Edgar Filing: 21ST CENTURY INSURANCE GROUP

21st Century Insurance Group 10-Q 6-30-2006

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 June 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 July 13, 2006 was 86,335,335.

TABLE OF CONTENTS

Description		Page Number
PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements	2
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35
Item 4.	Controls and Procedures	37
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3.	Defaults Upon Senior Securities	38
Item 4.	Submission of Matters to a Vote of Security Holders	38
Item 5.	Other Information	38
Item 6.	Exhibits	38
SIGNATURES		39
EXHIBIT INDEX		40
31.1	Certification of Principal Executive Officer Pursuant to Exchange Act Rule 13a-14(a)
31.2	Certification of Principal Financial Officer Pursuant to Exchange Act Rule 13a-14(a)
32.1	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED BALANCE SHEETS
Unaudited

AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	June 30, 2006			December 31, 2005
Assets
Fixed maturity investments available-for-sale, at fair value (amortized cost: $1,472,300 and $1,365,948)	$	1,426,728		$	1,354,707
Equity securities available-for-sale, at fair value (cost: $0 and $49,210)		—			47,367
Total investments		1,426,728			1,402,074
Cash and cash equivalents		40,188			68,668
Accrued investment income		17,304			16,585
Premiums receivable		98,887			100,900
Reinsurance receivables and recoverables		6,521			6,539
Prepaid reinsurance premiums		2,072			1,946
Deferred income taxes		57,321			56,209
Deferred policy acquisition costs		68,248			59,939
Leased property under capital lease, net of deferred gain of $1,313 and $1,534 and net of accumulated amortization of $39,542 and $36,995		20,568			22,651
Property and equipment, at cost less accumulated depreciation of $100,295 and $89,595		148,213			145,811
Other assets		41,323			38,907
Total assets	$	1,927,373		$	1,920,229
Liabilities and stockholders’ equity
Unpaid losses and loss adjustment expenses	$	495,092		$	523,835
Unearned premiums		321,166			319,676
Debt		121,619			127,972
Claims checks payable		38,363			42,681
Reinsurance payable		748			643
Other liabilities		95,220			75,450
Total liabilities		1,072,208			1,090,257

Commitments and contingencies

Stockholders’ equity:
Common stock, par value $0.001 per share; 110,000,000 shares authorized; shares issued 86,341,626 and 85,939,889		86			86
Additional paid-in capital		435,894			425,454
Treasury stock; at cost shares: 6,291 and 5,929		(89	)		(84	)
Retained earnings		450,774			414,898
Accumulated other comprehensive loss		(31,500	)		(10,382	)
Total stockholders’ equity		855,165			829,972
Total liabilities and stockholders’ equity	$	1,927,373		$	1,920,229

See accompanying Notes to Condensed Consolidated Financial Statements.

21ST CENTURY INSURANCE GROUP
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Unaudited

	Three Months Ended June30,					Six Months Ended June 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	2006		2005			2006			2005
Revenues
Net premiums earned	$	325,512	$	336,845		$	651,336		$	673,209
Net investment income		17,174		17,006			34,929			34,043
Other income		10		367			10			367
Net realized investment gains (losses)		30		(1,267	)		(1,037	)		(1,727	)
Total revenues		342,726		352,951			685,238			705,892
Losses and expenses
Net losses and loss adjustment expenses		223,094		248,284			459,590			499,315
Policy acquisition costs		64,887		63,755			124,219			128,078
Other underwriting expenses		9,504		8,765			22,104			16,123
Other expense		923		—			923			—
Interest and fees expense		1,854		2,031			3,752			4,088
Total losses and expenses		300,262		322,835			610,588			647,604
Income before provision for income taxes		42,464		30,116			74,650			58,288
Provision for income taxes		14,143		9,621			25,011			18,356
Net income	$	28,321	$	20,495		$	49,639		$	39,932

Earnings per common share
Basic earnings per share	$	0.33	$	0.24		$	0.58		$	0.47
Diluted earnings per share	$	0.33	$	0.24		$	0.57		$	0.47
Weighted-average shares outstanding — basic		85,968,155		85,704,165			85,918,791			85,613,043
Weighted-average shares outstanding — diluted		86,232,103		85,890,984			86,373,845			85,803,214

See accompanying Notes to Condensed Consolidated Financial Statements.

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)											49,639	⁽¹⁾		(21,118	)⁽²⁾		28,521
Cash dividends declared on common stock ($0.16 per share)											(13,763	)					(13,763	)
Exercise of stock options		293,187				3,844											3,844
Issuance of restricted stock		108,550															—
Forfeiture of 362 shares of restricted stock						5		(5	)								—
Stock-based compensation cost						6,478											6,478
Excess tax benefits of stock-based compensation						113											113
Balance - June 30, 2006		86,341,626	$	86	$	435,894	$	(89	)	$	450,774		$	(31,500	)	$	855,165

⁽¹⁾	Net income for the six months ended June 30, 2006.

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

	Six Months Ended June 30, 2006
Unrealized holding losses arising during the period, net of tax benefit of $11,734	$	(21,792	)
Reclassification adjustment for investment losses included in net income, net of tax benefit of $363		674
Total	$	(21,118	)

See accompanying Notes to Condensed Consolidated Financial Statements.

21ST CENTURY INSURANCE GROUP

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA
Six Months Ended June 30,	2006			2005
Operating activities
Net income	$	49,639		$	39,932
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		13,304			14,995
Net amortization of investment premiums and discounts		4,496			4,840
Stock-based compensation cost		6,478			138
Provision for deferred income taxes		9,431			5,903
Net realized investment losses		1,037			1,717
Changes in assets and liabilities
Premiums receivable		2,013			234
Deferred policy acquisition costs		(8,309	)		(3,446	)
Reinsurance receivables and recoverables		(3	)		1,377
Federal income taxes		2,786			(69	)
Other assets		(1,866	)		5,241
Unpaid losses and loss adjustment expenses		(28,743	)		(20	)
Unearned premiums		1,490			5,207
Claims checks payable		(4,318	)		(170	)
Other liabilities		16,983			(5,638	)
Net cash provided by operating activities		64,418			70,241
Investing activities
Purchases of:
Fixed maturity investments available-for-sale		(180,179	)		(76,575	)
Equity securities available-for-sale		(35,627	)		(160,730	)
Property and equipment		(13,346	)		(12,591	)
Maturities and calls of fixed maturity investments available-for-sale		12,618			17,225
Sales of:
Fixed maturity investments available-for-sale		55,346			27,192
Equity securities available-for-sale		84,836			152,688
Net cash used in investing activities		(76,352	)		(52,791	)
Financing activities
Repayment of debt		(6,740	)		(5,953	)
Dividends paid (per share: $0.16 and $0.08)		(13,763	)		(6,847	)
Proceeds from the exercise of stock options		3,844			1,975
Excess tax benefits from stock-based compensation		113			—
Net cash used in financing activities		(16,546	)		(10,825	)
Net (decrease) increase in cash and cash equivalents		(28,480	)		6,625
Cash and cash equivalents, beginning of period		68,668			34,697
Cash and cash equivalents, end of period	$	40,188		$	41,322

Supplemental information:
Income taxes paid	$	12,863		$	9,434
Interest paid		3,682			4,017

See accompanying Notes to Condensed Consolidated Financial Statements.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 six-month period ended June 30, 2006 are not necessarily indicative of results that may be expected for the remaining interim periods or the year as a whole.

Earnings Per Share (“EPS”)

For each of the quarters ended June 30, 2006 and 2005, the numerator for the calculation of both basic and diluted earnings per share 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 earnings per share excludes dilution and reflects net income divided by the weighted-average shares of common stock outstanding during the periods presented. The denominator for the computation of basic EPS was 85,968,155 and 85,918,791 shares for the three and six months ended June 30, 2006, respectively, and 85,704,165 and 85,613,043 shares for the three and six months ended June 30, 2005, respectively.

Diluted earnings per share 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 are computed using the treasury stock method. For the three and six months ended June 30, 2006, this amounted to 86,232,103 and 86,373,845 shares, respectively, which include 263,948 and 455,054 dilutive common stock equivalents, respectively. For the three and six months ended June 30, 2005, this amounted to 85,890,984 and 85,803,214 shares, respectively, which include 186,819 and 190,171 dilutive common stock equivalents, respectively.

Options to purchase an aggregate of 6,157,293 and 5,359,356 shares of common stock during the three and six months ended June 30, 2006, respectively, and 7,475,427 and 7,341,859 shares of common stock during the three and six months ended June 30, 2005, respectively, were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market prices of the common stock for each respective period. These options expire at various points in time through 2016.

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. (“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 or above the grant date market price. 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 consolidated financial statement footnotes.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 results differ significantly from these 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 options. The use of the non-substantive vesting period approach will not affect the overall amount of compensation expense recognized, but could accelerate the recognition of expense for grants made since January 1, 2006. However, the Company will continue to follow the nominal vesting approach for the remaining portion of unvested awards that were granted prior to January 1, 2006 and will continue to recognize expense from the grant date to the earlier of the actual date of retirement or the vesting date.

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 share option exercise or restricted share unit conversion, 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.

Recent Accounting Standards

In June 2006, the Financial Accounting Standards Board (“FASB”) issued interpretation of FASB Statement No. 109, Accounting for Uncertainty in Income Taxes (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 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. This interpretation will be effective January 1, 2007. The Company is currently assessing the effect of implementing FIN 48.

Statement of Position (“SOP”) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts, 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 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.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 and cash flows is as follows:

	Three Months Ended June 30, 2006							Six Months Ended June 30, 2006
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	Without FAS 123R ¹		FAS 123R Impact			With FAS 123R		Without FAS 123R ¹		FAS 123R Impact			With FAS 123R
Total revenues	$	342,726	$	—		$	342,726	$	685,238	$	—		$	685,238
Losses and expenses
Net losses and loss adjustment expenses		222,335		759			223,094		457,697		1,893			459,590
Policy acquisition costs		64,439		448			64,887		123,284		935			124,219
Other underwriting expenses		9,070		434			9,504		19,835		2,269			22,104
Other expense		923		—			923		923		—			923
Interest and fees expense		1,854		—			1,854		3,752		—			3,752
Total losses and expenses		298,621		1,641			300,262		605,491		5,097			610,588
Income before provision for income taxes		44,105		(1,641	)		42,464		79,747		(5,097	)		74,650
Provision for income taxes		14,431		(288	)		14,143		26,056		(1,045	)		25,011
Net income	$	29,674	$	(1,353	)	$	28,321	$	53,691	$	(4,052	)	$	49,639

Basic earnings per share ²	$	0.35	$	(0.02	)	$	0.33	$	0.62	$	(0.05	)	$	0.58
Diluted earnings per share ²	$	0.34	$	(0.02	)	$	0.33	$	0.62	$	(0.05	)	$	0.57

The six months ended June 30, 2006 results include $0.7 million and $1.4 million, respectively, 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 actual vesting in accordance with an executive retention agreement, respectively. As compensation costs for certain employees are included in deferred policy acquisition costs, pre-tax compensation cost related to stock-based compensation of $0.9 million was deferred, for the six months ended June 30, 2006. The remaining unrecognized compensation cost related to unvested awards as of June 30, 2006, was $13.4 million and the weighted-average period over which this cost will be recognized is 2.1 years. The six-month period ended June 30, 2006, results included $113 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 $1.3 million and $2.6 million for the three and six months ended June 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 $0.3 million and $0.5 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 six months ended June 30, 2006, respectively.

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

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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

	Three Months Ended			Six Months Ended
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	June 30, 2005			June 30, 2005
Net income, as reported	$	20,495		$	39,932
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		68			90
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of related tax effects		(1,298	)		(2,565	)
Net income, pro forma	$	19,265		$	37,457
Basic and diluted earnings per share
As reported	$	0.24		$	0.47
Pro forma	$	0.22		$	0.44

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 June 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		(975	)		(204	)
Number of securities issuable upon the exercise of all outstanding options		(6,710	)		(3,617	)
Number of securities forfeited		(2,600	)		(74	)
Number of forfeited securities returned to plan		2,600			74
Unused options assumed by 2004 Stock Option Plan		(2,315	)		2,315
Number of securities available for future grants under each plan		—			2,494

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

Current Activity

A summary of the Company’s stock option activity for the six months ended June 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		2,000			16.55
Exercised in 2006		(293	)		13.11
Forfeited in 2006		(9	)		14.59
Canceled in 2006		(240	)		19.51
Options outstanding June 30, 2006		10,327			16.30

A summary of the Company’s stock option activity and related information follows:

	Three Months Ended June30,				Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006		2005		2006		2005
Fair value of stock options granted	$	900	$	2,214	$	9,994	$	8,186
Intrinsic value of options exercised		266		114		483		353
Grant date fair value of options vested		884		284		7,399		5,241
Proceeds from exercise of stock options		3,126		666		3,844		1,975
Tax benefit realized as a result of stock option exercises		53		23		97		70

SHARE DATA
Weighted-average fair value per option granted	$	4.82	$	4.46	$	5.00	$	4.75

Black-Scholes Assumptions

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:

Six Months Ended June 30,	2006			2005 Pro Forma
Risk-free interest rate:
Minimum		4.5	%		3.7	%
Maximum		4.8	%		4.3	%
Dividend yield		1.9	%		1.1	%
Volatility factor of the expected market price of the Company’s common stock:
Minimum		29.4			28.6
Maximum		29.4			32.2
Expected option term		6 years			6 years

The expected term for options granted during the six months ended June 30, 2006, was calculated using the simplified method in accordance with Staff Accounting Bulletin No. 107. The expected volatility of employee stock options was based on the historical volatility of key competitors in the property & 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 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.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

Outstanding Options

The following table summarizes information about stock options outstanding at June 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		1,260	6.7 Years	$	11.73	$	3,361		1,249	6.7 Years	$	11.72	$	3,345
13.01 - 15.00		2,910	8.2 Years		14.28		355		1,491	8.1 Years		14.30		153
15.01 - 17.00		3,357	8.0 Years		16.38		—		1,490	5.8 Years		16.18		—
17.01 - 19.00		1,776	4.2 Years		18.05		—		1,776	4.2 Years		18.05		—
19.01 - 22.00		246	1.4 Years		20.75		—		246	1.4 Years		20.75		—
22.01 - 29.25		778	2.9 Years		25.43		—		778	2.9 Years		25.43		—
$11.68 -$29.25		10,327	6.7 Years	$	16.30	$	3,716		7,030	5.6 Years	$	16.65	$	3,498

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 $0.4 million and $0.5 million for the three and six months ended June 30, 2006, respectively, and $0.1 million for the three and six months ended June 30, 2005. Unrecognized compensation cost in connection with restricted stock grants totaled $2.2 million at June 30, 2006. The cost is expected to be recognized over a weighted-average period of 2.4 years.

Restricted Shares Issuable and Issued

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

AMOUNTS IN THOUSANDS	Restricted Shares Plan
Total number of securities authorized		1,422
Number of securities issued		(1,252	)
Number of forfeited securities returned to plan		162
Number of securities remaining available for future grants under the plan		332

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

Current Restricted Shares Activity

The following table summarizes activity under the Restricted Shares Plan for the six months ended June 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		109		15.90
Non-vested, June 30, 2006		163		15.22

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

	Three Months Ended June30,				Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006		2005		2006		2005
Fair value of restricted stock awards granted	$	80	$	1,267	$	1,724	$	1,267
Fair value of restricted stock awards vested		475		30		475		183

SHARE DATA
Weighted-average fair value per share for restricted shares granted		$	16.01		$	14.10			$	15.90		$	14.10

NOTE 3. HOMEOWNER AND EARTHQUAKE LINES IN RUNOFF

California Senate Bill 1899 (“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 California SB 1899 have been resolved. The Company’s total loss and loss adjustment expenses (“LAE”) reserves for SB 1899 claims as of June 30, 2006 and December 31, 2005, were less than $0.1 million and $0.5 million, respectively.

Loss and LAE incurred for the homeowner and earthquake lines in runoff were $0.3 million for the three and six months ended June 30, 2006, compared to $0.2 million and $0.4 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 claims and insurance policy issues, both on individual policy files and by class actions seeking to attack the Company’s 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 possibly for 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.

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.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

Poss v. 21st Century Insurance Company was filed on June 13, 2003, in Los Angeles Superior Court. The complaint sought 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. Based on California’s Proposition 64, passed in November 2004, the court granted the Company’s motion to dismiss the complaint, but allowed the addition of a second plaintiff, Leacy. The court stayed discovery in this litigation pending appellate court decisions involving similar issues by other parties. To date, these decisions have favored the Company’s position. Because this matter is 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 $1.8 million.

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 contends that the Company uses “biased” software in determining the value of total-loss automobiles. Specifically, Plaintiff alleges 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 has been ordered. The Company intends to vigorously defend the suit with other defendants in the coordinated proceedings. This matter is in the pleading stage of litigation and no reasonable estimate of potential losses in the event of a negative outcome can be made at this time.

Thomas Theis, on his own behalf and on behalf of all others similarly situated v. 21st Century Insurance 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.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

Silvia Quintana, on her own behalf and on behalf of all others similarly situated v. 21st Century Insurance 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 initial stages of pleading 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 changes in unrealized gains and losses; reclassification adjustments for investment losses and gains included in net income; and changes in minimum pension liability in excess of unamortized prior service cost.

A summary of accumulated other comprehensive loss follows:

	June 30, 2006			December 31, 2005
Net unrealized losses on available-for-sale investments, net of deferred income taxes of $15,950 and $4,579	$	(29,622	)	$	(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	$	(31,500	)	$	(10,382	)

NOTE 6. EMPLOYEE BENEFIT PLANS

The Company has both funded and unfunded non-contributory defined benefit pension plans, which together cover essentially all employees who have completed at least one year of service. 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. For other eligible employees, the pension benefits 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.

Components of Net Periodic Cost

Net pension costs for all plans were as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Service cost	$	1,693		$	1,762		$	3,565		$	3,524
Interest cost		1,898			1,855			3,869			3,710
Expected return on plan assets		(2,112	)		(1,830	)		(4,220	)		(3,660	)
Amortization of prior service cost		39			27			73			54
Amortization of net loss		628			507			1,306			1,014
Total	$	2, 146		$	2,321		$	4,593		$	4,642

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 June 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 $0.9 million in 2006.

Defined Contribution Plans

The Company sponsors a 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 investment types 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. Company contributions to both plans were $1.2 million and $3.1 million for the three and six months ended June 30, 2006, respectively, and $0.9 million and $2.3 million for the same periods in 2005.

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 homeowner policies in February 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.

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 June 30, 2006
Net premiums earned	$	325,512	$	—		$	325,512
Depreciation and amortization expense		6,642		1			6,643
Segment profit (loss)		28,293		(266	)		28,027

Three Months Ended June 30, 2005
Net premiums earned	$	336,842	$	3		$	336,845
Depreciation and amortization expense		8,391		2			8,393
Segment profit (loss)		16,239		(198	)		16,041

Six Months Ended June 30, 2006
Net premiums earned	$	651,336	$	—		$	651,336
Depreciation and amortization expense		13,301		3			13,304
Segment profit (loss)		45,765		(342	)		45,423

Six Months Ended June 30, 2005
Net premiums earned	$	673,203	$	6		$	673,209
Depreciation and amortization expense		14,990		5			14,995
Segment profit (loss)		30,063		(370	)		29,693

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

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Segment profit	$	28,027		$	16,041		$	45,423		$	29,693
Net investment income		17,174			17,006			34,929			34,043
Other income		10			367			10			367
Net realized investment gains (losses)		30			(1,267	)		(1,037	)		(1,727	)
Other expense		(923	)		—			(923	)		—
Interest and fees expense		(1,854	)		(2,031	)		(3,752	)		(4,088	)
Income before provision for income taxes	$	42,464		$	30,116		$	74,650		$	58,288

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

21ST CENTURY INSURANCE GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2006

DOLLAR AMOUNTS IN THOUSANDS, EXCEPT WHERE NOTED

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 June 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, none of which exceeds 11.1%.

In addition to the above, the Company held $6.0 million and $6.2 million in other Impact related fixed-income investments as of June 30, 2006 and December 31, 2005, respectively. The Company also held $0.3 million in other Impact related private equity investments reclassified as other assets as of June 30, 2006. There were no private equity investments for the same period in the prior year. Total Impact related investment income was $0.2 million and $0.5 million for the three and six months ended June 30, 2006, respectively, and $0.2 million and $0.3 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 investments program. The program will be 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 later 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 in July 2006.

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, 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 on the phone with our licensed insurance professionals at 1-800-211-SAVE. Service is offered in English and Spanish, both on 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. In the second quarter of 2006, the Company began operations in Florida, Georgia and Pennsylvania, increasing the percentage of the U.S. personal auto market that the Company operates in to 49%. The Company plans to add three additional states in the second half of 2006. Growth in direct premiums written in non-California markets in the second quarter of 2006 was 51.8%. 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 second quarter ended June 30:

Total direct premiums written decreased 3.6% to $316.8 million in 2006, from $328.7 million for same period in 2005.

California direct premiums written decreased 7.1% to $287.4 million in 2006, compared to $309.2 million for the same period in 2005.

Non-California direct premiums written increased by 51.8% to $29.4 million for the quarter ended June 30, 2006, compared to $19.5 million for the same period in 2005.

Our consolidated combined ratio of 91.4% was favorably impacted by 5.6 points of prior accident year loss and LAE reserve decreases, versus 95.2% for the second quarter of 2005, which was favorably impacted by 3.5 points.

Financial highlights for the six months ended June 30:

Total direct premiums written declined 3.7% to $655.4 million in 2006, from $680.8 million for the same period in 2005.

California direct premiums written decreased 6.6% to $599.2 million in 2006, compared to $641.8 million for the same period in 2005.

Non-California direct premiums written increased by 44.1% to $56.2 million in 2006, compared to $39.0 million for the same period in 2005.

Our consolidated combined ratio of 93.0% was favorably impacted by 3.9 points of prior accident year loss and LAE reserves, versus 95.6% for the same period in 2005, which was favorably impacted by 2.9 points.

For the three months and six months ended June 30, 2006, 21st’s insurance subsidiaries achieved underwriting profitability, but total direct premiums written declined. In recent quarters, the California market, which represented 90.7% of our total direct premiums written during the second 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 level filing in the third quarter of 2006, competitive rate levels may change and consumer shopping behavior may increase in the future. 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. 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 & casualty insurance written in California. If approved without 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 38% to $28.3 million for the three months ended June 30, 2006, or $0.33 per basic share, compared to $20.5 million, or $0.24 per basic share, for the same period in 2005. The second quarter 2006 results include prior year favorable reserve development totaling $18.1 million, versus $11.9 million in the second quarter of 2005. Net income increased 24% to $49.6 million for the six months ended June 30, 2006, or $0.58 per basic share, compared to $39.9 million, or $0.47 per basic share, for the same six-month period in 2005. The six months ended June 30, 2006 include favorable prior year reserve development totaling $25.1 million, versus $19.6 million for the same period in 2005.

The underwriting expense to net premiums earned ratio increased to 22.9% for the three months ended June 30, 2006 from 21.5% for the same period in 2005. For the six months ended June 30, 2006, the underwriting expense to net premiums earned ratio increased to 22.4% from 21.4% 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 increases in deferred policy acquisition costs. Underwriting expenses during the six months ended June 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 Expense for further discussion. Stock-based compensation classified as underwriting expense for the three and six months ended June 30, 2006, was $0.9 million and $3.2 million, respectively.

Non-GAAP Measures

Premiums written 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. 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. 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 Standards

Forward-Looking Statements

RESULTS OF OPERATIONS

Consolidated Results

The following table summarizes the Company’s condensed consolidated results of operations:

	Three Months Ended June 30,							Six Months Ended June 30,
AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA	2006		2005		Increase/ (Decrease)			2006		2005		Increase/ (Decrease)
Direct premiums written	$	316,837	$	328,669		(3.6	)%	$	655,406	$	680,786		(3.7	)%
Net premiums earned		325,512		336,845		(3.4	)		651,336		673,209		(3.2	)
Net income		28,321		20,495		38.2			49,639		39,932		24.3
Basic earnings per share		0.33		0.24		45.8			0.58		0.47		23.4
Diluted earnings per share		0.33		0.24		45.8			0.57		0.47		21.3

For the three months ended June 30, 2005, the results include net realized capital losses of $1.3 million. For the six months ended June 30, 2006, the results included net realized capital losses of $1.0 million compared to net realized capital losses of $1.7 million for the same period in 2005.

The following table summarizes losses and loss adjustment expenses (“LAE”) incurred, net of applicable reinsurance, for the periods indicated:

	Three Months Ended June 30,						Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Net losses and LAE incurred related to insured events in:
Current year personal auto lines	$	241,215		$	260,200		$	484,726		$	518,902
Prior accident years:
Personal auto lines		(18,387	)		(12,116	)		(25,479	)		(19,963	)
Homeowner and earthquake lines in runoff		266			200			343			376
Total prior years’ redundancy recorded in current year		(18,121	)		(11,916	)		(25,136	)		(19,587	)
Total net losses and LAE incurred	$	223,094		$	248,284		$	459,590		$	499,315

While 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. 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 June 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 automobile insurance is our primary line of business. Non-California vehicles accounted for 9.3% of our direct premiums written for the three months ended June 30, 2006, compared to 5.9% for the same period in 2005. For the six months ended June 30, 2006, non-California vehicles accounted for 8.6% of our direct premiums written, compared to 5.7% for the same period in 2005. This increase is due to our ongoing national expansion program, which includes marketing in non-California states. The Company is currently selling policies in 12 states and plans to expand into three additional states during the second half of 2006 as part of its national expansion strategy.

Personal Auto Lines Underwriting Results

The following table presents the components of our personal auto lines underwriting profit and the components of the combined ratio:

	Three Months Ended June 30,									Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006			2005			Increase/ (Decrease)			2006			2005			Increase/ (Decrease)
Direct premiums written	$	316,837		$	328,669			(3.6	)%	$	655,406		$	680,786			(3.7	)%

Net premiums written	$	315,476		$	327,479			(3.7	)%	$	652,700		$	678,420			(3.8	)%

Net premiums earned	$	325,512		$	336,842			(3.4	)%	$	651,336		$	673,203			(3.2	)%
Net losses and LAE		222,828			248,083			(10.2	)		459,248			498,939			(8.0	)
Underwriting expenses		74,391			72,520			2.6			146,323			144,201			1.5
Underwriting profit	$	28,293		$	16,239			74.2	%	$	45,765		$	30,063			52.2	%

Ratios:
Loss and LAE ratio		68.5	%		73.7	%		(5.2	)%		70.5	%		74.1	%		(3.6	)%
Underwriting expense ratio		22.9			21.5			1.4			22.5			21.4			1.1
Combined ratio		91.4	%		95.2	%		(3.8	)%		93.0	%		95.5	%		(2.5	)%

The following table reconciles our personal auto lines underwriting profit to our consolidated net income:

	Three Months Ended June 30,						Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Personal auto lines underwriting profit	$	28,293		$	16,239		$	45,765		$	30,063
Homeowner and earthquake lines in runoff underwriting loss		(266	)		(198	)		(342	)		(370	)
Net investment income		17,174			17,006			34,929			34,043
Other income		10			367			10			367
Net realized investment gains (losses)		30			(1,267	)		(1,037	)		(1,727	)
Other expense		(923	)		—			(923	)		—
Interest and fees expense		(1,854	)		(2,031	)		(3,752	)		(4,088	)
Provision for income taxes		(14,143	)		(9,621	)		(25,011	)		(18,356	)
Net income	$	28,321		$	20,495		$	49,639		$	39,932

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

	Three Months Ended June 30,						Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Direct premiums written	$	316,837		$	328,669		$	655,406		$	680,786
Ceded premiums written		(1,361	)		(1,190	)		(2,706	)		(2,366	)
Net premiums written		315,476			327,479			652,700			678,420
Net change in unearned premiums		10,036			9,363			(1,364	)		(5,217	)
Net premiums earned	$	325,512		$	336,842		$	651,336		$	673,203

We remain focused on achieving our long-term goals of a combined ratio of 96% or lower and 15% annual growth in direct premiums written.

Direct premiums written decreased in the three months and six months ended June 30, 2006, as compared to the same period in 2005, primarily due to continued competitiveness in the California market. As discussed in the Operating Highlights, in July 2006, the California Department of Insurance issued changes to regulations relating to automobile insurance rating factors, particularly concerning territorial rating. 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, which if approved without modification, could have a materially adverse impact on the Company’s California results. See further discussion 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. Net premiums earned decreased in the three months and six months ended June 30, 2006, compared to the same periods a year ago, consistent with the decline in direct premiums written during the same periods. 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 six months ended June 30, 2006 of 5.2 points and 3.6 points, respectively, are partially due to the effect of favorable development related to prior accident years. The loss and LAE ratios for the three months ended June 30, 2006 included 5.6 points ($18.4 million) of favorable development compared to 3.6 points ($12.1 million) in the same period of 2005. Similarly, the six months ended June 30, 2006 loss and LAE ratio included 3.9 points ($25.5 million) of favorable reserve development in 2006 compared to 2.9 points ($20.0 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 periods was primarily attributable to the decline in frequency.

The underwriting expense to net premiums earned ratios increased in the three months and six months ended June 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 six months ended June 30, 2006 was impacted by severance costs and corporate litigation incurred during the three months ended March 31, 2006.

The combined ratio was 91.4% for the quarter ended June 30, 2006, compared to 95.2% for the same period in 2005. The decrease was mainly due to the 5.2 point decrease in the loss and LAE ratio partially offset by 1.4 point increase in the underwriting expense ratio as a result of the items discussed above. The combined ratios for the six months ended June 30, 2006 and 2005 were 93.0% and 95.5%, respectively. The decrease was mainly due to favorable prior accident year loss and LAE development of $25.5 million.

Homeowner and Earthquake Lines in Runoff

We have not written any earthquake policies since 1994 and exited the homeowner insurance business in 2002. Underwriting results of the homeowner and earthquake lines, which are in runoff, include losses and LAE incurred of $0.3 million for the three months ended June 30, 2006, compared to $0.2 million for the same period a year ago. For the six months ended June 30, 2006 and 2005, losses and LAE for those same lines were $0.3 million and $0.4 million, respectively, of which the earthquake lines accounted for less than $0.1 million in loss and LAE during the three months and six months ended June 30, 2006.

Net Investment Income

We utilize a conservative investment philosophy. No derivatives or nontraditional securities are held in our investment portfolio and there were no equity securities at June 30, 2006. Substantially the entire fixed maturity portfolio is investment grade (weighted-average Standard & Poor’s credit quality of “AA”).

The components of net investment income were as follows:

	Three Months Ended June 30,				Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006		2005		2006		2005
Fixed maturity investments available-for-sale	$	16,886	$	15,187	$	33,495	$	30,673
Equity securities available-for-sale		—		1,601		811		2,977
Cash and cash equivalents		288		218		623		393
Net investment income	$	17,174	$	17,006	$	34,929	$	34,043

The average annual yields on fixed income assets were as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2006			2005			2006			2005
Pre-tax - fixed maturity securities		4.6	%		4.5	%		4.7	%		4.6	%
After-tax - fixed maturity securities		3.3			3.3			3.4			3.3

The fixed maturity portfolio, which comprised 97% and 95% of the total investment portfolio at June 30, 2006 and December 31, 2005, respectively, displayed a 10 basis point improvement, on a pre-tax basis, in both the three and six month periods ended June 30, 2006, when compared to the same periods in 2005. This yield improvement was due to the reinvestment of funds from investment sales and maturities into higher yielding fixed maturity securities during a rising rate environment in 2006.

At June 30, 2006, $383.0 million, or 26.9%, of our total fixed maturity investments at fair value were invested in tax-exempt bonds with the remainder, representing 73.1% of the portfolio, invested in taxable securities, compared to 23.1% and 76.9%, respectively, at December 31, 2005 and 21.0% and 79.0%, respectively, at June 30, 2005. As of June 30, 2006, no investments were rated below investment grade.

The net realized gains (losses) on investments were as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
AMOUNTS IN THOUSANDS	2006			2005			2006			2005
Gross realized gains¹	$	97		$	1,966		$	1,549		$	3,304
Gross realized losses²		(67	)		(3,233	)		(2,586	)		(5,031	)
Net realized gains (losses) on investments	$	30		$	(1,267	)	$	(1,037	)	$	(1,727	)

Our policy is to investigate, on a quarterly basis, all investments for possible “other-than-temporary” impairment when the fair value of a security falls below its amortized cost, based on all relevant facts and circumstances. No such impairments were recorded in the three and six months ended June 30, 2006 or 2005. See discussion under Critical Accounting Estimates - Investments for further information.

Other Income and Expense

Other income consists of interest income relating to a refund claim with the IRS. Other expense of $0.9 million in the second quarter of 2006 relates to an impairment charge incurred in connection with vacated space in our headquarters in Woodland Hills, California, which will be sublet starting in the third quarter.

FINANCIAL CONDITION

Investments and cash were approximately $1.5 billion at June 30, 2006 and December 31, 2005. The Company initiated the sale of its equity securities during the first quarter of 2006 and did not hold any equity securities as of June 30, 2006. Applicable funds realized from the sale of equity securities were primarily reinvested in fixed maturity investments. However, the Company executed a $35 million funding commitment for a private equity investment program during the second quarter of 2006, as described in Note 9 of the Notes to Condensed Consolidated Financial Statements.

The Company also has unrated, community investments representing 0.2% of total investments. These investments have been made in an effort to provide housing and other services to economically disadvantaged communities. See Note 8 of the Notes to Condensed Consolidated Financial Statements for additional information.

Increased advertising, sales and customer service costs in the second quarter of 2006 contributed to an increase in deferred policy acquisition costs (“DPAC”) of $8.3 million to $68.2 million, compared to $59.9 million at December 31, 2005. Our DPAC is estimated to be fully recoverable (see Critical Accounting Estimates - Deferred Policy Acquisition Costs).

Gross realized gains during the three months ended June 30, 2006 and 2005 include $64 thousand and $1.9 million, respectively, from the sale of equity securities. Gross realized gains during the six months ended June 30, 2006 and 2005, include $1.2 million and $3.3 million from the sale of equity securities, respectively.

Gross realized losses during the three months ended June 30, 2006 and 2005 include $67 thousand and $3.2 million, respectively, from the sale of equity securities. Gross realized losses during the six months ended June 30, 2006 and 2005, include $2.6 million and $5.0 million from the sale of equity securities, respectively.

The following table summarizes unpaid losses and LAE, gross and net of applicable reinsurance, with respect to our lines of business:

	June 30, 2006				December 31, 2005
AMOUNTS IN THOUSANDS	Gross		Net		Gross		Net
Unpaid losses and LAE
Personal auto lines	$	493,584	$	488,397	$	521,528	$	516,849
Homeowner and earthquake lines in runoff		1,508		783		2,307		1,368
Total	$	495,092	$	489,180	$	523,835	$	518,217

At June 30, 2006, gross unpaid losses and LAE decreased $28.7 million, primarily due to a reserve decrease of $27.9 million in the personal auto lines as a result of $25.5 million of favorable loss development related to prior accident years recorded during the six months ended June 30, 2006 and fewer number of exposures. The gross unpaid losses and LAE in the homeowner and earthquake lines decreased $0.8 million as the result of continued runoff activity (see Critical Accounting Estimates - Losses and Loss Adjustment Expenses