Progressive 2012 Annual Report Download - page 62

We monitor prepayment and extension risk, especially in our structured product and preferred stock portfolios. Prepayment
risk includes the risk of early redemption of security principal that may need to be reinvested at less attractive rates.
Extension risk includes the risk that a security will not be redeemed when anticipated, and that the security that is extended
has a lower yield than a security we might be able to obtain by reinvesting the expected redemption principal. Our holdings
of different types of structured debt and preferred securities, which are discussed in more detail below, help minimize this
risk. During 2012, we did not experience significant prepayment or extension of principal relative to our cash flow
expectations in the portfolio.
The pricing on the majority of our preferred stocks continues to reflect expectations that many issuers will not call such
securities, and hence reflects an assumption that the securities will remain outstanding for a period of time beyond such
initial call date (extension risk). Most of our preferred securities either convert from a fixed-rate coupon to a variable-rate
coupon after the call date, or remain variable-rate coupon securities after the call date. The variable-rate coupon is
determined by adding a benchmark interest rate, which is reset quarterly to a credit spread premium that was fixed when
the security was first issued. Many of these securities have a minimum or floor coupon that is currently in effect. Extension
risk on holding these securities is limited to the credit risk premium being below that of a new similar security since the
benchmark variable-rate portion of the security’s coupon adjusts for movements in interest rates. Reinvestment risk is
similarly limited to receiving a below market level coupon for the credit risk premium portion of a similar security as the
benchmark variable interest rate adjusts for changes in short-term interest rate levels. Since the beginning of 2011, ten
securities that converted from a fixed-rate coupon to a variable-rate coupon had their first call date; only two of these
securities were called. The eight securities that were not called had a value of $343.5 million at December 31, 2012.
We also face the risk that our preferred stock dividend payments could be deferred for one or more periods. As of
December 31, 2012, all of our preferred securities continued to pay their dividends in full and on time.
Liquidity risk is another risk factor we monitor. Our overall portfolio remains very liquid and is sufficient to meet expected
liquidity requirements. As of December 31, 2012, we held $4.9 billion of U.S. Treasury and short-term securities, compared
to $4.5 billion at December 31, 2011. The short-to-intermediate duration of our portfolio provides an additional source of
liquidity, as we expect approximately $1.5 billion, or 16%, of our fixed-income portfolio, excluding U.S. Treasury and short-
term securities, to repay principal during 2013. Cash from interest and dividend payments provide an additional source of
recurring liquidity.
Included in the fixed-income portfolio are U.S. government obligations, which include U.S. Treasury Notes and interest rate
swaps. Although the interest rate swaps are not obligations of the U.S. government, they are recorded in this portfolio as the
change in fair value is correlated to movements in the U.S. Treasury market. The duration of these securities was
comprised of the following at December 31, 2012:
($ in millions)
Fair
Value
Duration
(years)
U.S. Treasury Notes
Less than two years $ 829.0 1.3
Two to five years 2,067.5 3.2
Total U.S. Treasury Notes 2,896.5 2.7
Interest Rate Swaps
Two to five years ($900 notional value) 0 (3.7)
Five to nine years ($363 notional value) 0 (6.4)
Total interest rate swaps ($1,263 notional value) 0 (4.5)
Total U.S. government obligations $2,896.5 .7
The interest rate swap positions show a fair value of zero as they are in an overall liability position of $95.5 million, which is
fully funded through collateral payments to the counterparty; the liability is reported in the “other liabilities” section of the
Consolidated Balance Sheets. The negative duration of the interest rate swaps is due to the positions being short interest-
rate exposure (i.e., receiving a variable-rate coupon). In determining duration, we add the interest rate sensitivity of our
interest rate swap positions to that of our Treasury holdings, but do not add the notional value of the swaps to our Treasury
holdings in order to calculate an unlevered duration for the portfolio.
App.-A-62