  Average  Fair Value** | ** ** | **Shares  Under  Restriction** | ** ** | **Weighted  Average  Fair Value** | ** ** |
|------------------------------------------|------------|--------------------------------|-------------|----------------------------------------|------------|--------------------------------|------------|----------------------------------------|------------|
| Outstanding at  beginning of year        | ** ** |                           | **70,271**  | ** **                             |       |                           | **$**      | **18.50**                              |       |   |   | — |   |   |   | $ | — |   |   |
| Granted during  the year                 | ** ** |                           | **60,770**  | ** **                             |       |                           | **35.23**  |                                   |       |   | 70,271 |   |   |   | 18.50 |   |   |
| Forfeited during  the year               | ** ** |                           | **(11,543** | **)**                                  |       |                           | **27.55**  |                                   |       |   | — |   |   |   | — |   |   |
| Vested and  unrestricted during the year | ** ** |                           | **(21,081** | **)**                                  |       |                           | **18.50**  |                                   |       |   | — |   |   |   | — |   |   |
| Outstanding at  end of year              | ** ** |                           | **98,417**  | ** **                             |       |                           | **27.77**  |                                   |       |   | 70,271 |   |   |   | 18.50 |   |   |

 

**6.**                 Commitments andContingencies

**Lease Commitments**

The Company has various noncancelable long-termoperating leases. The approximate minimum annual rental payments due under theselease agreements as of December 31, 2005 are as follows:

| 2006                          |   | $     | 2,888  |   |
|-------------------------------|--------|-------|--------|--------|
| 2007                          |   | 2,923 |   |
| 2008                          |   | 3,031 |   |
| 2009                          |   | 38    |   |
| 2010                          |   | 6     |   |
| Total minimum lease  payments |   | $     | 8,886  |   |

 

Certain lease agreementscontain renewal options and, in addition to the minimum annual rentals,generally provide for payment of a share of the real estate taxes and operatingexpenses in excess of a base amount. Rental expense was $3,042, $2,826, $2,718for the years ended December 31, 2005, 2004 and 2003, respectively. Allleases expire prior to 2011. The Company expects that in the normal course ofbusiness, leases that expire will be renewed.

**Employee Tax Indemnification**

In connection with theAcquisition, the Company entered into an agreement with members of itsmanagement team to indemnity them for any tax loss they may incur in connectionwith the purchase of its common stock at the time the Company acquired TBC, dueto a determination by the Internal Revenue Service that the value of such stockwas higher than the purchase price agreed upon by the Company and itsmanagement team.

**Contingencies**

Various claims, generally incidental to the conduct ofnormal business, are pending or alleged against the Company from time to time.In the opinion of management, based in part on the advice of legal counsel, theultimate resolution of such claims will not have a material adverse effect onthe Company’s consolidated financial statements. However, liabilities relatedto those proceedings could be established in the near term if estimates of the ultimateresolutions of those proceedings are revised.

83

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Massachusetts law requires that insurers licensed todo business in Massachusetts participate in the Massachusetts InsurersInsolvency Fund (“Insolvency Fund”). Members of the Insolvency Fund areassessed a proportionate share of the obligations and expenses of theInsolvency Fund in connection with an insolvent insurer. In 2005, the Companyreceived a refund of prior years’ assessments from the Insolvency Fund of $50which it credited for the year ended December 31, 2005. In 2004 and 2003,the Company received notice of assessments from the Insolvency Fund amountingto $2,538 and $3,423 which it expensed for the years ended December 31,2004 and 2003, respectively.

It is anticipated that there will be additionalassessments from time to time relating to various insolvencies. Although thetiming and amounts of any future assessments are not known, based upon existingknowledge, management’s opinion is that such future assessments will not have amaterial effect upon the financial position of the Company.

**7.**                 Debt

**Secured Revolving Credit Facility**

Concurrent with the closing of the Company’s November 27,2002 initial public offering (“IPO”) and repayment of the old credit facility,Safety obtained a new $30,000 revolving credit facility. Safety borrowed theentire $30,000 under this credit facility at the closing of the IPO and paiddown the balance to $19,956 on December 5, 2002 with the approximately$10,000 net proceeds from the exercise of the underwriter’s over-allotmentoption for 900,000 shares of our common stock. Loans under the credit facilitybear interest at the Company’s option at either (i) the LIBOR rate plus1.50% per annum or (ii) the higher of the bank’s prime rate or 0.50% abovethe federal funds rate plus 1.50% per annum. Interest only is payable prior tomaturity. The obligations of the Company under the credit facility are securedby pledges of the assets of the Company and the capital stock of the Company’soperating subsidiaries. The credit facility is guaranteed by the non-insurancecompany subsidiaries of the Company. The credit facility contains covenantsincluding requirements to maintain minimum risk based capital ratios andstatutory surplus of Safety Insurance as well as limitations or restrictions onindebtedness, liens, dividends, and other matters. As of December 31,2005, the Company was in compliance with all such covenants.

Bank of America was the lender under this creditfacility. Under an agreement effective on June 17, 2005, Bank of Americaassigned the revolving credit facility to Citizens Bank of Massachusetts. Nomaterial change in the terms or conditions of the revolving credit facility orthe pledge of the stock of the Company as security for the revolving creditfacility has been made.

The Company paid down thebalance of $19,956 on December 8, 2005 and had no amounts outstanding onits credit facility at December 31, 2005. At December 31, 2004, theCompany had utilized advances of $19,956. The interest rate on the $30,000commitment was .25% at December 31, 2005 and 2004. The interest rate onthe amounts advanced was 4.26% at December 31, 2004. The average interestrate during 2005 and 2004 was 4.59% and 3.27%, respectively.

84

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

**Capital Lease Obligation**

During 2003, theCompany entered in to a three-year term lease agreement to finance theacquisition of new equipment. Minimum payments due under this capital leaseobligation as of December 31, 2005 are as follows:

| 2006                          |   | $233 |   |
|-------------------------------|--------|------|--------|
| 2007                          |   | 39   |   |
| Total minimum lease  payments |   | $272 |   |

 

The Company incurredinterest expense of $948, $672 and $646 for the years ended December 31,2005, 2004 and 2003,respectively, related to all current outstandingobligations during these periods.

**8.**                 Reinsurance

The Company cedes insurance to CAR and to otherreinsurers. The Company has a property catastrophe excess of loss agreement anda casualty excess of loss agreement that qualify as reinsurance treaties andare designed to protect against large or unusual loss and LAE activity.Reinsurance contracts do not relieve the Company from its obligations to policyholders.Failure of reinsurers to honor their obligations could result in losses to theCompany. The Company evaluates the financial condition of its reinsurers andmonitors economic characteristics of the reinsurers to minimize its exposure tosignificant losses from reinsurer insolvencies.

The Company is subject to concentration of credit riskwith respect to reinsurance ceded to CAR. At December 31, 2005 and 2004,respectively, reinsurance receivables on paid and unpaid loss and LAE with acarrying value of $84,099 and $90,126 and prepaid reinsurance premiums of$32,186 and $38,229 were associated with CAR. The Company’s participation inCAR resulted in assumed net losses of $5,771, $39,038 and $48,367 for the yearsended December 31, 2005, 2004 and 2003, respectively.

CAR is, with few exceptions, required by law to issuea policy to any applicant who seeks it. As a servicing carrier of CAR, this requirementapplies to the Company. The Company has entered into service contracts withother insurance carriers under which the Company services the residual marketbusiness assigned to the carriers by CAR (the “buyout program”). Businessgenerated through the buyout program is 100% ceded to the applicable carrierand serviced for a fee. Servicing carrier fees amounted to $588, $628 and $548for the years ended December 31, 2005, 2004 and 2003, respectively.

85

----

**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Theeffect of reinsurance on net written and earned premiums and losses and LAE isas follows:

| ** **            | ** ** | **For the Years Ended December 31,** | ** **  |
|-----------------------|------------|---------------------------------------------------------------|-------------|
| ** **            | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| **Written  Premiums** | ** ** | ** **                                                    | ** **  | ** ** | ** ** | ** ** | ** ** |
| Direct                | ** ** | **$**                                                         | **649,113** |   | $ | 628,295 |   | $ | 571,545 |   |
| Assumed               | ** ** | **66,772**                                                    |        | 86,505 |   | 69,625 |   |
| Ceded                 | ** ** | **(83,049**                                                   | **)**       | (95,877 | ) | (74,200 | ) |
| Net written  premiums | ** ** | **$**                                                         | **632,836** |   | $ | 618,923 |   | $ | 566,970 |   |
| **Premiums  Earned**  |       |                                                          |        |   |   |   |   |
| Direct                | ** ** | **$**                                                         | **638,142** |   | $ | 599,608 |   | $ | 544,664 |   |
| Assumed               | ** ** | **73,966**                                                    |        | 78,634 |   | 67,276 |   |
| Ceded                 | ** ** | **(89,277**                                                   | **)**       | (85,950 | ) | (71,692 | ) |
| Net premiums  earned  | ** ** | **$**                                                         | **622,831** |   | $ | 592,292 |   | $ | 540,248 |   |
| **Loss  and LAE**     |       |                                                          |        |   |   |   |   |
| Direct                | ** ** | **$**                                                         | **411,184** |   | $ | 434,053 |   | $ | 431,461 |   |
| Assumed               | ** ** | **57,546**                                                    |        | 94,136 |   | 96,748 |   |
| Ceded                 | ** ** | **(83,137**                                                   | **)**       | (103,128 | ) | (107,240 | ) |
| Net loss and LAE      | ** ** | **$**                                                         | **385,593** |   | $ | 425,061 |   | $ | 420,969 |   |

 

**9.**                 Lossand Loss Adjustment Expense Reserves

The following tablesets forth a reconciliation of beginning and ending reserves for losses andLAE, as shown, in the Company’s consolidated financial statements for the yearsindicated:

| ** **                                              | ** ** | **For the Years Ended December 31,** | ** **  |
|---------------------------------------------------------|------------|---------------------------------------------------------------|-------------|
| ** **                                              | ** ** | **2005**                                                      | ** **  | **2004** | ** ** | **2003** | ** ** |
| Reserves for  losses and LAE, beginning of year         | ** ** | **$**                                                         | **450,897** |   | $ | 383,551 |   | $ | 333,297 |   |
| Less reinsurance  recoverable on unpaid losses and LAE  | ** ** | **(84,167**                                                   | **)**       | (73,539 | ) | (66,661 | ) |
| Net reserves for  losses and LAE, beginning of year     | ** ** | **366,730**                                                   |        | 310,012 |   | 266,636 |   |
| Incurred losses  and LAE, related to:                   |       |                                                          |        |   |   |   |   |
| Current year                                            | ** ** | **425,213**                                                   |        | 431,839 |   | 420,788 |   |
| Prior years                                             | ** ** | **(39,620**                                                   | **)**       | (6,778 | ) | 181 |   |
| Total incurred  losses and LAE                          | ** ** | **385,593**                                                   |        | 425,061 |   | 420,969 |   |
| Paid losses and  LAE related to:                        |       |                                                          |        |   |   |   |   |
| Current year                                            | ** ** | **237,557**                                                   |        | 217,989 |   | 240,501 |   |
| Prior years                                             | ** ** | **144,600**                                                   |        | 150,354 |   | 137,092 |   |
| Total paid losses  and LAE                              | ** ** | **382,157**                                                   |        | 368,343 |   | 377,593 |   |
| Net reserves for  losses and LAE, end of year           | ** ** | **370,166**                                                   |        | 366,730 |   | 310,012 |   |
| Plus reinsurance  recoverables on unpaid losses and LAE | ** ** | **80,550**                                                    |        | 84,167 |   | 73,539 |   |
| Reserves for losses and  LAE, end of year               | ** ** | **$**                                                         | **450,716** |   | $ | 450,897 |   | $ | 383,551 |   |

 

At the end of each period, the reserves werere-estimated for all prior accident years. Primarily due to an improvement inCAR results, prior year reserves decreased by $39,620 and $6,778 for the yearsended December 31, 2005 and 2004, respectively. These decreases in prioryear reserves resulted from 

86

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

re-estimations ofprior accident years ultimate loss and LAE liabilities which resulted inreductions of $22,162 in CAR assumed reserves, $14,600 in the Company’sautomobile reserves, $1,872 in FAIR Plan assumed reserves, and $986 inhomeowners reserves in 2005. At December 31,2004, the re-estimations ofprior accident years ultimate loss and LAE liabilities resulted  in reductions of $6,854 in CAR assumedreserves, $2,523 in homeowners reserves, $329 in FAIR Plan assumed reserves,and an increase of $2,928 in the Company’s automobile reserves in 2004. Prioryear reserves increased by $181 for the year ended December 31, 2003.Conditions and trends that have affected development of the loss and LAEreserves in the past may not necessarily occur in the future.

Due to the nature of therisks that the Company underwrites and has historically underwritten,management does not believe that it has an exposure to asbestos orenvironmental pollution liabilities.

**10.**          RelatedParty Transactions

In connection with theAcquisition, each member of the executive management team issued a recoursepromissory note to, and entered into a pledge agreement with the Company.Pursuant to the notes, the Company loaned management an aggregate of $695 inorder to purchase common stock in connection with the Acquisition and theRestricted Stock Plan. Pursuant to pledge agreements, the management teampledged the common stock back to the Company as security for the loans madeunder the promissory notes. The notes bore interest at a rate of 5% annuallyand were due and payable on the earlier of December 31, 2011 or90 days after any management team member ceases to be an employee of theCompany. Each member could prepay his note at any time without penalty. At December 31,2003, the loans were carried in the financial statements at $34, whichrepresents the outstanding principal and accrued interest on the notes. During2004 the Company received $34 representing prepayments of all outstanding loanprincipal and accrued interest through the dates of final payments. Such loanshad been recorded as contra-equity in accordance with the accountingpolicy described in Note 2.

**11.**          IncomeTaxes

Provisionfor income taxes has been calculated in accordance with the provision ofStatement No. 109. A summary of the income tax expense in the ConsolidatedStatements of Income is shown below:

| ** **                  | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Current  Income Taxes:**  | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                     | ** ** | **$**                                                         | **43,366** |   | $ | 22,505 |   | $ | 12,569 |   |
| State                       | ** ** | **2**                                                         |       | 2 |   | 2 |   |
|                        |       | **43,368**                                                    |       | 22,507 |   | 12,571 |   |
| **Deferred  Income Taxes:** |       |                                                          |       |   |   |   |   |
| Federal                     | ** ** | **(303**                                                      | **)**      | (2,702 | ) | (1,666 | ) |
| State                       | ** ** | **—**                                                    |       | 837 |   | 156 |   |
|                        |       | **(303)**                                                     |       | (1,865 | ) | (1,510 | ) |
| Total income tax expense    | ** ** | **$**                                                         | **43,065** |   | $ | 20,642 |   | $ | 11,061 |   |

 

87

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

Theincome tax expense attributable to the consolidated results of operations isdifferent from the amounts determined by multiplying income before federalincome taxes by the statutory federal income tax rate. The sources of thedifference and the tax effects of each were as follows:

| ** **                                     | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Federal income  tax expense, at statutory rate | ** ** | **$**                                                         | **48,387** |   | $ | 22,971 |   | $ | 13,840 |   |
| Tax-exempt  investment income, net             | ** ** | **(4,013**                                                    | **)**      | (3,424 | ) | (3,029 | ) |
| State taxes, net                               | ** ** | **—**                                                    |       | 544 |   | 103 |   |
| Changes in tax  estimates                      | ** ** | **(1,161**                                                    | **)**      | 85 |   | — |   |
| Other, net                                     | ** ** | **(148**                                                      | **)**      | 466 |   | 147 |   |
| Total income tax expense                       | ** ** | **$**                                                         | **43,065** |   | $ | 20,642 |   | $ | 11,061 |   |

 

Thedeferred income tax asset (liability) represents the tax effects of temporarydifferences attributable to the Company’s consolidated federal tax returngroup. Its components were as follows:

| ** **                                             | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Deferred tax assets:**                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Discounting of loss reserves                           | ** ** | **$9,803**            |       | $10,156 |   |
| Discounting of unearned premium reserve                | ** ** | **21,715**            |       | 21,100 |   |
| Bad debt allowance                                     | ** ** | **322**               |       | 64 |   |
| Depreciation                                           | ** ** | **716**               |       | 706 |   |
| Employee benefits                                      | ** ** | **1,515**             |       | 756 |   |
| Transaction related costs                              | ** ** | **174**               |       | 477 |   |
| State loss carryforwards                               | ** ** | **4,060**             |       | 3,787 |   |
| Net unrealized losses on investments                   | ** ** | **449**               |       | — |   |
| Other                                                  | ** ** | **681**               |       | 424 |   |
| Total deferred  tax assets before valuation allowance  | ** ** | **39,435**            |       | 37,470 |   |
| Valuation  allowance for deferred tax assets           | ** ** | **(4,742**            | **)**      | (4,210 | ) |
| Total deferred  tax assets, net of valuation allowance | ** ** | **34,693**            |       | 33,260 |   |
| **Deferred  tax liabilities:**                         |       |                  |       |   |   |
| Deferred acquisition costs                             | ** ** | **(15,918**           | **)**      | (15,022 | ) |
| Investments                                            | ** ** | **(655**              | **)**      | (869 | ) |
| Net unrealized gains on investments                    | ** ** | **—**            |       | (4,690 | ) |
| Total deferred  tax liabilities                        | ** ** | **(16,573**           | **)**      | (20,581 | ) |
| Net deferred tax asset                                 | ** ** | **$18,120**           |       | $12,679 |   |

 

The Company believes, based upon consideration ofobjective and verifiable evidence, including its recent earnings history andits future expectations, that the Company’s taxable income in future years willbe sufficient to realize all federal deferred tax assets. A valuation allowanceof $4,742 and $4,210 was established against state deferred tax assets at December 31,2005 and 2004, respectively. This valuation allowance is based upon management’sassessment that it is more likely than not that the Company will not be able toutilize these state deferred tax assets.

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Dollars in thousands except per share and share data)**

During the year ended December 31,2005, an examination of the Company’s federal income tax returns for the taxperiods ended December 31, 2003, 2002, and 2001 by the Internal RevenueService (“IRS”) was completed. The Company recorded a $1,616 tax benefitrepresenting a reduction in federal income tax reserves for tax years 2001through 2003, resulting from a settlement reached with the IRS in August 2005.Of this total tax benefit, $455 was recorded as an increase to additionalpaid-in capital and $1,161 was recorded as a reduction to income tax expensefor the year ended December 31, 2005.

**12.**          StatutoryNet Income and Surplus

**Statutory Accounting Practices**

The Company’s Insurance Subsidiaries, domiciled in theCommonwealth of Massachusetts, prepare statutory financial statements inaccordance with the accounting practices prescribed or permitted by theDivision. Statutory net income of the Company’s insurance subsidiaries was$97,337, $44,575 and $28,480 for the years ended December 31, 2005, 2004and 2003, respectively. Statutory capital and surplus of the Company’sinsurance subsidiaries was $350,833 and $278,161 at December 31, 2005 and2004, respectively.

**Dividends**

The Company’s insurancesubsidiaries are subject to various regulatory restrictions that limit themaximum amount of dividends available to be paid to their parent without priorapproval of the Commonwealth of Massachusetts Commissioner of Insurance (the “Commissioner”).Massachusetts statute limits the dividends an insurer may pay in any twelvemonth period, without the prior permission of the Commissioner, to the greaterof (i) 10% of the insurer’s surplus as of the preceding December 31or (ii) the insurer’s net income for the twelve-month period endingthe preceding December 31, in each case determined in accordance withstatutory accounting practices. The Company’s insurance company subsidiariesmay not declare an “extraordinary dividend” (defined as any dividend ordistribution that, together with other distributions made within the precedingtwelve months, exceeds the limits established by Massachusetts statute) untilthirty days after the Commissioner has received notice of the intended dividendand has not objected. As historically administered by the Commissioner, thisprovision requires the Commissioner’s prior approval of an extraordinarydividend. Under Massachusetts law an insurer may pay cash dividends only fromits unassigned funds, also known as earned surplus, and the insurer’s remainingsurplus must be both reasonable in relation to its outstanding liabilities andadequate to its financial needs. At year-end 2005, the statutory surplus ofSafety Insurance was $350,833, and its net income for 2005 was $92,432. As aresult, a maximum of $92,432 is available in 2006 for such dividends withoutprior approval of the Commissioner.

**13.**          FairValue of Financial Instruments

The Company uses various financial instruments in thenormal course of its business. Certain insurance contracts are excluded byStatement of Financial Accounting Standards No. 107, “Disclosures aboutFair Value of Financial Instruments,” and, therefore, are not included in theamounts discussed.

At December 31, 2005 and 2004, investments infixed maturities and equity securities had a fair value, which equaled carryingvalue, of $714,543 and $664,596, respectively. There were no investments infixed maturities and equity securities for which a quoted market price ordealer price was not available at December 31, 2005 or, 2004,respectively.

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**Safety Insurance Group, Inc. and Subsidiaries Notes to Consolidated Financial Statements(Dollars                 in thousands except per share and share data)**

The carrying values of cash and cash equivalents andinvestment income accrued approximate fair value.

At December 31, 2005 the Company had no amountsoutstanding on its secured credit facility. At December 2004, the carryingvalue of the secured revolving credit facility was $19,956 which approximatedits fair value as described in Note 7.

**14.**          QuarterlyResults of Operations

**Anunaudited summary of the Company’s 2005 and 2004 quarterly performance, andaudited annual performance, is as follows:**

| ** **                                   | ** ** | **Year ended December 31, 2005** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| Total revenue                                |       | $                                                    | 168,251    |   | $ | 168,133 |   | $ | 169,840 |   | $ | 165,233 |   | $ | 671,457 |   |
| Net income                                   |       | 14,502                                               |       | 23,246 |   | 30,475 |   | 26,959 |   | 95,182 |   |
| Earnings per weighted  average common share: |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 0.94                                                 |       | 1.49 |   | 1.95 |   | 1.72 |   | 6.11 |   |
| Diluted                                      |       | 0.92                                                 |       | 1.46 |   | 1.92 |   | 1.69 |   | 5.97 |   |
| Cash dividends  paid per common share        |       | 0.12                                                 |       | 0.12 |   | 0.18 |   | 0.18 |   | 0.60 |   |
|                                              |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Year ended December 31, 2004** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Total  Year** | ** ** |
| Total revenue                                |       | $                                                    | 155,011    |   | $ | 157,159 |   | $ | 161,149 |   | $ | 163,121 |   | $ | 636,440 |   |
| Net income                                   |       | 6,370                                                |       | 10,280 |   | 15,177 |   | 13,163 |   | 44,990 |   |
| Earnings per weighted  average common share: |       |                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 0.42                                                 |       | 0.67 |   | 0.99 |   | 0.85 |   | 2.94 |   |
| Diluted                                      |       | 0.41                                                 |       | 0.66 |   | 0.98 |   | 0.84 |   | 2.90 |   |
| Cash dividends paid per  common share        |       | 0.10                                                 |       | 0.10 |   | 0.12 |   | 0.12 |   | 0.44 |   |
|                                              |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***ITEM 9.****                 CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE*

None.

***ITEM 9A.****         CONTROLSAND PROCEDURES*

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report. Based on thatevaluation, our CEO and CFO have concluded that our disclosure controls andprocedures are adequate and effective and ensure that all information requiredto be disclosed is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and that information required to bedisclosed in such reports is accumulated and communicated to management,including our Chief Executive Officer and Chief Financial Officer, to allowtimely decisions regarding required disclosures.

**Management’sReport on Internal Control over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as defined inExchange Act Rules 13a-15(f) and 15d-15(f). Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, we conducted an evaluation ofthe effectiveness of our internal control over financial reporting based on theframework in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on our evaluation under the framework in *Internal Control—Integrated Framework*, ourmanagement concluded that our internal control over financial reporting waseffective as of December 31, 2005.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2005 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which is included herein.

**Changesin Internal Control over Financial Reporting**

There have been nosignificant changes in our internal control over financial reporting thatoccurred during our last fiscal quarter that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

***ITEM 9B.****         OTHERINFORMATION*

The followingdisclosures relate to actions taken by the Board of Directors of the Company(the “Board”), the Compensation Committee of the Board and the Board ofDirectors of Safety Insurance Company and would otherwise have been filedduring the first fiscal quarter of 2005 on a Form 8-K under theheading “Item 1.01. Entry into a Material Definitive Agreement.”

·       Uponrecommendation from the Compensation Committee, on March 10, 2006, theBoard approved the 2005 annual executive cash bonus pool in the total amount of$1,965. The total $1,965 pool will be allocated as follows: David Brussard,$830; Daniel D. Loranger, $304; Edward N. Patrick, Jr., $268;  William J. Begley, Jr., $231; David E.Krupa, $171; and Robert J. Kerton, $161.

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·       OnMarch 10, 2006, the Compensation Committee approved executive long-termincentive awards to certain members of senior management pursuant to our 2002Management Omnibus Incentive Plan. The long-term incentive awards were grantedin a total amount of $2,500 in the form of restricted stock, to be effective onand given a fair value of the closing price of our common stock on March 10,2006. The restricted stock vests in three annual installments of 30% on March 10,2007, 30% on March 10, 2008, and 40% on March 10, 2009. The $2,500aggregate amount will be allocated as follows: David Brussard, $1,000 worth ofrestricted stock;  Daniel D. Loranger,$375 worth of restricted stock;  EdwardN. Patrick, Jr., $375 worth of restricted stock;  William J. Begley, Jr., $300 worthof  restricted stock;  David E. Krupa $150 worth of restrictedstock; Robert J. Kerton, $150 worth of restricted stock; George M. Murphy, $75worth of restricted stock;  and James D.Berry, $75 worth of restricted stock. The form of restricted stock agreementthat will be entered into is attached hereto as Exhibit 10.19.

·  On March 10, 2006, the Compensation Committeeapproved a grant of 1,000 shares of restricted stock to each of ournon-employee directors (A. Richard Caputo, Jr., Frederic H. Lindeberg, Peter J.Manning, and David K. McKown) pursuant to our 2002 Management Omnibus IncentivePlan, to be effective on March 10, 2005. The shares cannot be sold, assigned,pledged or otherwise transferred, encumbered or disposed of until the recipientis no longer a member of our Board. The form of restricted stock agreement thatwill be entered into is attached hereto as Exhibit 10.21. 

**PART III**

***ITEM 10.****          DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT*

The information called for by Item 401 ofRegulation S-K, regarding directors, executive officers, promoters andcontrol persons, and not provided in Part I. Item 4A, “Executive Officersof the Registrant”, will be contained in the Company’s Proxy Statement for itsAnnual Meeting of Shareholders, to be held on May 19, 2006 in Boston, MA,which the Company intends to file with the U.S. Securities and ExchangeCommission within 120 days after December 31, 2006 (the Company’sfiscal year end), and such information is incorporated herein by reference.

The information called forby Item 406 of Regulation S-K regarding the Company’s code of ethics canbe found on the Company’s public website located on the internet at www.SafetyInsurance.com under “About Safety”and “Investor Information”.

***ITEM 11.****          EXECUTIVECOMPENSATION*

The information called forby this Item will be contained in the Company’s Proxy Statement for its AnnualMeeting of Shareholders, to be held on May19, 2006 in Boston, MA, which theCompany intends to file with the U.S. Securities and Exchange Commission within120 days after December 31, 2005 (the Company’s fiscal year end), andsuch information is incorporated herein by reference.

***ITEM 12.****          SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT*

The information called forby this Item will be contained in the Company’s Proxy Statement for its AnnualMeeting of Shareholders, to be held on May 19, 2006 in Boston, MA, whichthe Company intends to file with the U.S. Securities and Exchange Commissionwithin 120 days after December 31, 2005 (the Company’s fiscal yearend), and such information is incorporated herein by reference.

***ITEM 13.****          CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS*

The information called forby this Item will be contained in the Company’s Proxy Statement for its AnnualMeeting of Shareholders, to be held on May 19, 2006 in Boston, MA, whichthe Company intends 

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to filewith the U.S. Securities and Exchange Commission within 120 days after December 31,2005 (the Company’s fiscal year end), and such information is incorporatedherein by reference.

***ITEM 14.****          PRINCIPALACCOUNTING FEES AND SERVICES*

The information called forby this Item will be contained in the Company’s Proxy Statement for its AnnualMeeting of Shareholders, to be held on May 19, 2006 in Boston, MA, whichthe Company intends to file with the U.S. Securities and Exchange Commissionwithin 120 days after December 31, 2005 (the Company’s fiscal yearend), and such information is incorporated herein by reference.

**PART IV.**

***ITEM 15.****          EXHIBITS,FINANCIAL STATEMENT SCHEDULES.*

(a)   The following documents are filed as a partof this report:

1.                FinancialStatements: The Consolidated Financial Statements for the year ended December 31,2005 are contained herein as listed in the Index to Consolidated FinancialStatements on page 64.

2.                FinancialStatement Schedules: The Financial Statement Schedules are contained herein aslisted in the Index to Financial Statement Schedules on page 94.

3.                Exhibits:The exhibits are contained herein as listed in the Index to Exhibits on page 103.

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**SAFETY INSURANCE GROUP, INC.**

**INDEXTO FINANCIAL STATEMENT SCHEDULES**

|               | ** ** | ** ** | ** ** | **Page**                                                                        | ** ** |
|---------------|------------|------------|------------|---------------------------------------------------------------------------------|------------|
| **Schedules** | ** ** | ** ** | ** ** | ** **                                                                      | ** ** |
|          | I          |       |       | Summary of Investments—Other than Investments in  Related Parties          |       |   | 95 |   |   |
|          | II         |       |       | Condensed Financial Information of the Registrant                               |       |   | 96 |   |   |
|          | III        |       |       | Supplementary Insurance Information                                             |       |   | 98 |   |   |
|          | IV         |       |       | Reinsurance                                                                     |       |   | 99 |   |   |
|          | V          |       |       | Valuation and Qualifying Accounts                                               |       |   | 100 |   |   |
|          | VI         |       |       | Supplemental  Information Concerning Property and Casualty Insurance Operations |       |   | 101 |   |   |

 

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**Safety Insurance Group, Inc.**

**Summary ofInvestments—Other than Investments in Related Parties**

**Schedule I**

**AtDecember 31, 2005**

**(Dollars inthousands)**

 

| ** **                                               | ** ** | **Cost** | ** ** | **Fair Value** | ** ** | **Amount at  which shown  in the Balance  Sheet** | ** ** |
|----------------------------------------------------------|------------|----------|------------|---------------------|------------|-----------------------------------------------------------------------|------------|
| **Fixed maturities:**                                    |       |     |       |                |       |                                                                  |       |   |   |
| Bonds:                                                   |       |     |       |                |       |                                                                  |       |   |   |
| U.S. government and government agencies and  authorities |       | $        | 127,764    |                | $          | 125,220                                                               |       |   | $ | 125,220 |   |   |
| States, municipalities and political subdivisions        |       | 321,250  |       | 322,609             |       |                                                                  | 322,609    |   |   |
| Corporate bonds                                          |       | 262,030  |       | 261,798             |       |                                                                  | 261,798    |   |   |
| Redeemable preferred stocks                              |       | 2,886    |       | 2,911               |       |                                                                  | 2,911      |   |   |
| **Total  fixed maturities**                              |       | 713,930  |       | 712,538             |       |                                                                  | 712,538    |   |   |
| **Equity  securities:**                                  |       |     |       |                |       |                                                                  |       |   |   |
| Common Stocks                                            |       |     |       |                |       |                                                                  |       |   |   |
| Industrial, miscellaneous and all other                  |       | 1,895    |       | 2,005               |       |                                                                  | 2,005      |   |   |
| **Total  equity securities**                             |       | 1,895    |       | 2,005               |       |                                                                  | 2,005      |   |   |
| **Total investments**                                    |       | $        | 715,825    |                | $          | 714,543                                                               |       |   | $ | 714,543 |   |   |

 

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*** ***

**Safety InsuranceGroup, Inc.Condensed Financial Information of the RegistrantCondensed Balance SheetsSchedule II(Dollars in thousands)**

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                           |       |                  |       |   |   |   |   |   |   |
| Investments in consolidated affiliates               |       |                  | $          | 389,469 |   |   |   | $ | 324,313 |   |   |
| Other                                                |       |                  | —     |   |   |   | 2,070 |   |   |
| **Total assets**                                     |       |                  | $          | 389,469 |   |   |   | $ | 326,383 |   |   |
| **Liabilities**                                      |       |                  |       |   |   |   |   |   |   |
| Accounts payable and other liabilities               |       |                  | $          | 1,520 |   |   |   | $ | 1,093 |   |   |
| Debt                                                 |       |                  | —     |   |   |   | 19,956 |   |   |
| **Total liabilities**                                |       |                  | 1,520      |   |   |   | 21,049 |   |   |
| **Shareholders’  equity**                       |       |                  | 387,949    |   |   |   | 305,334 |   |   |
| **Total liabilities and  shareholders’ equity** |       |                  | $          | 389,469 |   |   |   | $ | 326,383 |   |   |

 

**Safety Insurance Group, Inc.Condensed Financial Information of the RegistrantCondensed Statements of Income and Comprehensive IncomeSchedule II(Dollars in thousands)**

| ** **                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues, net of  income taxes             |       | $                                                             | —     |   | $ | — |   | $ | 11 |   |
| Expenses                                   |       | 2,007                                                         |       | 1,542 |   | 604 |   |
| Net loss                                   |       | (2,007                                                        | )          | (1,542 | ) | (593 | ) |
| Earnings from  consolidated affiliates     |       | 97,189                                                        |       | 46,532 |   | 29,075 |   |
| **Consolidated net income**                |       | 95,182                                                        |       | 44,990 |   | 28,482 |   |
| Other net  comprehensive loss, after tax   |       | (9,542                                                        | )          | (3,941 | ) | (1,671 | ) |
| **Consolidated  comprehensive net income** |       | $                                                             | 85,640     |   | $ | 41,049 |   | $ | 26,811 |   |

*** ***

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**Safety Insurance Group, Inc.Condensed Financial Information of the RegistrantCondensed Statements of Cash FlowsSchedule II(Dollars in thousands)**

| ** **                                                                         | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Consolidated  net income**                                                       |       | $                                                             | 95,182     |   | $ | 44,990 |   | $ | 28,482 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                                          |       |   |   |   |   |
| Undistributed earnings in consolidated subsidiaries                                |       | (97,189                                                       | )          | (46,532 | ) | (29,075 | ) |
| Amortization                                                                       |       | 903                                                           |       | 301 |   | — |   |
| Changes in assets  and liabilities:                                                |       |                                                          |       |   |   |   |   |
| Other assets                                                                       |       | 2,070                                                         |       | (101 | ) | — |   |
| Accounts payable and accrued liabilities                                           |       | 427                                                           |       | 222 |   | (898 | ) |
| **Net  cash used for operating activities**                                        |       | 1,393                                                         |       | (1,120 | ) | (1,491 | ) |
| Contribution to subsidiaries                                                       |       | —                                                        |       | (2,474 | ) | — |   |
| Dividends  received from consolidated subsidiaries                                 |       | 24,900                                                        |       | 8,201 |   | 5,976 |   |
| **Net  cash (used for) provided by investing activities**                          |       | 24,900                                                        |       | 5,727 |   | 5,976 |   |
| Payments on  revolving credit facility                                             |       | (19,956                                                       | )          | — |   | — |   |
| Proceeds from  exercise of stock options                                           |       | 3,072                                                         |       | 2,126 |   | — |   |
| Dividends paid                                                                     |       | (9,409                                                        | )          | (6,767 | ) | (5,188 | ) |
| Payments on  promissory notes from management                                      |       | —                                                        |       | 34 |   | 715 |   |
| Other                                                                              |       | —                                                        |       | — |   | (12 | ) |
| **Net cash provided used for financing activities**                                |       | (26,293                                                       | )          | (4,607 | ) | (4,485 | ) |
| **Net  increase (decrease) in cash and cash equivalents**                          |       | —                                                        |       | — |   | — |   |
| **Cash  and cash equivalents, beginning of year**                                  |       | —                                                        |       |   |   |   |   |
| **Cash and cash equivalents, end  of year**                                        |       | $                                                             | —     |   | $ | — |   | $ | — |   |

 

97

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**Safety Insurance Group, Inc.**

**SupplementaryInsurance Information**

**Schedule III**

**(Dollarsin thousands)**

| **Segment**  | ** ** | ** ** | ** ** | **Deferred  Policy  Acquisition  Costs** | ** ** | **Future Policy  Benefits,  Losses,  Claims and Loss  Expenses** | ** ** | **Unearned  Premiums** | ** ** | **Other  Policy  Claims and  Benefits  Payable** | ** ** | **Premium  Revenue** | ** ** | **Net  Investment  Income** | ** ** | **Benefits,  Claims,  Losses, and  Settlement  Expenses** | ** ** | **Amortization  of Deferred  Policy  Acquisition  Costs** | ** ** | **Other  Operating  Expenses** | ** ** | **Premium  Written** |
|--------------|------------|------------|------------|------------------------------------------|------------|---------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------|------------|----------------------|
| Years Ended: |       |       |       |                                     |       |                                                                            |       |                   |       |                                                  |       |                 |       |                        |       |                                                           |       |                                                           |       |                           |       |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|              |            |            |            |                                          |            |                                                                                 |            |                        |            |                                                       |            |                      |            |                             |            |                                                                |            |                                                                |            |                                |            |                      |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

| December 31,  2005 |   |   | $      | 45,480 |   |   |    | $      | 450,716 |   |    |   | $      | 341,562 |   |   |   | $      | —  |   |   |   | $      | 622,831 |   |   |    | $      | 31,573 |   |   |   | $      | 385,593 |   |   |   | $      | 93,515  |   |   |   | $ | 53,154 |   |   |   | $ | 632,836 |   |
|-------------------------|--------|--------|--------|--------|--------|--------|---------|--------|---------|--------|---------|--------|--------|---------|--------|--------|--------|--------|---------|--------|--------|--------|--------|---------|--------|--------|---------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|--------|---------|--------|--------|--------|---|--------|--------|--------|--------|---|---------|--------|
| December 31,  2004 |   |   | 42,919 |   |   |   | 450,897 |   |    |   | 337,786 |   |   |    | — |   |   |   | 592,292 |   |   |   | 27,259 |    |   |   | 425,061 |   |   |   | 88,425 |   |   |    | 56,650 |   |   |   | 618,922 |   |
| December 31, 2003  |   |   | 40,177 |   |   |   | 383,551 |   |    |   | 301,227 |   |   |    | — |   |   |   | 540,248 |   |   |   | 26,086 |    |   |   | 420,969 |   |   |   | 82,203 |   |   |    | 48,433 |   |   |   | 566,970 |   |

 

 

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**Safety Insurance Group, Inc.**

**Reinsurance**

**Schedule IV**

**(Dollarsin thousands)**

| **Total Premiums** | ** ** | ** ** | ** ** | **Gross  Amount** | ** ** | **Ceded to Other  Companies** | ** ** | **Assumed from  Other  Companies** | ** ** | **Net  Amount** | ** ** | **Percentage  of Amount  Assumed  to Net** | ** ** |
|-------------------------|------------|------------|------------|-------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|-----------------|------------|------------------------------------------------------|------------|
| Years ended:       |       |       |       |              |       |                                    |       |                                    |       |            |       |                                                 |       |   |   |   |   |
| December 31,  2005 |       | $          | 638,142    |              |       | $                                       | 89,277     |                                    |       |            | $          | 73,966                                               |       |   | $ | 622,831 |   |   | 11.9 | % |   |
| December 31,  2004 |       | 599,608    |       |              | 85,950     |                                    |       |                                    | 78,634     |            |       | 592,292                                              |       |   | 13.3 | % |   |
| December 31, 2003  |       | 544,664    |       |              | 71,692     |                                    |       |                                    | 67,276     |            |       | 540,248                                              |       |   | 12.5 | % |   |
|                         |            |            |            |                   |            |                                         |            |                                         |            |                 |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |

 

 

99

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**Safety Insurance Group, Inc.**

**Valuation andQualifying Accounts**

**Schedule V**

**(Dollarsin thousands)**

| **Description**                  | ** ** | **Balance at  Beginning of Period** | ** ** | **Charged to Costs  and Expenses** | ** ** | **Charged to  Other Accounts** | ** ** | **Deductions (1)** | ** ** | **Balance at  End of Period** | ** ** |
|----------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|----------------------------------------------|------------|
| December 31, 2005           |       |                                               |       |                                              |       |                                     |       |                    |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  Doubtful Accounts |       |                                               | $          | 183                                               |       |                                     |       | $                       | 901        |                                         |       |   | $ | — |   |   |   | $ | 864 |   |   |   | $ | 220 |   |   |
| December 31, 2004           |       |                                               |       |                                              |       |                                     |       |                    |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  Doubtful Accounts |       |                                               | 484        |                                              |       |                                     | 442        |                    |       |                                         | —     |   |   |   | 743 |   |   |   | 183 |   |   |
| December 31, 2003           |       |                                               |       |                                              |       |                                     |       |                    |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for  Doubtful Accounts |       |                                               | 548        |                                              |       |                                     | 582        |                    |       |                                         | —     |   |   |   | 646 |   |   |   | 484 |   |   |
|                                  |            |                                                    |            |                                                   |            |                                          |            |                         |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Deductions representwrite-offs of accounts determined to be uncollectible

100

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**Safety Insurance Group, Inc.**

**SupplementalInformation Concerning Property and Casualty Insurance Operations**

**Schedule VI**

**(Dollarsin Thousands)**

| ** **                             | ** ** | **Deferred  Policy** | ** ** | **Reserves for   Unpaid Claims  and Claims** | ** ** | **Discount,  if any,** | ** ** | ** **                          | ** ** | ** **             | ** ** | **Net**              | ** ** | **Claims and  Claims Adjustment  Expenses Incurred  Related to** | ** ** | **Amortization  of Deferred  Policy** | ** ** | **Paid Claims  and Claims** | ** ** | ** **             | ** ** |
|----------------------------------------|------------|----------------------|------------|------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------------------|------------|------------------------|------------|----------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------|------------|------------------------|------------|
| **Affiliations  With Registrant** | ** ** | ** **           | ** ** | **Acquisition  Costs**                                           | ** ** | **Adjustment  Expenses**    | ** ** | **deducted in  Column C** | ** ** | **Unearned  Premiums** | ** ** | **Earned  Premiums** | ** ** | **Investment  Income**                                                          | ** ** | **Current  Year**                          | ** ** | **Prior  Year**                       | ** ** | **Acquisition  Costs** | ** ** | **Adjustment  Expenses** | ** ** | **Premiums  Written** | ** ** |
|                                        |            |                      |            |                                                                  |            |                             |            |                                     |            |                        |            |                      |            |                                                                                 |            |                                            |            |                                       |            |                        |            |  |  |  |  |

| Consolidated Property  & Casualty Subsidiaries |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|----------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|

| 2005 |   |   | $      | 45,480 |   |   |    | $      | 450,716 |   |   |   | $      | — |    |   |   | $      | 341,562 |   |   |   | $      | 622,831 |   |    |   | $      | 31,573 |   |   | $      | 425,213 |   | $       | (39,620 | )      |   | $       | 93,515 |   |   |   | $ | 382,157 |   |   |   | $ | 632,836 |   |   |
|------|--------|--------|--------|--------|--------|--------|---------|--------|---------|--------|--------|--------|--------|--------|---------|--------|--------|--------|---------|--------|--------|--------|--------|---------|--------|---------|--------|--------|--------|--------|--------|--------|---------|--------|---------|---------|--------|--------|---------|--------|--------|--------|--------|---|---------|--------|--------|--------|---|---------|--------|--------|
| 2004 |   |   | 42,919 |   |   |   | 450,897 |   |    |   | — |   |   |   | 337,786 |   |   |   | 592,292 |   |   |   | 27,259 |    |   | 431,839 |   | (6,778 | )      |   | 88,425 |   |    |   | 368,343 |    |   |   | 618,922 |   |   |
| 2003 |   |   | 40,177 |   |   |   | 383,551 |   |    |   | — |   |   |   | 301,227 |   |   |   | 540,248 |   |   |   | 26,086 |    |   | 420,788 |   | 181    |   |   | 82,203 |   |    |   | 377,593 |    |   |   | 566,970 |   |   |

 

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

|                           | SAFETY INSURANCE GROUP, INC. |
|---------------------------|-----------------------------------|
|                      | (Registrant)                      |
| Date: March 16, 2006 |                              |   |
|                      | By:                               | David F. Brussard |
|                      |                              | *President, Chief Executive Officer and Chairman  of the Board* |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints David F. Brussard andWilliam J. Begley, Jr., and each of them individually, his true and lawfulattorney-in-fact and agent with full power of substitution and resubstitutionfor him and in his name, place and stead, in any and all capacities, to signany and all amendments to this Annual Report, and to file the same, with allexhibits thereto, and other documents in connection therewith, with theSecurities and Exchange Commission, granting unto each such attorney-in-factand agent, or his substitutes, full power and authority to do and perform eachand every act and thing requisite and necessary to be done in and about thepremises, to all intents and purposes and as fully as he might or could do inperson, hereby ratifying and confirming all that each such attorney-in-fact andagent, or his substitutes, may lawfully do or cause to be done by virtuehereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this Annual Reporthas been signed by the following persons in the capacities and on the dateindicated:

|                                       | **Signature** | ** **                                               | ** ** |                | **Title** | ** ** | ** ** |  | **Date** | ** ** | ** ** |
|---------------------------------------|---------------|----------------------------------------------------------|------------|----------------|-----------|------------|------------|--|----------|------------|------------|
| /s/ DAVID  BRUSSARD              |          | President, Chief  Executive Officer                      |       | March 16, 2006 |      |
| David  Brussard                       |          | and Chairman of the  Board (Principal Executive Officer) |       |           |      |
| /s/ WILLIAM  J. BEGLEY, JR. |          | Chief Financial  Officer, Vice                           |       | March 16, 2006 |      |
| William  J. Begley, Jr.          |          | President and Secretary                                  |       |           |      |
| /s/ A.  RICHARD CAPUTO, JR. |          | Director                                                 |       | March 16, 2006 |      |
| A.  Richard Caputo, Jr.          |          |                                                     |       |           |      |
| /s/ FREDERIC  H. LINDEBERG       |          | Director                                                 |       | March 16, 2006 |      |
| Frederic  H. Lindeberg                |          |                                                     |       |           |      |
| /s/ PETER  J. MANNING            |          | Director                                                 |       | March 16, 2006 |      |
| Peter  J. Manning                     |          |                                                     |       |           |      |
| /s/ DAVID  K. MCKOWN             |          | Director                                                 |       | March 16, 2006 |      |
| David K. McKown                       |          |                                                     |       |           |      |

 

 

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**SAFETY INSURANCE GROUP, INC.**

**INDEXTO EXHIBITS**

| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                          |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1              |       | Merger Agreement dated May 31, 2001 by and  among Safety Holdings, Inc., Safety Acquisition, Inc., Thomas Black  Corporation and the stockholders of Thomas Black Coporation**                                                                                                                                                                                                      |
| 2.2              |       | First Amendment to the Merger Agreement, dated July 17,  2001 by and among Safety Holdings, Inc., Safety Merger Co., Inc. and Thomas  Black Corporation**                                                                                                                                                                                                                           |
| 3.1              |       | Form of Amended and Restated Certificate of  Incorporation of Safety Insurance Group, Inc.**                                                                                                                                                                                                                                                                                   |
| 3.2              |       | Form of Amended and Restated Bylaws of Safety  Insurance Group, Inc.**                                                                                                                                                                                                                                                                                                         |
| 4                |       | Form of Stock Certificate for the Common  Stock**                                                                                                                                                                                                                                                                                                                                   |
| 10.1             |       | Lease Agreement between Thomas Black Corporation and  Aman, Inc. for the lease of office space located on the 1st through 5th,  11th and 12th floors of 20 Custom House Street, Boston, Massachusetts, dated  June 11, 1987, and as amended on October 11, 1988,  September 14, 1989, September 19, 1990, February 23, 1994 and  December 20, 1996.** |
| 10.2             |       | Tax Indemnity Agreement by and among Safety  Holdings, Inc. and the Management Team, dated October 16, 2001.**                                                                                                                                                                                                                                                                 |
| 10.3             |       | Management Consulting Agreement by and among TJC  Management Corporation and Safety Holdings, Inc., dated October 16,  2001.**                                                                                                                                                                                                                                                 |
| 10.4             |       | Form of First Amendment to the Management  Consulting Agreement by and among TJC Management Corporation and Safety  Group.**                                                                                                                                                                                                                                                        |
| 10.5             |       | 2002 Management Omnibus Incentive Plan(1)**                                                                                                                                                                                                                                                                                                                                              |
| 10.6             |       | Employment Agreement by and between Safety Insurance  Group, Inc. and David F. Brussard, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                      |
| 10.7             |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Edward N. Patrick, Jr., dated November 8,  2004.(1)*                                                                                                                                                                                                                                           |
| 10.8             |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Daniel F. Crimmins, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                          |
| 10.9             |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Daniel D. Loranger, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                     |
| 10.11            |       | Employment Agreement by and between Safety Insurance  Group, Inc. and Robert J. Kerton, dated November 8, 2004.(1)*                                                                                                                                                                                                                                                       |
| 10.12            |       | Reinsurance Agreement between Safety Insurance  Company, Safety Indemnity Insurance Company and the Hartford Steam Boiler  Inspection and Insurance Company, effective February 1, 2000.**                                                                                                                                                                                          |
| 10.13            |       | Reinsurance Terms Sheet between Safety Insurance  Company and Swiss Re America Corporation, effective January 1, 2002.**                                                                                                                                                                                                                                                            |
| 10.14            |       | Excess Catastrophe Reinsurance Program Terms Sheet  between Safety Insurance Company, Safety Indemnity Insurance Company and  Benfield Blanch, effective January 1, 2002.**                                                                                                                                                                                                         |
| 10.15            |       | Property Risk Excess of Loss Reinsurance Program  Terms Sheet between Safety Insurance Company, Safety Indemnity Insurance  Company and Benfield Blanch, effective January 1, 2002.**                                                                                                                                                                                               |
| 10.16            |       | Employment Agreement by and between Safety Insurance  Group, Inc. and William J. Begley, Jr., dated November 8,  2004.(1)*                                                                                                                                                                                                                                           |
| 10.17            |       | Safety Insurance Company Executive Incentive  Compensation Plan—Basic Document(1)(2)                                                                                                                                                                                                                                                                                                |
| 10.18            |       | Safety Insurance Company Executive Incentive  Compensation Plan—Adoption Agreement(1)(2)                                                                                                                                                                                                                                                                                            |

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| 10.19 |   | Safety Insurance Company Executive Incentive  Compensation Plan—Rabbi Trust Agreement(1)(2)                                             |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
| 10.20 |   | Form of Restricted  Stock Notice and Agreement (with vesting) under the 2002 Management Omnibus  Incentive Plan(1)(2)                   |
| 10.21 |   | Form of Restricted  Stock Notice and Agreement (without vesting) under the 2002 Management  Omnibus Incentive Plan(1)(2)                |
| 10.22 |   | Form of Nonqualified Stock Option Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                          |
| 10.23 |   | Form of Incentive Stock Option Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                             |
| 10.24 |   | Form of Stock Appreciation Right Notice and  Agreement under the 2002 Management Omnibus Incentive Plan(1)(2)                           |
| 10.25 |   | Employment Agreement by and between Safety Insurance  Group, Inc. and David E. Krupa, dated November 8, 2004.(1)*             |
| 10.26 |   | Employment Agreement by and between Safety Insurance  Group, Inc. and James D. Berry, dated October 1, 2005.(1)(3)                 |
| 10.27 |   | Employment Agreement by and between Safety Insurance  Group, Inc. and George M. Murphy, dated October 1, 2005.(1)(3)               |
| 21    |   | Subsidiaries of Safety Insurance Group, Inc.(3)                                                                                         |
| 23    |   | Consent of PricewaterhouseCoopers LLP.(3)                                                                                                    |
| 24    |   | Power of Attorney—Included on signature page.                                                                                           |
| 31.1  |   | CEO Certification Pursuant to Rule 13a-14(a)/15d-14(a),  as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.(3) |
| 31.2  |   | CFO Certification Pursuant to Rule 13a-14(a)/15d-14(a),  as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.(3) |
| 32.1  |   | CEO Certification Pursuant to U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.(3)      |
| 32.2  |   | CFO Certification Pursuant to U.S.C. Section 1350,  as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.(3)      |

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*                    Incorporatedherein by reference to the Registrant’s Quarterly Report on Form 10-Qfor the quarterly period ended September 30, 2004 filed on November 9,2004.

**             Incorporated hereinby reference to the Registrant’s Registration Statement on Form S-1(File No. 333-87056) filed April 26, 2002, as amended.

(1)          Denotes managementcontract or compensation plan or arrangement.

(2)          Incorporated herein byreference to the registrant’s Annual Report on Form 10K for the year endedDecember 31, 2004 filed on March 16, 2005.

(3)          Included herein.

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