The Company's 517,800 square foot corporate office complex is located on a 42-acre parcel in Mayfield Village, Ohio, owned by a subsidiary. The Company's central data processing facility occupies a building containing approximately 107,000 square feet of office space, on this same parcel.
1 During 1994, based on a review of the adequacy of its total loss reserves, the Company eliminated its $71.0 million "supplemental reserve" ($46.2 million after tax), resulting in a one-time increase in earnings of $.62 per share.
During 1998, the Company repurchased 404,079 of its Common Shares at a total cost of $42.6 million (average $105.28 per share), including 11,079 Common Shares repurchased to satisfy obligations under the Company's benefit plans. During the three-year period ended December 31, 1998, the Company repurchased 1.4 million of its Common Shares at a total cost of $87.4 million (average $60.75 per share), .2 million of its 9 3/8% Serial Preferred Shares, Series A, at a total cost of $6.0 million (average $25.60 per share) and redeemed its remaining Preferred Shares at a total cost of $82.1 million ($25.00 per share). The Company also sold $100.0 million of Notes. During the same period, The Progressive Corporation made $1.1 million of capital contributions to its subsidiaries, net of dividends received from these subsidiaries. The regulatory restrictions on subsidiary dividends are described in Item 5(C) on page 12 herein.
The Company's insurance operations create liquidity by collecting and investing premiums from new and renewal business in advance of paying claims. For the three years ended December 31, 1998, operations generated positive cash flows of $2,004.9 million, and cash flows are expected to be positive in both the short-term and reasonably foreseeable future. The Company's substantial investment portfolio is highly liquid, consisting almost entirely of readily marketable securities.
INVESTMENTS The Company invests in fixed-maturity, equity and short-term securities. The Company's investment strategy recognizes its need to maintain capital adequate to support its insurance operations. The Company evaluates the risk/reward tradeoffs of investment opportunities, measuring their effects on stability, diversity, overall quality and liquidity of the investment portfolio.
The majority of the portfolio is invested in high-grade, fixed-maturity securities, of which short- and intermediate-term securities represented $4,439.4 million, or 78.3%, at the end of 1998, compared to $4,024.9 million, or 76.4%, at the end of 1997. Long-term investment-grade securities, including those principal paydowns from asset-backed securities that are greater than 10 years, were $93.5 million, or 1.6%, at the end of 1998, compared to $143.4 million, or 2.7%, at the end of 1997. Non-investment-grade fixed-maturity securities were $128.0 million, or 2.3%, at the end of 1998, compared to $132.5 million, or 2.5%, at the end of 1997, and offer the Company higher returns and added diversification without a significant adverse effect on the stability and quality of the investment portfolio as a whole. Non-investment-grade securities may involve greater risks often related to creditworthiness, solvency and relative liquidity of the secondary trading market. The duration of the fixed-income portfolio was 2.8 years at December 31, 1998, compared to 3.3 years at December 31, 1997.
A portion of the investment portfolio is invested in marketable equity securities. Common stocks represented $636.9 million, or 11.2%, of the portfolio, at the end of 1998, compared to $620.8 million, or 11.8%, a year earlier. The majority of the common stock portfolio is invested in domestic equities traded on nationally recognized securities exchanges. In addition, the Company invests in foreign equities, which may include stock index futures and foreign currency forwards, which comprised $130.7 million of the common stock portfolio at the end of 1998, compared to $106.0 million last year, and partnership investments, which comprised $63.7 million of the common stock portfolio at the end of 1998, compared to $31.8 million last year. Preferred stocks represented $376.5 million, or 6.6%, of the portfolio at the end of 1998, compared to $348.8 million, or 6.6%, a year earlier, and was comprised of over 72% of fixed-rate preferred stocks with mechanisms that are expected to provide an opportunity to liquidate at par.
RESULTS OF OPERATIONS Operating income, which excludes net realized gains and losses from security sales and one-time items, was $449.3 million, or $6.01 per share, in 1998, $336.0 million, or $4.46 per share, in 1997 and $309.1 million, or $4.12 per share, in 1996. The GAAP combined ratio was 91.6 in 1998, 93.4 in 1997 and 91.5 in 1996.
Direct premiums written increased 13% to $5,451.3 million in 1998, compared to $4,825.2 million in 1997 and $3,638.4 million in 1996. Net premiums written increased 14% to $5,299.7 million in 1998, compared to $4,665.1 million in 1997 and $3,441.7 million in 1996. The difference between direct and net premiums written is partially attributable to premiums written under state-mandated involuntary Commercial Auto Insurance Procedures (CAIP), for which the Company retains no indemnity risk, of $60.7 million in 1998, $78.4 million in 1997 and $99.5 million in 1996. The Company provided policy and claim processing services to 27 state CAIPs in all three years. Premiums earned, which are a function of the amount of premiums written in the current and prior periods, increased 18% in 1998, compared to 31% in 1997 and 17% in 1996.
Net premiums written in the Company's Personal Lines, which write insurance for private passenger automobiles and recreational vehicles, grew 15%, 36% and 20% in 1998, 1997 and 1996, respectively, primarily reflecting an increase in unit sales. The slower growth in 1998 is a result of intensified competition in the auto insurance market. Many of the Company's competitors reduced rates, increased advertising, entered new states, expanded their distribution channels, entered the nonstandard auto insurance market and increased agents' compensation. The Company expects continued growth in 1999 despite increased competition. The Company decreased rates an average of 5.3% in 1998, compared to rate decreases of .9% in 1997 and rate increases of 2.5% in 1996. The Company continues to write through multiple distribution methods, including Independent Agents, Direct (via 1 800 AUTO PRO(R) and progressive.com) and through Strategic Alliances. In 1998, the Direct distribution channel represented between 10% and 15% of the Personal Lines volume, compared to between 5% and 10% in 1997 and less than 5% in 1996. The sales generated via the Internet represented approximately 2% of the Direct business net premiums written in 1998. The Company also writes through its Strategic Alliances channel, which includes alliances with other insurance companies, employers, affinity groups and national brokerage agencies. The Strategic Alliances channel represented between 5% and 10% of the Personal Lines premiums in all three years. The remainder of the Personal Lines premiums are written through a network of over 30,000 Independent Insurance Agents. Through these multiple distribution channels, the Company continues to write standard and preferred risks, which represented between 30% and 35% of total 1998 Personal Lines volume, compared to between 20% and 25% in 1997 and between 10% and 15% in 1996, as well as its traditional nonstandard auto products.
$402 million in 1997 and $330 million in 1996. Pretax operating profit was $62 million in 1998, compared to $37 million in 1997 and $46 million in 1996. Most of these businesses are in markets that are declining in size.
The Company writes directors and officers and other professional liability coverage for community banks and credit unions and, therefore, could potentially be exposed to liability for errors made by these institutions relating to the year 2000 conversion. To minimize its risk, from October 1997 through May 1998, the Company included year 2000 exclusions in all new and renewal policies for commercial banks which have multi-year terms that extend beyond December 31, 1999. This placed the Company at a competitive disadvantage since few of its competitors included similar exclusions. The Company has obtained additional reinsurance to limit its potential exposure to about 7% of the average policy limits in the event any of the insured directors or officers are held liable for year 2000 noncompliance by their financial institutions. In light of this additional reinsurance contract, which reduced the Company's net exposure by 68% and covers all of the Company's in-force directors and officers insurance business, in June 1998, the Company stopped including year 2000 exclusions in its multi-year policies. Additionally, the Company has begun to selectively remove previously issued year 2000 exclusions. As a regulated industry, financial institutions are under pressure from government regulatory agencies and other interested parties to ensure they achieve readiness for the year 2000. The Company is monitoring its customers' compliance efforts and believes that substantially all such customers are pursuing plans to achieve year 2000 compliance. It is currently unknown whether these financial institutions will be able to completely avoid errors relating to year 2000 compliance and the Company is unable to predict to what extent such financial institutions will incur losses as a result of noncompliance and whether their directors and officers will be subject to individual liability for such noncompliance. In the event of a claim, applicable factual and coverage issues would have to be resolved. Based on information currently available and management's best estimate, the Company does not believe that any losses resulting from this exposure will have a material impact on the Company's liquidity, financial condition, cash flows or results of operations.
Recurring investment income (interest and dividends) increased 7% to $294.8 million in 1998, compared to $274.9 million in 1997 and $225.8 million in 1996, primarily due to an increase in the size of the investment portfolio. Net realized gains on security sales were $11.4 million in 1998, $98.5 million in 1997 and $7.1 million in 1996. Investment expenses were $7.4 million in 1998, compared to $9.9 million in 1997 and $6.1 million in 1996; in 1997, the Company purchased a new portfolio management system and incurred expenses related to the sale of the commercial mortgage-backed securities.
The Company continually evaluates computer hardware and software upgrades for enhancements and, therefore, many of the costs to replace these items to be year 2000 compliant are not likely to be incremental costs to the Company. The Company's remediation of its mainframe hardware and operating software is 94% complete and the remediation of its servers and client server operating software is 30% complete. The Company estimates that all mainframe and client server hardware and operating software will be year 2000 compliant by the first half of 1999. In addition, during 1998, the Company secured software which will assist in the discovery of noncompliant desktop hardware and software. It is estimated that the assessment and remediation process will be completed by the first half of 1999.