The Company also owns six other buildings in suburbs adjoining the corporate office complex, five buildings in Tampa, Florida, a building in Tempe, Arizona and a building in Tigard, Oregon. In total, these buildings contained approximately 1,088,500 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, one in Tampa, Florida and one in Plymouth Meeting, Pennsylvania, which are 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 current corporate headquarters. This office complex is part of a five-year cooperative effort with Mayfield Village to develop over 300 acres. Progressive would serve as the anchor corporate user with additional business users and recreational facilities on the site. The Company is constructing three buildings containing a total of approximately 443,000 square feet on the site and could build up to two additional buildings, containing about 500,000 additional square feet in total, in the future. The first three buildings are expected to be completed during 1999 and are estimated to cost $68.3 million. As of December 31, 1998, $28.7 million has been paid. The Company is also constructing a 90,000 square foot office in Albany, New York, which is expected to be completed during 1999. The construction projects are being funded through operating cash flows.
The Company leases approximately 490,000 square feet of office and warehouse space at various locations throughout the United States for its other business units and staff functions. In addition, the Company leases approximately 365 claim offices, consisting of 1,540,000 square feet, at various locations throughout the United States. Two offices are leased in Canada. These leases are generally short-term to medium-term leases of standard commercial office space.
As the Company continues to grow, it expects that it will need additional space and is actively engaged in seeking out additional locations to meet its current and anticipated needs.
2 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.
FINANCIAL CONDITION The Progressive Corporation is a holding company and does not have any revenue producing operations of its own. It receives cash through borrowings, equity sales, subsidiary dividends and other transactions, and may use the proceeds to contribute to the capital of its insurance subsidiaries in order to support premium growth, to repurchase its Common Shares and other outstanding securities, to retire its outstanding indebtedness, to pay dividends and for other business purposes.
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 are intended to replace current outstanding debt upon its maturity. The Company also has available a $10.0 million revolving credit agreement. With its current 29% debt to capital ratio, management believes the Company has sufficient borrowing capacity and other capital resources to support current and anticipated growth.
In March 1997, the Company acquired Midland Financial Group, Inc. for about $50 million in cash. Midland underwrites and markets nonstandard private passenger automobile insurance through Independent Agents across 11 states, primarily in the southeastern and western United States.
Total capital expenditures for the three years ended December 31, 1998, aggregated $331.9 million. In December 1997, the Company purchased approximately 72 acres in Tampa, Florida to construct a three-building, 307,000 square foot, regional call center. The cost of the project is currently estimated at $45.2 million; $41.3 million has been paid as of December 31, 1998. The first two buildings were completed during 1998. The third building was completed in February 1999. In addition, in November 1997, the Company purchased 91 acres in Mayfield Village, Ohio to construct an office complex, near the site of its current 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 three buildings containing a total of approximately 443,000 square feet on the site and could build up to two additional buildings, containing about 500,000 square feet in total, in the future. The first three buildings are expected to be completed during 1999 and are estimated to cost $68.3 million. As of December 31, 1998, $28.7 million has been paid. The construction projects are being funded through operating cash flows.
As of December 31, 1998, the Company's portfolio had $174.3 million in unrealized gains, compared to $188.4 million in 1997. This decrease in value was the result of widening credit spreads on all non-treasury related products and the Company's underperformance relative to the S&P 500, due to overweighting in smaller capitalization value stocks.
The weighted average fully taxable equivalent book yield of the portfolio was 6.3%, 6.6% and 6.7% for the years ended December 31, 1998, 1997 and 1996, respectively.
As of December 31, 1998, the Company held $1,486.9 million of asset-backed securities, which represented 26.2% of the total investment portfolio. The asset-backed portfolio included collateralized mortgage obligations (CMO) and commercial mortgage-backed obligations (CMB) totaling $325.3 million and $728.9 million, respectively. The remainder of the asset-backed portfolio was invested primarily in auto loan and other asset-backed securities. As of December 31, 1998, the CMO portfolio primarily included sequential bonds, representing 90.3% of the CMO portfolio ($293.7 million)
with an average life of 3.6 years. At December 31, 1998, the CMO portfolio had a weighted average Moody's or Standard & Poor's rating of AAA and the CMB portfolio had an average life of 6.1 years and a weighted average Moody's or Standard & Poor's rating of AA. At December 31, 1998, the CMO and CMB portfolios had unrealized gains/(losses) of $.1 million and $(8.2) million, respectively. The single largest unrealized loss in any individual CMO security was $.9 million and in any CMB security was $5.4 million, at December 31, 1998. The CMB portfolio includes $132.5 million of CMB interest-only certificates, which had an average life of 6.6 years and a weighted average Moody's or Standard & Poor's rating of AAA at December 31, 1998. Both the CMO and CMB portfolios are highly liquid with readily available quotes and contain no residual interests. During 1997, the Company sold $178.4 million (proceeds of $200.8 million) of non-investment-grade CMB securities to a third-party purchaser. The purchaser subsequently transferred the securities to a trust as collateral in a resecuritized debt offering. The transaction was accounted for as a sale under Statement of Financial Accounting Standards (SFAS) 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," resulting in a net gain of $22.4 million. A bankruptcy remote subsidiary of the Company acquired $22.8 million of the resecuritized debt, which was subsequently sold in 1998 for a net gain of $3.5 million. This portion of the transaction was not accounted for as a sale in 1997 in accordance with SFAS 125.
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 and similar investments, which generally have greater risk and volatility of market value, are limited to a target of 15%, with a range of 0 to 25%. 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 regularly. 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 1998 Annual Report. The Company regularly 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 generally accepted accounting principles (GAAP) to reduce the carrying value of such security to its net realizable value. In 1998, the Company wrote down $32.2 million, including $20.8 million in two securities in emerging markets driven by changing economic conditions.
Included in the Company's non-investment-grade fixed-maturity securities and common stock portfolios are $299.6 million of other risk assets. Other risk assets include such items as high yield and distressed debt, private equities and warrants, mezzanine investments, and securities in emerging markets. No individual security in the other risk asset portfolio comprised more than one percent of Progressive's total investment portfolio. The total return on the average amount invested in this asset class in 1998 was (4.4)% with a total net unrealized gain of $4.7 million at December 31, 1998. The single largest unrealized loss in any individual other risk asset security was $5.4 million.
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. The interest rate swap hedge performed as expected and is recorded as an $11.0 million deferred asset under SFAS 80, "Accounting for Futures Contracts," as a qualified hedge. The short futures position, driven by changing economic conditions, did not meet the established criteria for hedging correlation and was discontinued as a hedge, recognizing a net realized loss of $9.2 million in 1998. The Company continues to hold the short futures position for risk management of the anticipated debt offering. Derivative instruments may also be used for trading purposes. During 1998, net activity in the trading portfolio was not material to the Company's financial position, cash flows or results of operations. Net cash requirements of derivative instruments 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. The Company has stringent restrictions on the amount of open
positions in the trading portfolios, limiting exposure to defined levels. At December 31, 1998, trading positions had a net market value of $(.4) million; at December 31, 1997, the net market value was $1.1 million.
In 1997, the Company began using rating criteria based partially on consumer financial responsibility. This approach is in use in 43 states that represent 91% of the Personal Lines volume. The Company expects product design and pricing methods to evolve constantly, based on the developing understanding of loss data, work flows, market conditions and technology, as well as consumer acceptance of the Progressive brand as an insurer for all drivers. The Company introduced the next generation of product design in mid-1998 and expects to have it in markets representing 80% of premium by April 1999. Early results suggest that the Company is attracting drivers from all risk profiles and retaining them longer. The Company believes that growing the numbers of policyholders, particularly standard and preferred risks with their higher retention rates, builds intrinsic value because renewals are more profitable than first year business. The drive to add customers faster resulted in more spending to promote the Progressive brand and to hire and develop more claim adjusters and customer service representatives, and the Company expects this to continue at least in the near term. These costs, along with lower margins on first year business, are expected to bring profit margins more in line with the Company's objective of achieving a 4% underwriting profit margin over the entire retention period of a policyholder. In 1998, Personal Lines generated an underwriting profit margin of 8%, compared to 6% in 1997 and 8% in 1996.
The Company's other lines of business include writing insurance for small fleets of commercial vehicles, collateral protection and loan tracking for auto lenders and financial institutions, directors' and officers' liability and fidelity coverage for American Bankers Association member community banks and independent credit unions, and providing related claim, underwriting and system services. Revenues in these businesses were $405 million in 1998, compared to
The Company began converting its applications software to be year 2000 compliant in July 1995 and, as a result, has been able to avoid redeploying significant resources or deferring other important projects to specifically address the year 2000 issues. During the first quarter 1998, the Company retained independent consultants to determine its state of readiness. Although some additional areas of focus were identified, the consultants noted that the Company was adequately addressing its critical internal systems and issues. As of December 31, 1998, the Company has completed approximately 94% of its efforts to bring its applications software in compliance. Testing of critical applications is being accomplished through the use of a special systems environment known as a "Time Warp Lab," which mimics the Company's production environment. As a final test of year 2000 readiness, after conversion and year 2000 certification, critical applications are run in the Time Warp Lab while systems clocks turn over from 1999 to 2000 and beyond. The total cost to modify these existing production systems, which includes both internal and external costs of programming, coding and testing, is estimated to be $8.0 million, of which $7.1 million had been expensed through December 31, 1998. The Company also replaced some of its systems during 1998. In addition to being year 2000 compliant, these new systems added increased functionality to the Company. The total cost of these systems, which include both internal and external costs, is estimated to be $4.8 million, and the majority of the projects were completed in 1998, with remaining parallel testing scheduled during the first quarter 1999. As of December 31, 1998, $4.7 million had been paid for these systems. All costs are being funded through operating cash flows. In addition, the Company has identified approximately 330 third parties with which data is exchanged. All critical data exchanges are being tested for compliance. Although dependent on business partners' testing schedules, testing of critical data exchanges is expected to be completed by the end of the second quarter 1999.
The Company is currently unable to determine the impact that year 2000 noncompliance may have on its financial condition, cash flows and results of operations. The Company believes that it is taking the necessary measures to address issues that may arise relating to the year 2000 and that its production systems will be compliant. The Company realizes, however, that noncompliance by third parties could impact its business. The possibility exists that a portion of the Company's distribution channel may not be compliant, that communication with agents could be disrupted, that underwriting data, such as motor vehicle reports, could be unobtainable, that the claim settling process could be delayed or that frequency and severity of losses may increase due to external factors. The Company is contacting its key independent insurance agents, vendors and suppliers (e.g. banks, credit bureaus, motor vehicle departments, rating agencies, etc.) to determine their status of compliance and to assess the impact of noncompliance to the Company. The Company is working closely with all critical business relationships to minimize its exposure to year 2000 issues, including on-site visits to identify their state of readiness.
The Company's process teams and business groups are identifying potential year 2000 scenarios. For those scenarios deemed to be both probable and with a potentially significant business impact, the Company is developing contingency plans. The majority of the contingency plans are drafted and were reviewed by the Company's chief financial and
technology officers during 1998. Contingency plans may include such items as hardening facilities with back-up generators, prioritizing resources, securing alternative vendors, developing alternative processes, pre-ordering policyholder information, and other measures. The contingency plans were substantially completed for all material relationships during the first quarter 1999 and the Company will continue to review them throughout 1999.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: EXCEPT FOR HISTORICAL INFORMATION, THE MATTERS DISCUSSED IN THIS ANNUAL REPORT ON FORM 10-K ARE FORWARD-LOOKING STATEMENTS THAT ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE THE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED. THESE RISKS AND UNCERTAINTIES INCLUDE, WITHOUT LIMITATION, PRICING COMPETITION AND OTHER INITIATIVES BY COMPETITORS, LEGISLATIVE AND REGULATORY DEVELOPMENTS, WEATHER CONDITIONS (INCLUDING THE SEVERITY AND FREQUENCY OF STORMS, HURRICANES, SNOWFALLS, HAIL AND WINTER CONDITIONS), DRIVING PATTERNS, COURT DECISIONS AND TRENDS IN LITIGATION, INTEREST RATE LEVELS AND OTHER CONDITIONS IN THE FINANCIAL AND SECURITIES MARKETS, UNFORESEEN TECHNOLOGICAL ISSUES ASSOCIATED WITH THE YEAR 2000 COMPLIANCE EFFORTS AND THE EXTENT TO WHICH VENDORS, PUBLIC UTILITIES, GOVERNMENTAL ENTITIES AND OTHER THIRD PARTIES THAT INTERFACE WITH THE COMPANY MAY FAIL TO ACHIEVE YEAR 2000 COMPLIANCE, AND OTHER RISKS DETAILED FROM TIME TO TIME IN THE COMPANY'S SEC REPORTS. THE COMPANY ASSUMES NO OBLIGATION TO UPDATE THE INFORMATION IN THIS ANNUAL REPORT.
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 1998 Annual Report, pages 34 through 47 and pages 52 through 59.