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 an additional 107,000 square feet of office space, on this same parcel.
The Company also owns six other buildings in suburbs adjoining the corporate office complex (excluding the buildings in the following paragraph), four buildings in Tampa, Florida, and a building in each of the following cities: Tempe, Arizona; Albany, New York; Tigard, Oregon; Plymouth Meeting, Pennsylvania; and Austin, Texas. In total, these buildings contain 1,497,000 square feet of office, warehouse and training facility space and are owned by subsidiaries of the Company. These locations are occupied by the Company's business units or other operations and are not segregated by industry segment. In addition, the Company owns two buildings in Tampa, Florida that are currently for sale, which are partially leased to non-affiliates. The building in Plymouth Meeting, Pennsylvania is also partially leased to non-affiliates.
In November 1997, the Company purchased 91 acres in Mayfield Village, Ohio to construct an office complex near the site of its corporate headquarters. This office complex is part of a five-year cooperative effort with Mayfield Village to develop over 300 acres. Progressive will serve as the anchor corporate user with additional business users and recreational facilities on the site. The Company is constructing five buildings, containing a total of approximately 770,000 square feet, on the site, and a parking garage, at an estimated cost of $132.5 million. As of December 31, 1999, $65.8 million has been paid. The first building was completed in May 1999. The next two buildings were completed in the first quarter of 2000. The parking garage and fourth building are scheduled to be completed in October 2000. The fifth building is scheduled to be completed in the first quarter of 2001. The construction projects are being funded through operating cash flows.
(1) Presented on a diluted basis. In 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) 128 "Earnings Per Share," and, as a result, restated prior periods per share amounts, if applicable.
The Company has substantial capital resources and is unaware of any trends, events or circumstances that are reasonably likely to affect its capital resources in a material way. In March 1999, the Company issued $300 million of 6 5/8% Senior Notes due 2029 under an outstanding shelf registration, which became effective in 1998. The net proceeds of $293.7 million will be used to repay current outstanding debt upon its maturity. The Company also has available a $10.0 million revolving credit agreement. The Company's debt to total capital ratio is 28%; management believes the Company has substantial capital resources and sufficient borrowing capacity to support current and anticipated growth.
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, 1999, operations generated positive cash flows of $2,127.8 million, and cash flows are expected to be positive in both the short-term and reasonably foreseeable future. The Company's investment portfolio is highly liquid and consists substantially of readily marketable securities.
As of December 31, 1999, the Company's portfolio had $5.4 million in unrealized losses, compared to $174.3 million in unrealized gains in 1998. This decrease in value was the result of widening credit spreads on non-treasury related products and the portfolio's underperformance relative to the S&P 500, due to underweighting in the technology sector. The weighted average fully taxable equivalent book yield of the portfolio was 6.3% for the years ended December 31, 1999 and 1998 and 6.6% for 1997.
Investments in the Company's portfolio have varying degrees of risk. The primary market risk exposure to the fixed-income portfolio is interest rate risk, which is limited by managing duration to a defined range of 1.8 to 5 years. The distribution of maturities and convexity are monitored on a regular basis. Common stocks, excluding term trust certificates, and other risk assets, which generally have greater risk and volatility of market value, may range from 0 to 25% of the total portfolio; at December 31, 1999, the Company held 16.5% of these securities. Market values, along with industry and sector concentrations of common stocks and similar investments, are monitored daily. Exposure to foreign currency exchange risk is limited by Company restrictions and is monitored quarterly for compliance. Exposures are evaluated individually and as a whole, considering the effects of cross correlation. For the quantitative market risk disclosures, see page 56 of the Company's Annual Report. The Company quarterly examines its portfolio for evidence of impairment. In such cases, changes in market value are evaluated to determine the extent to which such changes are attributable to: (i) interest rates, (ii) market-related factors other than interest rates and (iii) financial conditions, business prospects and other fundamental factors specific to the issuer. Declines attributable to issuer fundamentals are reviewed in further detail. Available evidence is considered to estimate the realizable value of the investment. When a security in the Company's investment portfolio has a decline in market value which is other than temporary, the Company is required by GAAP to reduce the carrying value of such security to its net realizable value.
Trading securities and derivative instruments held or issued for trading are entered into for the purpose of near-term profit taking. During 1999, net activity in the trading portfolio was not material to the Company's financial position, cash flows or results of operations. At December 31, 1999, trading positions had a net market value of $50.2 million, compared to $(.4) million at December 31, 1998. Net gains and losses for the year ended December 31, 1999 and 1998, were $.8 million and $(1.2) million, respectively.
Derivative instruments are primarily used to manage the risks and enhance the returns of the available-for-sale portfolio. This is accomplished by modifying the basis, duration, interest rate or foreign currency characteristics of the portfolio, hedged securities or hedged cash flows. During 1998, the Company entered into two transactions, an interest rate swap hedge and a short futures position, to hedge against possible rises in interest rates prior to the issuance of debt under the $300 million shelf registration. During 1999, the $300 million of debt was issued and the hedges were closed. The interest rate swap performed as expected and was recorded as a deferred asset under SFAS 80, "Accounting for Futures Contracts," as a qualified hedge. The deferred asset of $4.8 million is recognized as an adjustment to interest expense over the life of the debt. During 1998, the short futures position, driven by changing economic conditions, did not meet the established criteria for hedging correlation and was discontinued as a hedge, but the Company continued to hold it for risk management of the anticipated debt offering. The Company recognized a net realized gain of $8.1 million in 1999 and a net realized loss of $9.2 million in 1998, on the short futures position. Derivative instruments may also be used for trading purposes. For all derivative positions, net cash requirements are limited to changes in market values which may vary based upon changes in interest rates and other factors. Exposure to credit risk is limited to the carrying value; collateral is not required to support the credit risk.
RESULTS OF OPERATIONS Operating income, which excludes net realized gains and losses from security sales and one-time items, was $266.7 million, or $3.58 per share, in 1999, $449.3 million, or $6.01 per share, in 1998 and $336.0 million, or $4.46 per share, in 1997. The GAAP combined ratio was 98.3 in 1999, 91.6 in 1998 and 93.4 in 1997.
and $4,665.1 million in 1997. The difference between direct and net premiums written is attributable to premiums written under state-mandated involuntary Commercial Auto Insurance Procedures, for which the Company retains no indemnity risk, of $49.7 million in 1999, $60.7 million in 1998 and $78.4 million in 1997, and reinsurance the Company maintains in its auto and non-auto programs and its strategic alliance relationships. Premiums earned, which are a function of the amount of premiums written in the current and prior periods, increased 15% in 1999, compared to 18% in 1998 and 31% in 1997.
Net premiums written in the Company's Personal Lines business units, which write insurance for private passenger automobiles and recreation vehicles and represented 93% of the Company's 1999 total premiums written, grew 16%, 15% and 36% in 1999, 1998 and 1997, respectively, primarily reflecting an increase in unit sales. The Company decreased rates an average of 1.3% during the first six months of 1999, and increased rates 4.4% in the second half of the year, for an annual rate increase of 3.1% in 1999, compared to rate decreases of 5.3% and .9% in 1998 and 1997, respectively. The Company expects that these rate increases will likely slow volume growth in 2000 and, since nearly two-thirds of the Company's new auto policies are on an annual term, the Company does not expect to see the full impact of these rate changes until the fourth quarter of 2000.
The Personal Lines business is generated either by an Agent or written directly by the Company. The Agent channel includes business written by the Company's network of 30,000 Independent Insurance Agents and through Strategic Alliance business relationships (other insurance companies, financial institutions, employers and national brokerage agencies). Total net premiums written through Independent Agents and Strategic Alliance agency relationships were $4,746.5 million in 1999, compared to $4,390.4 million in 1998 and $4,033.8 million in 1997. The combined ratios for the Agency channel were 96.5, 90.6 and 93.2 for 1999, 1998 and 1997, respectively. Direct business includes business written through 1-800-AUTO-PRO(R), the Internet (progressive.com) and the Strategic Alliance business unit on behalf of affinity groups. Net premiums written and combined ratio on the Direct business were $955.9 million and 113.1, respectively, in 1999, compared to $531.9 million and 107.5 in 1998 and $255.0 million and 103.8 in 1997. The sales generated via the Internet represented approximately 7% and 2% of the Direct business net premiums written for 1999 and 1998, respectively; the Company started selling insurance directly over the Internet in August 1997. Through these multiple distribution channels, the Company continues to write standard and preferred risks, which represented between 45% and 50% of total 1999 Personal Lines volume, compared to between 30% and 35% in 1998 and between 20% and 25% in 1997, as well as its traditional nonstandard auto products.
Claim costs, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. These costs include a loss estimate for future assignments and assessments, based on current business, under state-mandated involuntary automobile programs. Claim costs are influenced by inflation and loss severity and frequency, the impact of which is mitigated by adequate pricing. Increases in the rate of inflation increase loss payments, which are made after premiums are established. Accordingly, anticipated rates of inflation are taken into account when the Company establishes premium rates and loss reserves. Claim costs, expressed as a percentage of premiums earned, were 75% in 1999, compared to 68% in 1998 and 71% in 1997. The increase in the loss ratios was driven by the factors discussed below.
Four factors contributed to the Company's underwriting losses during the second half of 1999 and its inability to meet its traditional goals in 1999. The first factor was that, during 1999, the Company reduced loss reserves relating to prior accident years $29.8 million, or .5 points, compared to $184.2 million, or 3.7 points, and $103.3 million, or 2.5 points, for 1998 and 1997, respectively. The second factor was continued strong growth in the Direct business in 1999. In periods of rapid growth in the Direct business, the Company's earnings may be lower as a result of higher up-front costs and higher loss costs traditionally associated with new business. In response, the Company decided to return to profit targets based on a calendar year measure rather than over the entire retention period of a policyholder, with the intent to bring the combined ratio back to the historic goal of 96 over the next few years. The Company's profit and growth opportunities change from year to year; however, over every consecutive 5-year period, the Company strives to produce a four percent underwriting profit and to grow at 15 percentage points greater than the rate of inflation. The third factor was that the Company lowered rates in 1998 and during the first half of 1999, in an attempt to raise its combined ratio to 96 while achieving its growth target. Lastly, during 1999, loss trend accelerated at an unanticipated pace; consequently, loss costs rose faster than expected. The Company expects these loss costs trends to continue. In 1999, actual trend for
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. The Company has reinsurance to limit its potential exposure to approximately 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. It is currently unknown whether these financial institutions have been 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.
Because the Company is primarily an insurer of motor vehicles, it has limited exposure for environmental, product and general liability claims. The Company has established reserves for these exposures, in amounts which it believes to be adequate based on information currently known by it. Management does not believe that these claims will have a material impact on the Company's liquidity, financial condition, cash flows or results of operations.
Policy acquisition and other underwriting expenses as a percentage of premiums earned were 23% in 1999, 1998 and 1997. The Company advertises locally in 35 states, plus Washington D.C. (107 markets), as compared to 32 states (83 markets) in 1998 and 19 states (40 markets) in 1997. The Company expanded its television advertising campaign on a national level during 1998. During 1999, the Company incurred advertising expenses of $124 million, compared to $70 million in 1998 and $23 million in 1997.
YEAR 2000 COMPLIANCE The Company's five-year effort to achieve year 2000 compliance was successful. The Company successfully operated through the rollover to year 2000 with only minor issues and has not experienced any significant business outage or incurred any significant cost due to the year 2000 failure or errors of business partners to date. The total cost to modify existing production systems, which includes both internal and external costs of programming, coding and testing, was $9.3 million, of which $9.2 million had been expensed through December 31, 1999. The Company also replaced some of its systems. In addition to being year 2000 compliant, these new systems added increased functionality to the Company. The majority of the projects were completed in 1998, with remaining parallel testing completed during the first half of 1999. As of December 31, 1999, $5.5 million, which include both internal and external costs, had been paid for these systems. All costs were funded through operating cash flows.
The Consolidated Financial Statements of the Company, along with the related notes, supplementary data and report of independent accountants, are incorporated by reference from the Company's 1999 Annual Report, pages 33 through 47 and pages 51 through 58.