Progressive 2004 Annual Report Download - page 40

APP.-B-40
Critical Accounting Policies The Company is required to make certain estimates and assumptions when preparing its financial statements
and accompanying notes in conformity with GAAP. Actual results could differ from those estimates in a variety of areas. The two areas that
the Company views as most critical with respect to the application of estimates and assumptions are the establishment of its loss reserves
and its method of determining impairments in its investment portfolio.
LOSS AND LAE RESERVES Loss and loss adjustment expense (LAE) reserves represent the Company’s best estimate of its ultimate liability
for losses and LAE relating to events that occurred prior to the end of any given accounting period but have not yet been paid. At December
31, 2004, the Company had $4.9 billion of net loss and LAE reserves, which included $3.8 billion of case reserves and $1.1 billion of
incurred but not recorded (IBNR) reserves.
The Company’s actuarial staff reviews many subsets of the business, which are at a combined state, product and line coverage level
(the “products”), to calculate the needed loss and LAE reserves. The Company begins its review of a set of data by producing six different
estimates of needed reserves, three using paid data and three using incurred data, to determine if a reserve change is required. In the event
of a wide variation between results generated by the different projections, the actuarial group will further analyze the data using additional
techniques. Each review develops a point estimate for a relatively small subset of the business, which allows the Company to establish
meaningful reserve levels.
The Company reviews a large majority of its reserves by product/state combination on a quarterly time frame, with almost all the
remaining reserves reviewed on a semiannual basis. A change in the Company’s scheduled reviews of a particular subset of the business
depends on the size of the subset or emerging issues relating to the product or state. By reviewing the reserves at such a detailed level, the
Company has the ability to identify and measure variances in trend by state, product and line coverage that would not otherwise be seen
on a consolidated basis. The Company’s intricate process of reviewing over 300 products makes compiling a companywide roll up to generate
a range of needed loss reserves not meaningful. The Company does not review loss reserves on a macro level and, therefore, does not
derive a companywide range of reserves to compare to a standard deviation.
In analyzing the ultimate accident year loss experience, the Company’s actuarial staff reviews in detail, at the subset level, frequency
(number of losses per earned car year), severity (dollars of loss per each claim) and average premium (dollars of premium per earned car
year). The loss ratio, a primary measure of loss experience, is equal to the product of frequency times severity divided by the average
premium. The average premium for personal and commercial auto businesses are known and, therefore, are not estimated. The projection
of frequency for these lines of business is usually very stable because injured parties generally report their claims within a reasonably short
time period after the accident. The actual frequency experienced will vary depending on the change in mix of class of drivers written by the
Company, but the accuracy of the projected level is considered to be reliable. The severity experienced by the Company, which is much
more difficult to estimate, is affected by changes in underlying costs, such as medical costs, jury verdicts, etc. In addition, severity will vary
relative to the change in the Company’s mix of business by limit.
Assumptions regarding needed reserve levels made by the actuarial staff consider influences on the historical data that reduce the
predictiveness of the Company’s projected future loss development. Internal considerations that are process-related, which may result from
changes in the claims organization’s activities, include claim closure rates, the number of claims that are closed without payment and the
level of estimated needed case reserves by claim that are set by claims representatives. The Company studies these changes and their
effect on the historical data at the state level versus on a larger, less indicative, countrywide basis.
External items considered include the litigation atmosphere, state-by-state changes in medical costs, the availability of services to resolve
claims, etc. These again are better understood at the state level versus at a more macro countrywide level.
The manner in which the Company considers and analyzes the multitude of influences on the historical data, as well as how loss reserves
affect the Company’s financial results, is discussed in more detail in the Company’s
Report on Loss Reserving Practices , which was filed
on June 29, 2004 via Form 8-K.
The Company’s carried reserve balance of $4.9 billion implicitly assumes the loss and LAE severity will increase for accident year 2004
over accident year 2003 by 2.7% and 9.0% for personal auto liability and commercial auto liability, respectively. Personal auto liability and
Repurchase Transactions During 2004, the Company entered into repurchase commitment transactions, whereby the Company loaned
U.S. Treasury or U.S. Government agency securities to accredited brokerage firms in exchange for cash equal to the fair market value of
the securities. These internally managed transactions were typically overnight arrangements. The cash proceeds were invested in AA or
higher financial institution paper with yields that exceeded the Company’s interest obligation on the borrowed cash. The Company is able
to borrow the cash at low rates since the securities loaned are in short supply. The Company’s interest rate exposure does not increase or
decrease since the borrowing and investing periods match. During the year ended December 31, 2004, the Company’s largest single
outstanding balance of repurchase commitments was $989.2 million, which was open for seven business days, with an average daily
balance of $452.5 million for the year. During 2003, the largest single outstanding balance of repurchase commitments was $1.2 billion,
which was open for one business day, with an average daily balance of $524.3 million for the year. The Company had no open repurchase
commitments at December 31, 2004 and 2003. The Company earned income of $1.8 million, $2.1 million and $2.8 million on repurchase
commitments during 2004, 2003 and 2002, respectively.