Edgar Filing: 21ST CENTURY INSURANCE GROUP

21st Century Insurance 10-Q 9-30-2006

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-6964

(Exact name of registrant as specified in its charter)

	Delaware		95-1935264
	(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

	6301 Owensmouth Avenue
	Woodland Hills, California		91367
	(Address of principal executive offices)		(Zip Code)

	(818) 704-3700		www.21st.com
	(Registrant’s telephone number, including area code)		(Registrant’s web site)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨

Accelerated filer x

Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

The number of shares outstanding of the issuer’s common stock as of October 23, 2006 was 86,377,135.

TABLE OF CONTENTS

Description		Page Number
PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)	2
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	37
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 6.	Exhibits	38
SIGNATURES		39
EXHIBIT INDEX		40
31.1	Certification of principal executive officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934
31.2	Certification of principal financial officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934
32	Certification Pursuant to 18 U.S.C. Section 1350

Table of Contents

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED BALANCE SHEETS
Unaudited
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	September 30, 2006			December 31, 2005
Assets
Investments available for sale
Fixed maturity securities, at fair value (amortized cost: $1,487,873 and $1,365,948)	$	1,470,385		$	1,354,707
Equity securities, at fair value (cost: $0 and $49,210)		—			47,367
Other long-term investments, equity method		9,443			—
Total investments		1,479,828			1,402,074
Cash and cash equivalents		19,497			68,668
Accrued investment income		17,006			16,585
Premiums receivable		115,513			100,900
Reinsurance receivables and recoverables		6,550			6,539
Prepaid reinsurance premiums		2,141			1,946
Deferred income taxes		42,566			56,209
Deferred policy acquisition costs		67,592			59,939
Leased property under capital leases, net of deferred gain of $1,203 and $1,534 and net of accumulated amortization of $40,853 and $36,995		19,998			22,651
Property and equipment, at cost less accumulated depreciation of $105,780 and $89,595		152,480			145,811
Other assets		40,277			38,907
Total assets	$	1,963,448		$	1,920,229
Liabilities and stockholders’ equity
Unpaid losses and loss adjustment expenses	$	484,258		$	523,835
Unearned premiums		329,719			319,676
Debt		118,853			127,972
Claims checks payable		39,697			42,681
Reinsurance payable		769			643
Other liabilities		92,529			75,450
Total liabilities		1,065,825			1,090,257

Commitments and contingencies

Stockholders’ equity:
Common stock, par value $0.001 per share; 110,000,000 shares authorized; shares issued 86,381,472 and 85,939,889		86			86
Additional paid-in capital		438,618			425,454
Treasury stock; at cost shares: 8,804 and 5,929		(106	)		(84	)
Retained earnings		472,271			414,898
Accumulated other comprehensive loss		(13,246	)		(10,382	)
Total stockholders’ equity		897,623			829,972
Total liabilities and stockholders’ equity	$	1,963,448		$	1,920,229

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Unaudited


	Three Months Ended September 30,					Nine Months Ended September 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	2006		2005			2006			2005
Revenues
Net premiums earned	$	327,325	$	344,102		$	978,661		$	1,017,311
Net investment income		16,897		17,042			51,827			51,085
Other income (loss)		58		(3	)		68			364
Net realized investment gains (losses)		159		(939	)		(878	)		(2,666	)
Total revenues		344,439		360,202			1,029,678			1,066,094
Losses and expenses
Net losses and loss adjustment expenses		222,550		258,105			682,140			757,420
Policy acquisition costs		64,803		60,852			189,022			188,931
Other underwriting expenses		12,715		8,786			34,819			24,908
Other expense		—		—			924			—
Interest and fees expense		1,820		1,988			5,572			6,076
Total losses and expenses		301,888		329,731			912,477			977,335
Income before provision for income taxes		42,551		30,471			117,201			88,759
Provision for income taxes		14,144		9,369			39,155			27,725
Net income	$	28,407	$	21,102		$	78,046		$	61,034

Earnings per share:
Basic	$	0.33	$	0.25		$	0.91		$	0.71
Diluted	$	0.33	$	0.24		$	0.90		$	0.71
Cash dividends declared per share	$	0.08	$	0.04		$	0.24		$	0.12
Weighted-average shares outstanding:
Basic		86,192,395		85,793,904			86,010,994			85,672,993
Additional common shares assumed issued under treasury stock method		262,114		411,695			390,035			264,823
Diluted		86,454,509		86,205,599			86,401,029			85,937,816

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Unaudited
	Common Stock
			$0.001 par value
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	Issued Shares		Amount		Additional Paid-in Capital		Treasury Stock			Retained Earnings			Accumulated Other Comprehensive Loss			Total
Balance - January 1, 2006		85,939,889	$	86	$	425,454	$	(84	)	$	414,898		$	(10,382	)	$	829,972
Comprehensive income (loss)											78,046	⁽¹⁾		(2,864	)⁽²⁾		75,182
Cash dividends declared on common stock											(20,673	)					(20,673	)
Exercise of stock options		325,033				4,250											4,250
Issuance of restricted stock		116,550															—
Forfeiture of 2,875 shares of restricted stock						22		(22	)								—
Stock-based compensation cost						8,752											8,752
Excess tax benefits of stock-based compensation						140											140
Balance - September 30, 2006		86,381,472	$	86	$	438,618	$	(106	)	$	472,271		$	(13,246	)	$	897,623

⁽¹⁾	Net income for the nine months ended September 30, 2006.

⁽²⁾	Net change in accumulated other comprehensive loss follows:

	Nine Months Ended September 30, 2006
Unrealized holding losses arising during the period, net of tax benefit of $1,844	$	(3,423	)
Reclassification adjustment for investment losses included in net income, net of tax benefit of $301		559
Total	$	(2,864	)

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited

AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Nine Months Ended September 30,	2006			2005
Operating activities
Net income	$	78,046		$	61,034
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		20,393			24,502
Net amortization of investment premiums and discounts		7,318			7,205
Stock-based compensation cost		8,752			238
Provision for deferred income taxes		15,185			10,687
Net realized investment losses		878			2,779
Changes in assets and liabilities
Premiums receivable		(14,613	)		(11,166	)
Deferred policy acquisition costs		(7,653	)		(5,001	)
Reinsurance receivables and recoverables		(80	)		1,193
Federal income taxes		(5,540	)		(1,088	)
Other assets		1,531			6,723
Unpaid losses and loss adjustment expenses		(39,577	)		22,072
Unearned premiums		10,043			9,019
Claims checks payable		(2,984	)		1,974
Other liabilities		12,551			(7,802	)
Net cash provided by operating activities		84,250			122,369
Investing activities
Purchases of:
Fixed maturity securities available-for-sale		(228,027	)		(94,020	)
Equity securities available-for-sale		(35,627	)		(239,493	)
Other long-term investments, equity method		(9,123	)		—
Property and equipment		(23,315	)		(32,539	)
Maturities and calls of fixed maturity securitites available-for-sale		23,726			24,461
Sales of:
Fixed maturity securities available-for-sale		73,765			28,943
Equity securities available-for-sale		84,836			233,884
Net cash used in investing activities		(113,765	)		(78,764	)
Financing activities
Repayment of debt		(10,283	)		(9,343	)
Dividends paid (per share: $0.16 and $0.08)		(13,763	)		(6,850	)
Proceeds from the exercise of stock options		4,250			3,155
Excess tax benefit from stock-based compensation		198			—
Excess tax liability from stock-based compensation		(58	)		—
Net cash used in financing activities		(19,656	)		(13,038	)
Net (decrease) increase in cash and cash equivalents		(49,171	)		30,567
Cash and cash equivalents, beginning of period		68,668			34,697
Cash and cash equivalents, end of period	$	19,497		$	65,264

Supplemental information:
Income taxes paid	$	29,580		$	19,281
Interest paid		3,991			4,495

See accompanying Notes to Condensed Consolidated Financial Statements.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

NOTE 1. FINANCIAL STATEMENT PRESENTATION

General

21st Century Insurance Group and subsidiaries (the “Company”) prepared the accompanying unaudited condensed consolidated financial statements in accordance with the rules and regulations of the Securities and Exchange Commission for interim reporting. As permitted under those rules and regulations, certain notes or other information that are normally required by accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted if they substantially duplicate the disclosures contained in the annual audited consolidated financial statements. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

These unaudited condensed consolidated financial statements include all adjustments (including normal, recurring accruals) that are considered necessary for the fair presentation of our financial position and results of operations in accordance with GAAP. Intercompany accounts and transactions have been eliminated in consolidation. Operating results for the nine-month period ended September 30, 2006 are not necessarily indicative of results that may be expected for the remaining interim period or the year as a whole.

Other long-term investments, equity method

The Company started investing in limited partnerships and limited liability corporations during the third quarter of 2006, as further discussed in Note 9 of the Notes to Condensed Consolidated Financial Statements. Since our share of a partnership’s or corporation’s capital is greater than 3%, but less than 50%, we account for these investments on the equity method, and the carrying values of our investments are adjusted to reflect our share of the underlying equity of the partnerships or corporations, as applicable.

Earnings Per Share (“EPS”)

The numerator for the calculation of both basic and diluted EPS is equal to net income reported for that period. The difference between basic and diluted EPS denominators is due to dilutive common stock equivalents (stock options and restricted stock). Basic EPS excludes dilution and reflects net income divided by the weighted-average shares of common stock outstanding during the periods presented. Diluted EPS is based upon the weighted-average shares of common stock and dilutive common stock equivalents outstanding during the periods presented. Common stock equivalents arising from dilutive stock options and restricted common stock were computed using the treasury stock method.

The following shares attributable to outstanding stock options and restricted shares were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive (i.e., their inclusion under the treasury stock method would have increased EPS):

Three Months Ended

September 30,

Nine Months Ended

September 30,

2006

2005

2006

2005

Common stock equivalents excluded from calculation of diluted EPS

6,149,111

4,501,547

5,625,501

6,395,088

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Stock-Based Compensation

Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees, and related Interpretations, as permitted by Statement of Financial Accounting Standards No. (“FAS”) 123, Accounting for Stock-Based Compensation. Under the intrinsic-value method prescribed by APB 25, compensation cost for stock options was measured at the date of grant as the excess, if any, of the quoted market price of the Company’s stock over the exercise price of the options. All employee stock options were granted at the closing market price on the grant date. Accordingly, no compensation cost was recognized for fixed stock option grants in prior periods; however, stock-based compensation measured in accordance with the fair-value based method was included as a pro forma disclosure in the condensed consolidated financial statement footnotes.

Effective January 1, 2006, the Company adopted FAS 123 (revised 2004), Share-Based Payment (“FAS 123R”), which requires all stock-based payments to employees, including grants of employee stock options, to be recognized in the statements of operations based on their fair values. Determining the fair value of share-based awards at the grant date requires judgment in estimating the volatility and dividends over the expected term that the stock options will be outstanding prior to exercise. Judgment is also required in estimating the amount of stock-based awards expected to be forfeited prior to vesting. If actual forfeitures differ significantly from our estimates, stock-based compensation expense could be materially impacted.

In accordance with FAS 123R, the Company began recognizing the cost of all employee stock options on a straight-line basis over their respective vesting periods, net of estimated forfeitures, using the modified-prospective transition method. Under this transition method, results for prior periods have not been restated and 2006 results include:

Stock-based compensation cost related to stock options granted on or prior to, but not vested as of December 31, 2005, based on the grant date fair value originally estimated for the pro forma disclosures in accordance with the original provisions of FAS 123; and

All stock-based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of FAS 123R.

FAS 123R also prescribes the recognition of expense using the non-substantive vesting period approach for grants made after December 31, 2005. This expense attribution method requires recognition of compensation expense from the date of grant to the earlier of the vesting date or the date retirement eligibility is achieved for awards with retirement eligibility provisions. The use of the non-substantive vesting period approach will not affect the overall amount of compensation expense recognized, but will accelerate the recognition of expense for grants made since January 1, 2006. However, the Company will continue to follow the nominal vesting approach (i.e., recognize expense from the grant date to the earlier of the actual date of retirement or the vesting date) for the remaining portion of unvested awards that were granted prior to January 1, 2006.

Generally, stock-based awards are forfeited when employees terminate prior to the vesting date, and any compensation cost previously recognized with respect to such unvested stock awards is reversed in the period of forfeiture. Upon restricted share grant or share option exercise, the Company issues new shares, unless the Company elects to use available treasury shares. The Company records forfeitures of restricted stock as treasury share repurchases.

Prior to the adoption of FAS 123R, the Company previously presented all benefits of tax deductions resulting from the exercise of share-based compensation as operating cash flows in the Condensed Consolidated Statements of Cash Flows. FAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Recent Accounting Pronouncements

In September 2006, Financial Accounting Standards Board (“FASB”) issued FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an Amendment of FASB Statements No. 87, 88, 106 and 132(R) ("FAS 158"). FAS 158 requires an employer that is a business entity and sponsors one or more single employer benefit plans to (1) recognize the funded status of the benefit in its statement of financial position, (2) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period, but are not recognized as components of net periodic benefit cost, (3) measure defined benefit plan assets and obligations as of the date of the employer's fiscal year end statement of financial position and (4) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs on credits, and transition asset or obligations. Under FAS 158, the Company will be required to recognize the funded status of its defined benefit plans and to provide the required disclosures as of December 31, 2006. However, had we been required to adopt the provisions of FAS 158 as of September 30, 2006, the estimated cumulative impact on the Company’s condensed consolidated financial statements as a result of the adoption of this standard would have resulted in an approximate $17 million net after-tax reduction in equity with a corresponding reduction of $7.8 million in total assets, and an increase of $9.3 million in total liabilities. Because our net pension liabilities are dependent upon future events and circumstances, the impact at the time of adoption of FAS 158 may differ from these amounts. Adoption of FAS 158 will not have any effect on the Company's compliance with its financial covenants.

In September 2006, the FASB issued FAS 157, Fair Value Measurements (“FAS 157”). FAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted. The Company has not yet determined the effect, if any, that the implementation of FAS 157 will have on our results of operations or financial condition.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ending December 31, 2006. We do not expect SAB 108 to have a material impact on our consolidated financial statements.

FASB Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an Interpretation of FAS No. 109 (“FIN 48”), becomes effective January 1, 2007. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FAS 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company is currently assessing the effect of implementing FIN 48.

Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (“SOP 05-1”), becomes effective January 1, 2007. SOP 05-1 provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverage that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The Company is currently assessing the effect of implementing this guidance.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

NOTE 2. STOCK-BASED COMPENSATION

2006 Stock-Based Compensation Summary

The effect of the adoption of FAS 123R on the condensed consolidated statements of operations is as follows:

	Three Months Ended September 30, 2006								Nine Months Ended September 30, 2006
AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA	Without FAS 123R			FAS 123R Impact			With FAS 123R		Without FAS 123R			FAS 123R Impact			With FAS 123R
Total revenues	$	344,439		$	—		$	344,439	$	1,029,678		$	—		$	1,029,678
Losses and expenses
Net losses and loss adjustment expenses		221,767			783			222,550		679,464			2,676			682,140
Policy acquisition costs		63,893			910			64,803		187,177			1,845			189,022
Other underwriting expenses		12,184			531			12,715		32,019			2,800			34,819
Other expense		—			—			—		924			—			924
Interest and fees expense		1,820			—			1,820		5,572			—			5,572
Total losses and expenses		299,664			2,224			301,888		905,156			7,321			912,477
Income before provision for income taxes		44,775			(2,224	)		42,551		124,522			(7,321	)		117,201
Provision for income taxes		14,876			(732	)		14,144		40,932			(1,777	)		39,155
Net income	$	29,899	¹	$	(1,492	)	$	28,407	$	83,590	¹	$	(5,544	)	$	78,046

Basic earnings per share ²	$	0.35		$	(0.02	)	$	0.33	$	0.97		$	(0.06	)	$	0.91
Diluted earnings per share ²	$	0.35		$	(0.02	)	$	0.33	$	0.97		$	(0.06	)	$	0.90

The nine months ended September 30, 2006 results include $0.7 million of accelerated costs incurred during the first quarter to recognize the effect of retirement eligibility in accordance with the non-substantive vesting period approach and $1.4 million of actual vesting in accordance with an executive retention agreement. As compensation costs for certain employees are included in deferred policy acquisition costs, pre-tax compensation cost related to stock-based compensation of $0.8 million was deferred, for the nine months ended September 30, 2006. The remaining unrecognized compensation cost related to unvested awards as of September 30, 2006, was $11.3 million and the weighted-average period over which this cost will be recognized is 1.9 years. Results for the nine-month period ended September 30, 2006 included $140 thousand of excess tax benefits as a financing cash inflow and an increase of additional paid-in capital.

2005 Stock-Based Compensation Pro Forma Summary

Had compensation cost for the Company’s stock-based compensation plans been determined in the prior year based on the fair-value based method for all awards, net income would have been reduced by $1.2 million and $3.7 million for the three and nine months ended September 30, 2005, respectively. The Company followed the nominal vesting period approach, which recognizes compensation cost over the vesting period unless the employee retired before the end of the vesting period at which time the Company recognizes any remaining unrecognized compensation cost at the date of retirement. The Company did not determine the amount of stock-based compensation cost that would have been deferred as policy acquisition costs in its pro forma footnotes under FAS 123.

¹	Includes $0.2 million and $0.7 million stock-based compensation related to restricted shares and $0.1 million and $0.2 million associated tax, as the previous accounting under APB 25 was consistent with that of FAS 123, for the three months and nine months ended September 30, 2006, respectively.

²	Earnings per share figures may not total due to rounding.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

The pro forma net income and earnings per share amounts follow:

AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005
Net income, as reported	$	21,102		$	61,034
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		65			155
Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards, net of related tax effects		(1,278	)		(3,844	)
Net income, pro forma	$	19,889		$	57,345
Basic earnings per share:
As reported	$	0.25		$	0.71
Pro forma	$	0.23		$	0.67
Diluted earnings per share:
As reported	$	0.24		$	0.71
Pro forma	$	0.23		$	0.67

Stock Option Plans

The stockholders approved the 2004 Stock Option Plan (the “2004 Plan”) at the Annual Meeting of Shareholders on May 26, 2004. The 2004 Plan supersedes the 1995 Stock Option Plan (the “1995 Plan”), which remains in effect only as to outstanding awards under the 1995 Plan. The 2004 Plan authorizes a Committee of the Board of Directors to grant stock options for up to 4,000,000 shares to eligible employees and nonemployee directors, subject to the terms of the 2004 Plan. Additionally, under the 2004 Plan, the Committee may grant stock options that were subject to outstanding awards under the 1995 Plan to the extent such awards expire, are terminated, are canceled, or are forfeited for any reason without shares being issued.

Options granted to employees generally have ten-year terms and vest ratably over three years. Nonemployee director options vest over one year, provided that the nonemployee director is in the service of the Company during that time. Options granted to nonemployee directors expire one year after a nonemployee director ceases service with the Company, or ten years from the date of grant, whichever is sooner.

Issuable and Issued Securities

A summary of securities issuable and issued for the Company’s stock option plans at September 30, 2006, follows:

AMOUNTS IN THOUSANDS	1995 Stock Option Plan			2004 Stock Option Plan
Total number of securities authorized		10,000			4,000
Number of securities issued		(1,001	)		(210	)
Number of securities issuable upon the exercise of all outstanding options		(6,683	)		(3,545	)
Number of securities forfeited		(2,601	)		(151	)
Number of forfeited securities returned to plan		2,601			151
Unused options assumed by 2004 Stock Option Plan		(2,316	)		2,316
Number of securities available for future grants under each plan		—			2,561

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Current Activity

A summary of the Company’s stock option activity for the nine months ended September 30, 2006, follows:

AMOUNTS IN THOUSANDS, EXCEPT PRICE DATA	Number of Options			Weighted- Average Exercise Price
Options outstanding December 31, 2005		8,869		$	16.22
Granted in 2006		2,012			16.54
Exercised in 2006		(325	)		13.08
Forfeited in 2006		(88	)		14.38
Canceled in 2006		(240	)		19.49
Options outstanding September 30, 2006		10,228			16.32

A summary of the Company’s stock option activity and related information for the nine months ended September 30, follows:

AMOUNTS IN THOUSANDS	2006		2005
Fair value of stock options granted	$	10,040	$	8,186
Intrinsic value of options exercised		566		590
Grant date fair value of options vested		7,428		5,288
Proceeds from exercise of stock options		4,250		3,155
Tax benefit realized as a result of stock option exercises		198		247

Black-Scholes Fair Values

The weighted-average fair value per option granted during the nine months ended September 30, 2006 and 2005, was $4.99 and $4.75, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

Nine Months Ended September 30,	2006			2005 Pro Forma
Risk-free interest rate:
Minimum		4.5	%		3.7	%
Maximum		5.0	%		4.3	%
Dividend yield		1.9	%		1.1	%
Volatility factor of the expected market price of the Company’s common stock:
Minimum		0.29			0.29
Maximum		0.29			0.32
Expected option term		6 years			6 years

The expected term for options granted during the nine months ended September 30, 2006, was calculated using the simplified method in accordance with Staff Accounting Bulletin No. 107, Shared-Based Payment. The expected volatility of employee stock options was based on the historical volatility of key competitors in the property and casualty insurance industry (based on six years of closing stock prices). The Company believes that the use of historical competitor volatility better reflects current market expectations of the Company’s stock price volatility. The Company’s own historical stock price volatility is not representative of expected volatility due to significant prior year events, such as the effects of the 1994 Northridge earthquake and California Senate Bill 1899 (“SB 1899”), which would not be expected to significantly impact results in the future. The annual risk-free interest rate is based on a traded zero-coupon U.S. Treasury bond on the grant date with a term equal to the option’s expected term.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Outstanding Options

The following table summarizes information about stock options outstanding at September 30, 2006 (amounts in thousands, except price data):

	Outstanding								Exercisable
Range of Exercise Prices	Number of Options		Weighted- Average Remaining Contractual Term		Weighted- Average Exercise Price		Aggregate Intrinsic Value		Number of Options		Weighted- Average Remaining Contractual Term		Weighted- Average Exercise Price		Aggregate Intrinsic Value
$ 11.68 - 13.00		1,240		6.5 Years	$	11.73	$	3,991		1,235		6.5 Years	$	11.73	$	3,980
13.01 - 15.00		2,839		7.5 Years		14.28		1,894		1,409		7.5 Years		14.31		907
15.01 - 17.00		3,349		7.8 Years		16.38		—		1,489		6.1 Years		16.18		—
17.01 - 19.00		1,776		4.0 Years		18.05		—		1,776		4.0 Years		18.05		—
19.01 - 22.00		131		1.5 Years		19.65		—		131		1.5 Years		19.65		—
22.01 - 29.25		893		1.9 Years		24.99		—		893		1.9 Years		24.99		—
$ 11.68 - 29.25		10,228		6.3 Years		16.32	$	5,885		6,933		5.3 Years		16.69	$	4,887

The aggregate intrinsic value in the preceding table represents the pre-tax amount that would have been received by the option holders had all option holders exercised their options as of September 30, 2006. Vested and expected-to-vest options as of September 30, 2006, included in the table above, totaled 10,147,276 with a weighted-average exercise price of $16.33, a weighted-average contractual life of 6.2 years and an aggregate intrinsic value of $5.9 million.

Restricted Shares Plan

The Restricted Shares Plan, which was approved by the Company’s stockholders, currently authorizes grants of up to 1,421,920 shares of common stock to be made available to key employees. In general, one third of the shares granted vest on the anniversary date of each of the three years following the year of grant. The Company may also grant vested shares that contain sale restrictions. The Company becomes entitled to an income tax deduction in an amount equal to the taxable income reported by the holders upon vesting of the restricted shares.

Total compensation expense relating to the Restricted Shares Plan was $0.2 million and $0.7 million for the three and nine months ended September 30, 2006, respectively, and $0.1 million and $0.2 million for the three and nine months ended September 30, 2005. Unrecognized compensation cost in connection with restricted stock grants totaled $1.9 million at September 30, 2006. The cost is expected to be recognized over a weighted-average period of 2.2 years.

Restricted Shares Issuable and Issued

A summary of securities issuable and issued for the Company’s Restricted Shares Plan at September 30, 2006, follows:

AMOUNTS IN THOUSANDS	Restricted Shares Plan
Total number of securities authorized		1,422
Number of securities issued		(1,260	)
Number of forfeited securities returned to plan		164
Number of securities remaining available for future grants under the plan		326

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Current Restricted Shares Activity

The following table summarizes activity under the Restricted Shares Plan for the nine months ended September 30, 2006:

AMOUNTS IN THOUSANDS, EXCEPT PRICE DATA	Number of Shares			Weighted-Average Market Price Per Share on Date of Grant
Non-vested, December 31, 2005		87		$	14.08
Vested in 2006		(33	)		14.38
Granted in 2006		117			15.83
Forfeited in 2006		(3	)		15.65
Non-vested, September 30, 2006		168			15.22

A summary of the Restricted Shares Plan activity and related information follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
AMOUNTS IN THOUSANDS	2006		2005		2006		2005
Fair value of restricted stock awards granted	$	121	$	—	$	1,845	$	1,267
Fair value of restricted stock awards vested		—		29		475		212

SHARE DATA
Weighted-average fair value per share for restricted shares granted		$	15.11		$	—		$	15.83		$	14.09

NOTE 3. HOMEOWNER AND EARTHQUAKE LINES IN RUNOFF

SB 1899, effective from January 1, 2001 to December 31, 2001, allowed the re-opening of previously closed earthquake claims arising out of the 1994 Northridge earthquake. More than ninety-nine percent of the claims submitted and litigation brought against the Company as a result of SB 1899 have been resolved. The Company’s total reserves for losses and loss adjustment expenses (“LAE”) for SB 1899 claims as of September 30, 2006 and December 31, 2005, were less than $0.1 million and $0.5 million, respectively.

Losses and LAE incurred for the homeowner and earthquake lines in runoff were $0.2 million and $0.5 million for the three and nine months ended September 30, 2006, compared to $0.6 million and $1.0 million for the same periods in 2005, respectively.

NOTE 4. COMMITMENTS AND CONTINGENCIES

Legal Proceedings

In the normal course of business, the Company is named as a defendant in lawsuits related to its insurance operations and business practices. Many suits seek unspecified extra-contractual and punitive damages as well as contractual damages under the Company’s insurance policies in excess of the Company’s estimates of its obligations under such policies. The Company cannot estimate the amount or range of loss that could result from an unfavorable outcome on these suits and it denies liability for any such alleged damages. The Company has not established reserves for potential extra-contractual or punitive damages, or for contractual damages in excess of estimates the Company believes are correct and reasonable under its insurance policies. Nevertheless, extra-contractual and punitive damages, if assessed against the Company, could be material in an individual case or in the aggregate. The Company may choose to settle litigated cases for amounts in excess of its own estimate of contractual damages to avoid the expense and risk of litigation. Other than the possibility of the contingencies discussed below, the Company does not believe the ultimate outcome of these matters will be material to its results of operations, financial condition or cash flows.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

In addition, the Company denies liability and has not established a reserve for the matters discussed below. A range of potential losses in the event of a negative outcome is discussed where known.

Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los Angeles Superior Court and Axen v. 21st Century Insurance Company was filed on April 14, 2004 in Alameda County Superior Court. Both complaints seek injunctive and unspecified restitutionary relief against the Company under Business and Professions Code (“B&P”) Sec. 17200 for alleged unfair business practices in violation of California Insurance Code Sec. 1861.02(c) relating to Company rating practices. The court in the Poss case granted the Company’s motion to dismiss the complaint, based on California’s Proposition 64, but allowed the addition of a second plaintiff, Leacy. Discovery has been stayed in both cases and, because these matters are in the pleading stages, and no discovery has taken place, no estimate of the range of potential losses in the event of a negative outcome can be made at this time.

Cecelia Encarnacion, individually and as the Guardian Ad Litem for Nubia Cecelia Gonzalez, a Minor, Hilda Cecelia Gonzalez, a Minor, and Ramon Aguilera v. 20th Century Insurance was filed on July 3, 1997, in Los Angeles Superior Court. Plaintiffs allege bad faith, emotional distress, and estoppel involving the Company’s (the Company was formerly named 20th Century Insurance) handling of a 1994 homeowner’s claim. On March 1, 1994, Ramon Aguilera, a homeowner policyholder, shot and killed Mr. Gonzalez (the minor children’s father) and was later sued by Ms. Encarnacion for wrongful death. On August 30, 1996, judgment was entered against Ramon Aguilera for $5.6 million. The Company paid for Aguilera’s defense costs through the civil trial; however, the homeowner’s policy did not provide indemnity coverage for the incident, and the Company refused to pay the judgment. After the trial, Aguilera assigned a portion of his action against the Company to Encarnacion and the minor children. Aguilera and the Encarnacion family then sued the Company alleging that the Company had promised to pay its bodily injury policy limit if Aguilera pled guilty to involuntary manslaughter. In August 2003, the trial court held a bench trial on the limited issues of promissory and equitable estoppel, and policy forfeiture. On September 26, 2003, the trial court issued a ruling that the Company cannot invoke any policy exclusions as a defense to coverage. On May 14, 2004, the court granted the Encarnacion plaintiffs’ motion for summary adjudication, ordering that the Company must pay the full amount of the underlying judgment of $5.6 million, plus interest, for a total of $10.5 million. The Company disagrees with this ruling as it appears inconsistent with the court’s simultaneous ruling denying the Company’s motion for summary judgment on grounds that there are triable issues of material fact as to whether plaintiffs are precluded from recovering damages as a consequence of Aguilera’s inequitable conduct. The Company also believes that the court’s decision was not supported by the evidence in the case, demonstrating that no promise to settle was ever made. The Company has appealed the judgment as to the Encarnacions. The trial as to Aguilera concluded on December 9, 2005, on his claims for bad faith, emotional distress, punitive damages and attorney fees. A jury found he sustained no damages as to these claims. The Company’s exposure in this case includes the aforementioned $10.5 million judgment plus post-judgment interest, which currently totals $2.1 million. This matter is now subject to three separate appeals by the parties. The Company moved to consolidate the three appeals on October 18, 2006.

Insurance Company cases (Ramona Goldenburg) was originally filed as Bryan Speck, individually, and on behalf of others similarly situated v. 21st Century Insurance Company, 21st Century Casualty Company, and 21st Century Insurance Group. The original action was filed on June 20, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contended that the Company uses “biased” software in determining the value of total-loss automobiles. Specifically, Plaintiff alleged that database providers use improper methodology to establish comparable auto values and populate their databases with biased figures and that the Company and other carriers allegedly subscribe to the programs to unfairly reduce claims costs. This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. A court-ordered appraisal of Speck’s vehicle was favorable to the Company and Ramona Goldenberg was substituted as a Plaintiff, replacing Speck, and a new appraisal was ordered. On October 13, 2006, Plaintiff’s counsel offered to dismiss this case, with prejudice, in exchange for the Company waiving its costs. The Company has accepted Plaintiff’s counsel’s offer to dismiss the matter and will support a motion, containing the agreed terms, for the court to dismiss the action.

Thomas Theis, on his own behalf and on behalf of all others similarly situated v. 21st Century Insurance Company was filed on June 17, 2002, in Los Angeles Superior Court. Plaintiff seeks California class action certification, injunctive relief, and unspecified actual and punitive damages. The complaint contends that after insureds receive medical treatment, the Company used a medical-review program to adjust expenses to reasonable and necessary amounts for a given geographic area and the adjusted amount is “predetermined” and “biased.” This case is consolidated with similar actions against other insurers for discovery and pre-trial motions. Depositions have recently been taken and the Company intends to vigorously defend the suit. This matter is in the discovery stage of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time. A motion for certification of a class in this action is currently pending.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Silvia Quintana, on her own behalf and on behalf of all others similarly situated v. 21st Century Insurance Company was filed on November 16, 2005. This purported class action, filed in San Diego, names the Company in four causes of action: 1) violation of B&P Section 17200, 2) conversion, 3) unjust enrichment and, 4) declaratory relief. Silvia Quintana alleges that the Company’s demand for reimbursement of the medical payments it made to her pursuant to her insurance contract violates the “made-whole rule.” The Company anticipates that if the matter survives the initial pleading stage, it will be consolidated, for discovery and pre-trial motions, with actions alleging similar facts against other insurers. This matter is in the pleading stage and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time. In July 2006, the trial court denied the Company’s demurrer and motion to strike and the Company has filed a writ to the Court of Appeal for review of this decision.

Ronald A.Katz Technology Licensing, L.P. vs. American International Group, Inc. et al was filed on September 1, 2006, in the United States District Court for the District of Delaware. The defendants include American International Group, Inc., its subsidiaries and affiliates, including 21st Century Insurance Group, 21st Century Insurance Company, and 21st Century Casualty Company. The complaint alleges infringement of various patents relating to automated call processing applications. The matter is in the initial pleading stage and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.

NOTE 5. ACCUMULATED OTHER COMPREHENSIVE LOSS

Accumulated other comprehensive loss is a component of stockholders’ equity and includes all after-tax changes in unrealized gains and losses and changes in minimum pension liability in excess of unamortized prior service cost.

A summary of accumulated other comprehensive loss follows:

	September 30, 2006			December 31, 2005
Net unrealized losses on available-for-sale investments, net of deferred income taxes of $6,120 and $4,579	$	(11,368	)	$	(8,504	)
Minimum pension liability in excess of unamortized prior service cost, net of deferred income taxes of $1,011 and $1,011		(1,878	)		(1,878	)
Total accumulated other comprehensive loss	$	(13,246	)	$	(10,382	)

NOTE 6. EMPLOYEE BENEFIT PLANS

The Company has a qualified defined benefit pension plan, which covers essentially all employees who have completed at least one year of service. The pension benefits under the qualified plan are based on employees’ compensation during all years of service. The Company’s funding policy for the qualified plan is to make annual contributions as required by applicable regulations; employees may not make contributions to this plan. For certain key employees designated by the Board of Directors, the Company sponsors an unfunded non-qualified supplemental executive retirement plan. The supplemental plan benefits are based on years of service and compensation during the three highest of the last ten years of employment prior to retirement and are reduced by the benefit payable from the pension plan and 50% of the social security benefit.

Components of Net Periodic Cost

Net pension costs for all plans were as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Service cost	$	1,782		$	1,620		$	5,347		$	5,145
Interest cost		1,935			1,763			5,804			5,473
Expected return on plan assets		(2,110	)		(1,827	)		(6,330	)		(5,487	)
Amortization of prior service cost		36			78			109			131
Amortization of net loss		653			428			1,959			1,442
Total	$	2,296		$	2,062		$	6,889		$	6,704

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

Pension Plan Contributions

The Company previously disclosed in its consolidated financial statements for the year ended December 31, 2005, that it did not expect to contribute to its qualified defined benefit pension plan in 2006. As of September 30, 2006, no contributions have been made. However, the amount and timing of future contributions to the Company’s qualified defined benefit pension plan depends on a number of assumptions including statutory funding requirements, the market performance of the plan’s assets and future changes in interest rates that affect the actuarial measurement of the plan’s obligations.

Contributions to our non-qualified defined benefit pension plan generally are limited to amounts needed to make benefit payments to retirees, which are expected to total approximately $1.1 million in 2006.

Defined Contribution Plans

The Company sponsors a qualified 401(k) contributory savings and security plan for eligible employees and officers. The Company provides matching contributions equal to 75% of the lesser of 6% of an employee’s eligible compensation or the amount contributed by the employee up to the maximum allowable under Internal Revenue Service regulations. The plan offers a variety of investments among which employees exercise complete discretion as to choice and investment duration. The Company also sponsors a 401(k) supplemental plan to provide specified benefits to a select group of management and highly compensated employees. The charges to expenses equal to Company contributions to both plans were $1.5 million and $4.6 million for the three and nine months ended September 30, 2006, respectively, and $1.4 million and $3.7 million for the same periods in 2005, respectively.

NOTE 7. SEGMENT INFORMATION

The Company’s “Personal Auto Lines” reportable segment primarily markets and underwrites personal auto, motorcycle and personal umbrella insurance. The Company’s “Homeowner and Earthquake Lines in Runoff” reportable segment manages the runoff of the Company’s homeowner and earthquake programs. The Company has not written any earthquake coverage since 1994 and ceased writing voluntary homeowner policies in 2002.

Insurers offering homeowner insurance in California are required to participate in the California FAIR Plan (“FAIR Plan”). The FAIR Plan is a state administered pool of difficult to insure homeowners’ exposures. Each participating insurer is allocated a percentage of the total premiums written and losses and LAE incurred by the pool according to its share of total homeowner direct premiums written in the state. Participation in the current year FAIR Plan operations is based on premiums written from two years prior. Since the Company ceased writing homeowners business in 2002, the Company no longer receives assignments for plan years beyond 2004, but continues to participate in prior plan year activity, which is in runoff.

The Company evaluates segment performance based on pre-tax underwriting profit or loss. The Company does not allocate assets, net investment income, net realized investment gains or losses, other revenues, nonrecurring items, interest and fees expense, or income taxes to operating segments. The accounting policies of the reportable segments are the same as those described in Note 2 of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2005. All revenues are generated from external customers and the Company does not rely on any major customer.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

The following table presents net premiums earned, depreciation and amortization expense, and segment profit (loss) for the Company’s segments.

	Personal Auto Lines		Homeowner and Earthquake Lines in Runoff ³			Total
Three Months Ended September 30, 2006
Net premiums earned	$	327,325	$	—		$	327,325
Depreciation and amortization expense		7,088		1			7,089
Segment profit (loss)		27,447		(190	)		27,257

Three Months Ended September 30, 2005
Net premiums earned	$	344,099	$	3		$	344,102
Depreciation and amortization expense		9,504		3			9,507
Segment profit (loss)		16,972		(613	)		16,359

Nine Months Ended September 30, 2006
Net premiums earned	$	978,661	$	—		$	978,661
Depreciation and amortization expense		20,389		4			20,393
Segment profit (loss)		73,213		(533	)		72,680

Nine Months Ended September 30, 2005
Net premiums earned	$	1,017,302	$	9		$	1,017,311
Depreciation and amortization expense		24,495		7			24,502
Segment profit (loss)		47,035		(983	)		46,052

The following table reconciles segment profit to consolidated income before provision for income taxes:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Segment profit	$	27,257		$	16,359		$	72,680		$	46,052
Net investment income		16,897			17,042			51,827			51,085
Other income		58			(3	)		68			364
Net realized investment gains (losses)		159			(939	)		(878	)		(2,666	)
Other expense		—			—			(924	)		—
Interest and fees expense		(1,820	)		(1,988	)		(5,572	)		(6,076	)
Income before provision for income taxes	$	42,551		$	30,471		$	117,201		$	88,759

³	2005 revenue for the homeowner and earthquake lines in runoff segment represents premium earned as a result of the Company’s participation in the California FAIR Plan.

Table of Contents

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Unaudited

TABULAR DOLLAR AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA

September 30, 2006

NOTE 8. VARIABLE INTEREST ENTITIES

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities - an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46”), and amended it in December 2003. An entity is subject to the consolidation rules of FIN 46 and is referred to as a variable interest entity (“VIE”) if it lacks sufficient equity to finance its activities without additional financial support from other parties or if its equity holders lack adequate decision making ability based on criteria set forth in the interpretation. FIN 46 also requires disclosures about VIEs that a company is not required to consolidate, but in which a company has a significant variable interest.

The Company has decided to purchase investments that provide housing and other services to economically disadvantaged communities. To that end, the Company is a voluntary member, along with other participating insurance organizations, of Impact Community Capital, LLC (“Impact”). Impact’s charter is to facilitate loans and other investments in such communities.

The VIE structure provides a wider range of investment options through which insurance companies and other institutional investors can address the investment needs of these communities. The Company’s maximum participation in Impact C.I.L., LLC (“Impact C.I.L.”), a subsidiary of Impact and a VIE, is for up to 11.1% ($24.0 million) of $216.0 million of the entity’s funding activities. These commitments consist of a $4.8 million minimum investment and a $19.2 million guarantee of a warehouse lending facility. Potential losses are limited to the Company’s participation as well as associated operating fees. The Company’s pro rata share of these advances to Impact C.I.L., which in turn makes housing investments in economically disadvantaged communities, was approximately 11.1%, or $4.9 million and $5.0 million, as of September 30, 2006 and December 31, 2005, respectively. The revolving member loan and the warehouse financing agreement do not significantly impact the Company’s liquidity or capital.

The Company is not the primary beneficiary of any of the VIEs as the Company has voting rights, beneficiary rights, obligations, and ownership in proportion to each of its Impact related investments.

In addition to the above, the Company held $8.5 million and $6.2 million in other Impact related fixed-income investments as of September 30, 2006 and December 31, 2005, respectively. The Company also held $0.3 million in other Impact related private equity investments reclassified as other long-term investments as of September 30, 2006. Total Impact related investment income was $0.2 million and $0.7 million for the three and nine months ended September 30, 2006, respectively, and $0.1 million and $0.5 million for the same periods in 2005, respectively.

The Company does not have any other material VIEs that it needs, or will need, to consolidate or disclose.

NOTE 9. TRANSACTIONS WITH RELATED PARTIES

In June 2006, the Company executed a $35 million funding commitment for a private equity investment program, which is managed by AIG Global Investment Corp. (“AIGGIC”), which provides investment management and investment accounting services to the Company. In the event that the Company does not respond to a capital call during the investment term, the General Partner of the fund (“GP”) may apply the following default provisions: withhold 50% of distributions due to the Company at the time of the default and 50% of future distributions due to the Company; hold the Company liable for fund expenses above and beyond investments made by the Company (with the right of offset); terminate the Company’s Limited Partner status and not allow it any further investments; or charge interest on the defaulted capital commitment amount and fees at LIBOR + 4% (with the right of offset). However, the GP may choose not to designate the Company a “defaulting limited partner” and waive the default provisions. The investment term ends after the underlying investments are liquidated, but in no event is longer than 10 years. Multiple investments are expected to be purchased and liquidated over the investment term. The Company funded $9.1 million of the commitment during the third quarter in 2006.

Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

General

21st Century Insurance Group is an insurance holding company registered on the New York Stock Exchange. For convenience, the terms “Company”, “21st”, “we”, “us” or “our” are used to refer collectively to the parent company and its subsidiaries. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying condensed consolidated financial statements.

Founded in 1958, we are a direct-to-consumer provider of personal auto insurance. With $1.4 billion of revenue in 2005, we insure over 1.5 million vehicles in Arizona, California, Florida, Georgia, Illinois, Indiana, Nevada, New Jersey, Ohio, Oregon, Pennsylvania, Texas and Washington. We provide superior policy features and customer service at a competitive price. Customers can receive a quote, purchase a policy, service their policy, or report a claim at www.21st.com or over the phone with our licensed insurance professionals at 1-800-211-SAVE. Service is offered in English and Spanish, both over the phone and on the web, 24 hours a day, 365 days a year. Our insurance subsidiaries, 21st Century Insurance Company, 21st Century Casualty Company, and 21st Century Insurance Company of the Southwest (“21st of the Southwest”), are rated A+ by A.M. Best, Fitch Ratings and Standard & Poor’s. The Company’s A+ rating was affirmed by A.M. Best on June 13, 2006.

Our long-term financial goals include achieving a 96% or lower combined ratio, 15% annual growth in premiums written, 15% return on stockholders’ equity, and strong financial ratings.

National Expansion

The Company is implementing a multi-year strategy for national expansion and has previously announced plans to operate in additional states during the fourth quarter of 2006. The entry into New Jersey in October 2006 is the latest step of this strategy. 21st entered the Midwest in 2004, Texas in 2005, and three Eastern states - Florida, Georgia and Pennsylvania - during the second quarter of 2006. During the first 10 months of 2006, the Company has increased the percentage of the U.S. personal auto market in which it operates from 34 percent to 53 percent. Growth in direct premiums written in non-California markets in the third quarter of 2006 was 79.6% and we wrote 12.3% of the third quarter’s direct premium outside of California, versus 6.6% for the same period in 2005. Implementation of our growth strategy could be affected by a number of factors beyond our control, such as increased competition, judicial, regulatory, or legislative developments, general economic conditions or increased operating costs, and we cannot assure you that we will be able to maintain previously announced timetables. The ultimate benefits of the national expansion should include economies of scale, lower unit marketing costs due to the cost efficiency of buying advertising on a national basis, less dependency on any single market and the operating flexibility to focus resources on attractive markets and deemphasize less attractive markets.

Highlights

Financial highlights for the third quarters ended September 30, 2006 and 2005:

Total direct premiums written decreased 3.4% to $337.2 million in 2006, from $349.1 million for same period in 2005.

California direct premiums written decreased 9.3% to $295.8 million in 2006, compared to $326.0 million for the same period in 2005.

Non-California direct premiums written increased 79.6% to $41.4 million in 2006, compared to $23.1 million for the same period in 2005.

2006 consolidated combined ratio was 91.7%, versus 95.2% for the third quarter of 2005. 2006 was favorably impacted by 4.4 points of prior accident year loss and loss adjustment expenses (“LAE”) reserve development in 2006, while 2005 was favorably impacted by 0.3 points of prior accident year development.

Financial highlights for the nine months ended September 30, 2006 and 2005:

Total direct premiums written decreased 3.6% to $992.6 million in 2006, from $1,029.9 million for the same period in 2005.

California direct premiums written decreased 7.5% to $895.0 million in 2006, compared to $967.8 million for the same period in 2005.

Non-California direct premiums written increased 57.2% to $97.6 million in 2006, compared to $62.1 million for the same period in 2005.

2006 consolidated combined ratio was 92.6%, versus 95.5% for the same period in 2005. 2006 was favorably impacted by 4.0 points of prior accident year loss and LAE reserve development in 2006, while 2005 was favorably impacted by 2.0 points of prior accident year development.

Table of Contents

For the three months and nine months ended September 30, 2006, 21st’s insurance subsidiaries achieved underwriting profitability, but total direct premiums written declined. In recent quarters, the California market, which represented 87.7% of our total direct premiums written during the third quarter, has seen stable to declining rates from competitors and a reduced level of shopping behavior by consumers. Both of these factors reduced our opportunities for profitable growth in this state.

In July 2006, the California Department of Insurance (the “CDI”) obtained approval for changes to regulations (the “Auto Rating Factor Regulations”) relating to automobile insurance rating factors, particularly concerning territorial rating. Because the new Auto Rating Factor Regulations require every personal auto insurance company operating in California to make a class plan and rate filing in the third quarter of 2006, competitive rate levels may change and consumer shopping behavior may increase in the future. As of this date, the Company has filed for an overall rate decrease in California of approximately 5% of premium. Most of the Company’s main competitors have also filed for overall rate decreases of varying amounts, while others have not substantially changed overall rate levels while attempting to comply with the new regulations. It is not possible at this time to predict the ultimate timing or impact of these changes, which could have either a materially favorable or materially adverse impact on the Company. All rate changes and class plan filings must be approved by the California Department of Insurance. See further discussion in Part II - Item 1A. Risk Factors.

Also in July 2006, the CDI proposed new amended rate approval regulations (the “Rate Approval Regulations”), affecting personal auto, homeowners and most lines of commercial property and casualty insurance written in California. In October 2006, these proposed regulations were further amended. If approved without additional modification, the Rate Approval Regulations could have a materially adverse impact on the Company’s results. See further discussion in Part II - Item 1A. Risk Factors.

Net income increased 34.6% to $28.4 million for the three months ended September 30, 2006, or $0.33 per basic share, compared to $21.1 million, or $0.25 per basic share, for the same period in 2005. The third quarter 2006 results include prior year favorable reserve development totaling $14.4 million, versus $1.2 million in the third quarter of 2005. Net income increased 27.9% to $78.0 million, or $0.91 per basic share, for the nine months ended September 30, 2006, compared to $61.0 million, or $0.71 per basic share, for the same nine-month period in 2005. The nine months ended September 30, 2006 include favorable prior year reserve development totaling $39.5 million, versus $20.8 million for the same period in 2005.

The underwriting expense to net premiums earned ratio increased to 23.7% for the three months ended September 30, 2006 from 20.2% for the same period in 2005. For the nine months ended September 30, 2006, the underwriting expense to net premiums earned ratio increased to 22.9% from 21.0% for the same period in 2005. These underwriting expense ratio increases are primarily the result of expenses associated with the Company’s national expansion efforts and the 2006 recognition of stock-based compensation, which were partially offset by deferred policy acquisition costs. Underwriting expenses during the nine months ended September 30, 2006, were also impacted by severance costs and corporate litigation incurred during the first quarter.

The recognition of stock-based compensation resulted from our adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“FAS 123R”). FAS 123R requires the recognition of compensation expense in the Condensed Consolidated Statements of Operations based on the estimated fair value of the employee share-based options. See Critical Accounting Estimates - Stock-Based Compensation Cost for further discussion. Stock-based compensation classified as underwriting expense for the three and nine months ended September 30, 2006, was $1.4 million and $4.6 million, respectively.

Non-GAAP Measures

Information concerning premiums written, underwriting profit and statutory surplus have been presented to enhance investors’ understanding of the Company’s operations. These financial measures are not presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Premiums written represent the premiums charged on policies issued during a fiscal period. We use premiums written as a measure of the underlying growth of our insurance business from period to period. The most directly comparable GAAP measure, premiums earned, represents the portion of premiums written that is recognized as income on a pro rata basis over the terms of the policies.

Underwriting profit (loss) consists of net premiums earned less losses from claims, loss adjustment expenses and underwriting expenses. 21st believes that underwriting profit (loss) provides investors with financial information that is not only meaningful, but critically important to understanding the results of property and casualty insurance operations. The results of operations of a property and casualty insurance company includes three components: underwriting profit (loss), net investment income and realized capital gains (losses). Without disclosure of underwriting profit (loss), it is difficult to determine how successful an insurance company is in its core business activity of assessing and underwriting risk, as including investment income and realized capital gains (losses) in the results of operations without disclosing underwriting profit (loss) can mask underwriting losses.

Table of Contents

Statutory surplus represents equity as of the end of a fiscal period for the Company’s insurance subsidiaries, determined in accordance with statutory accounting principles prescribed by insurance regulatory authorities. Stockholders’ equity is the most directly comparable GAAP measure to statutory surplus.

The reconciliations of these financial measures to the most directly comparable GAAP measures are located in Results of Operations and Liquidity and Capital Resources, respectively. These financial measures are not intended to replace, and should be read in conjunction with the GAAP financial measures.

See Results of Operations for more details as to our overall and personal auto lines results.

The remainder of this MD&A includes the following sections:

Results of Operations

Financial Condition

Liquidity and Capital Resources

Transactions with Related Parties

Contractual Obligations and Commitments

Critical Accounting Estimates

Recent Accounting Pronouncements

Forward-Looking Statements

RESULTS OF OPERATIONS

Consolidated Results

The following table summarizes our condensed consolidated results of operations and reconciles personal auto lines underwriting profit to net income:

	Three Months Ended September 30,									Nine Months Ended September 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	2006			2005			Increase/ (Decrease)			2006			2005			Increase/ (Decrease)
Personal auto lines underwriting profit	$	27,447		$	16,972			61.7	%	$	73,213		$	47,035			55.7	%
Homeowner and earthquake lines in runoff underwriting loss		(190	)		(613	)		(69.0	)		(533	)		(983	)		(45.8	)
Net investment income		16,897			17,042			(0.9	)		51,827			51,085			1.5
Other income (loss)		58			(3	)		N/M	¹		68			364			N/M	¹
Net realized investment gain (losses)		159			(939	)		N/M	¹		(878	)		(2,666	)		(67.1	)
Other expense		—			—			—			(924	)		—			—
Interest and fees expense		(1,820	)		(1,988	)		(8.5	)		(5,572	)		(6,076	)		(8.3	)
Provision for income taxes		(14,144	)		(9,369	)		51.0			(39,155	)		(27,725	)		41.2
Net income	$	28,407		$	21,102			34.6		$	78,046		$	61,034			27.9
Basic earnings per share		0.33			0.25			32.0			0.91			0.71			28.2
Diluted earnings per share		0.33			0.24			37.5			0.90			0.71			26.8

¹	Ratio is not meaningful.

Table of Contents

Underwriting results above include the effect of prior years’ reserve redundancy recorded in the current year. The following table summarizes losses and LAE incurred, net of applicable reinsurance, for the periods indicated:

	Three Months Ended September 30,						Nine Months Ended September 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Net losses and LAE incurred related to insured events in:
Current accident year personal auto lines	$	236,942		$	259,301		$	721,668		$	778,203
Prior accident years:
Personal auto lines		(14,582	)		(1,811	)		(40,061	)		(21,774	)
Homeowner and earthquake lines in runoff		190			615			533			991
Total prior years’ redundancy recorded in current year		(14,392	)		(1,196	)		(39,528	)		(20,783	)
Total net losses and LAE incurred	$	222,550		$	258,105		$	682,140		$	757,420

We perform quarterly reviews of the adequacy of carried unpaid losses and LAE. These estimates depend on many assumptions about the outcome of future events. Consequently, there can be no assurance that our ultimate unpaid losses and LAE will not develop redundancies or deficiencies and materially differ from our unpaid losses and LAE as of September 30, 2006. In the future, if the unpaid losses and LAE develop redundancies or deficiencies, such redundancy or deficiency would have a positive or adverse impact, respectively, on future results of operations. See Critical Accounting Estimates - Losses and Loss Adjustment Expenses for additional discussion of our reserving policy.

Personal Auto Lines Underwriting Results

Personal automobile insurance is our primary line of business. Non-California vehicles accounted for 12.3% of our direct premiums written for the three months ended September 30, 2006, compared to 6.6% for the same period in 2005. For the nine months ended September 30, 2006, non-California vehicles accounted for 9.8% of our direct premiums written, compared to 6.0% for the same period in 2005. This increase is due to our ongoing national expansion program, which includes marketing in non-California states. Prior to September 30, 2006, 21st sold policies in 12 states. The Company entered New Jersey in October 2006 and plans to expand into additional states during the fourth quarter of 2006 as part of its national expansion strategy. The following table presents the components of our personal auto lines underwriting profit and the components of the combined ratio:

	Three Months Ended September 30,									Nine Months Ended September 30,
AMOUNTS IN THOUSANDS	2006			2005			Increase/ (Decrease)			2006			2005			Increase/ (Decrease)
Direct premiums written	$	337,217		$	349,119			(3.4	)%	$	992,623		$	1,029,905			(3.6	)%
Net premiums written	$	335,809		$	347,827			(3.5	)	$	988,509		$	1,026,247			(3.7	)

Net premiums earned	$	327,325		$	344,099			(4.9	)	$	978,661		$	1,017,302			(3.8	)
Net losses and LAE		(222,360	)		(257,489	)		(13.6	)		(681,607	)		(756,428	)		(9.9	)
Underwriting expenses		(77,518	)		(69,638	)		11.3			(223,841	)		(213,839	)		4.7
Underwriting profit	$	27,447		$	16,972			61.7		$	73,213		$	47,035			55.7

Ratios:
Loss and LAE ratio		67.9	%		74.8	%		(6.9	)		69.6	%		74.4	%		(4.8	)
Underwriting expense ratio		23.7			20.3			3.4			22.9			21.0			1.9
Combined ratio		91.6	%		95.1	%		(3.5	)		92.5	%		95.4	%		(2.9	)

The following table reconciles our personal auto lines direct premiums written to net premiums earned:

	Three Months Ended September 30,						Nine Months Ended September 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Direct premiums written	$	337,217		$	349,119		$	992,623		$	1,029,905
Ceded premiums written		(1,408	)		(1,292	)		(4,114	)		(3,658	)
Net premiums written		335,809			347,827			988,509			1,026,247
Net change in unearned premiums		(8,484	)		(3,728	)		(9,848	)		(8,945	)
Net premiums earned	$	327,325		$	344,099		$	978,661		$	1,017,302

Table of Contents

Direct premiums written decreased in the three months and nine months ended September 30, 2006, as compared to the same period in 2005, primarily due to continued competitiveness in the California market. As discussed in the Highlights, the California Department of Insurance issued changes to regulations relating to automobile insurance rating factors, particularly concerning territorial rating in July 2006. It is not possible at this time to predict the ultimate timing or impact of these changes, which could have either a materially favorable or materially adverse impact on the Company. Also in July 2006, the CDI proposed new amended rate approval regulations, subsequently amended in October of 2006, which if approved without further modification, could have a materially adverse impact on the Company’s California results. See further discussion of both regulations in Item 1A. Risk Factors.

As the Company proceeds with its national expansion, we believe that achieving our long-term growth goal will steadily depend less on the California marketplace. The Company’s national expansion efforts will provide us with flexibility to use combinations of local and national marketing media, as appropriate, and the ability to focus our marketing expenditures and Company resources on attractive markets, while minimizing costs in less attractive markets.

The declines in the loss and LAE ratios for the three months and nine months ended September 30, 2006 of 6.9 points and 4.8 points, respectively, are primarily due to the effect of favorable development related to prior accident years and lower accident frequency. The loss and LAE ratios for the three months ended September 30, 2006, included 4.5 points ($14.6 million) of favorable development compared to 0.5 points ($1.8 million) in the same period of 2005. For the nine months ended September 30, 2006 loss and LAE ratio included 4.1 points ($40.1 million) of favorable reserve development compared to 2.1 points ($21.8 million) in the same period of 2005. Changes in estimates are recorded in the period in which new information becomes available indicating that a change is warranted. The remaining decrease in the loss and LAE ratios for both of the 2006 periods was primarily attributable to the decline in frequency.

The underwriting expense to net premiums earned ratios increased in the three months and nine months ended September 30, 2006, as compared to the same periods in the prior year. This was primarily due to our investments in the Company’s national expansion efforts and the 2006 recognition of stock-based compensation, partially offset by an increase in deferred policy acquisition costs. Also, the underwriting expense ratio for the nine months ended September 30, 2006 was impacted by severance costs and corporate litigation incurred during the three months ended March 31, 2006.

Homeowner and Earthquake Lines in Runoff

We have not written any earthquake policies since 1994 and exited the voluntary homeowner insurance business in 2002. Underwriting results of the homeowner and earthquake lines, which are in runoff, include losses and LAE incurred of $0.2 million for the three months ended September 30, 2006, compared to $0.6 million for the same period in 2005. For the nine months ended September 30, 2006 and 2005, losses and LAE for those same lines were $0.5 million and $1.0 million, respectively, of which the earthquake lines accounted for $0.1 million in loss and LAE during the three months and nine months ended September 30, 2006.

Net Investment Income

We utilize a conservative investment philosophy. No derivatives are held in our investment portfolio and there were no equity securities at September 30, 2006. The Company had previously held publicly traded equities, but exited the asset class in the first quarter of 2006. Substantially the entire fixed maturity portfolio is investment grade, having a weighted average Standard & Poor’s credit quality of “AA”. The components of net investment income were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
AMOUNTS IN THOUSANDS	2006		2005		2006		2005
Fixed maturity securities available-for-sale	$	16,597	$	15,471	$	50,095	$	46,145
Equity securities available-for-sale		—		1,188		811		4,164
Cash and cash equivalents		300		383		921		776
Net investment income	$	16,897	$	17,042	$	51,827	$	51,085

The fixed maturity portfolio comprised 99% and 95% of the total investment portfolio at September 30, 2006 and December 31, 2005, respectively. The average annual yields on fixed income assets were as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Pre-tax - fixed maturity securities		4.5	%		4.6	%		4.6	%		4.6	%
After-tax - fixed maturity securities		3.3	%		3.3	%		3.3	%		3.3	%

Table of Contents

The yield declined slightly due to the reinvestment of funds from sales of equity securities and maturities of fixed-income securities into lower yielding fixed maturity securities during the first and second quarters of 2006.