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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

[   ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-6563

Safeco Corporation

State of Incorporation: Washington
I.R.S. Employer I.D. No.: 91-0742146

Address of Principal Executive Offices: Safeco Plaza, Seattle, Washington 98185
Telephone: 206-545-5000

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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X]. NO [   ].

Common Stock, No Par Value 138,384,390 shares were outstanding at April 30, 2003.

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Safeco Corporation and Subsidiaries

CONTENTS

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Safeco Corporation and Subsidiaries

Consolidated Statements of Income

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Consolidated Balance Sheets

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Consolidated Balance Sheets

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Consolidated Statements of Cash Flows

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Consolidated Statements of Cash Flows –
Reconciliation of Net Income to Net Cash Provided by Operating Activities

There were no significant non-cash financing or investing activities for the three months ended March 31, 2003 and 2002.

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Consolidated Statements of Shareholders’ Equity

Consolidated Statements of Comprehensive Income (Loss)

See condensed notes to consolidated financial statements.

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Safeco Corporation and Subsidiaries

Condensed Notes to Consolidated Financial Statements (unaudited)

(Dollar amounts in millions except per share data, unless noted otherwise)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Safeco Corporation is a Washington corporation that has been in the insurance business since 1923. We operate subsidiaries on a nationwide basis in segments of the insurance industry and other financial services-related businesses. Our two principal businesses are (1) property and casualty insurance, including surety, and (2) life insurance and asset management. These activities generated nearly all of our revenues for the interim periods presented in this report.

Throughout our unaudited consolidated financial statements and condensed notes and management’s discussion and analysis, Safeco Corporation and its subsidiaries are referred to as “Safeco” “we” and “our.” The property and casualty businesses including surety, are referred to as “Property & Casualty.” The life insurance and asset management businesses are referred to as “Life & Investments.” All other activities, primarily the financing of our business activities, are collectively referred to as “Corporate.”

Basis of Consolidation and Reporting and Use of Estimates

These unaudited consolidated financial statements and condensed notes have been prepared in conformity with accounting principles generally accepted in the United States (GAAP) for interim financial information and with the instructions to Form 10-Q. Certain financial information, which is required in the annual financial statements prepared in conformity with GAAP, may not be required for interim financial reporting purposes and has been condensed or omitted. In the opinion of management, all adjustments (consisting of normal and recurring adjustments) considered necessary for a fair presentation of results for the interim periods have been included. Operating results for the three-month period ended March 31, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003.

These unaudited consolidated financial statements and condensed notes should be read in conjunction with the financial statements and notes included in Safeco’s 2002 Annual Report on Form 10-K that was previously filed with the Securities and Exchange Commission.

The preparation of these interim consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in these consolidated financial statements. Actual results could differ from those estimates.

The unaudited consolidated financial statements include Safeco Corporation and its subsidiaries. All significant intercompany transactions and accounts have been eliminated in the consolidated financial statements.

Certain reclassifications have been made to the prior year amounts to conform to the current year presentation.

Earnings Per Share

Basic earnings per share is calculated by dividing net income by the weighted-average number of common shares outstanding. Diluted earnings per share reflects the potential dilution that could occur if options or other dilutive instruments outstanding under Safeco’s stock-based compensation plans were exercised.

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The computation of net income per share is presented below, based upon weighted-average common and dilutive shares outstanding:

Stock Compensation Expense

Prior to 2003, Safeco applied Accounting Principles Board (APB) Opinion 25 in accounting for its stock options, as allowed under Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) 123, as amended. Under APB 25, no compensation expense related to options is recognized because the exercise price of Safeco’s employee stock options equals the fair market value of the underlying stock on the date of grant.

In December 2002, the FASB issued SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” amending SFAS 123, to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation under SFAS 123. Effective January 1, 2003, Safeco adopted the fair value method for accounting for stock options as defined in SFAS 123, using the prospective basis transition method provided for under SFAS 148. Safeco typically grants options to employees in the second quarter. As no options were granted, modified or settled during the three months ended March 31, 2003, there is no associated compensation expense recognized.

The following table illustrates the pro forma effect on net income and net income per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.

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Property & Casualty Loss and Loss Adjustment Expense Reserves

Safeco’s consolidated financial statements include estimated reserves for unpaid losses and related claim settlement or loss adjustment expenses (LAE) of our Property & Casualty businesses. We set loss and LAE reserves at each balance sheet date at amounts estimated to equal the ultimate payments that will be made to settle all losses incurred at that date and to pay related expenses.

When claims for losses that are covered by Safeco’s insurance policies are reported to us, our claim adjusters establish a reserve for the expected cost to settle the claim, including estimates of any related legal expenses and other costs associated with resolving the claim. These reserves are called “case basis” reserves. In addition, at the end of each reporting period, certain losses will have occurred that have not yet been reported to Safeco. Accordingly, we set up reserves for such incurred but not reported losses (IBNR) and related LAE.

The process of estimating loss and LAE reserves involves significant judgment and is complex and imprecise due to the number of variables and assumptions inherent in the estimation process. These variables include the effects on ultimate loss payments of internal factors such as changes in claims handling practices and changes in business mix, as well as external factors such as trends in loss costs, economic inflation, judicial trends and legislative changes. In addition, certain claims may be paid out over many years; for example, workers compensation medical costs for severe injuries, and there may be significant lags between the occurrence of an insured event and the time it is actually reported to us, contributing to the variability in estimating ultimate loss payments. Variables such as these affect the reserving process in a variety of ways and the impacts of many of these variables cannot be directly quantified, particularly on a prospective basis.

As a result of the inherent variability in estimating reserves, we use a number of actuarial techniques to estimate loss and LAE reserves. Standard actuarial techniques rely on the premise that historic loss experience can be used to estimate future loss experience. However, Safeco has undergone substantial transformation since 2000, including new product launches, changes in underwriting criteria and improvements in claim handling practices. These actions serve to improve business performance but also affect loss trends and actuarial data. As a result, Safeco has employed a more sophisticated set of actuarial techniques to assess the variables affecting loss experience in certain lines of business and applied multiple actuarial techniques to lines with the greatest volatility. In some cases, these actuarial techniques produce a cluster of estimates, giving management confidence that the reserve estimate is within a relatively tight band of possible outcomes. In other cases, however, additional techniques produce conflicting results. Management reviews reserve indications and the assumptions underlying them in applying the judgments necessary to determine its best estimate for Safeco’s carried reserves.

Due to the assumptions and judgments inherent in the estimation of loss and LAE reserves, actual experience may differ from these estimates. We refine reserve estimates in an ongoing quarterly process as experience develops. We record adjustments to reserves in our results of operations in the periods in which we change the estimate.

We do not discount any of our reserves.

We reduce reserves by amounts that we expect to recover from salvage and subrogation. These recoveries are accrued on an individual case basis for large claims, and actuarial estimation procedures are used for smaller claims.

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Investments

In accordance with the provisions of SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” Safeco classifies its investments into one of three categories: held-to-maturity, available-for-sale or trading. Safeco determines the appropriate classification of both fixed maturities and equities at the time of purchase and re-evaluates such designation as of each balance sheet date. Fixed maturity investments include bonds, mortgage-backed securities and redeemable preferred stocks. Fixed maturity investments are classified as available-for-sale and are carried at fair value. Net unrealized investment gains and losses related to available-for-sale securities are reflected in shareholders’ equity (other comprehensive income) on the Consolidated Statements of Comprehensive Income net of related deferred policy acquisition costs and deferred income taxes.

For the mortgage-backed securities included in the fixed maturity investment portfolio, Safeco recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. Quarterly, actual prepayments are compared to anticipated prepayments and the effective yield is recalculated to reflect actual payments-to-date plus anticipated future payments. Any resulting adjustment is included in net investment income.

Marketable equity securities are classified as available-for-sale and are carried at fair value, with changes in unrealized appreciation and depreciation recorded directly to shareholders’ equity (other comprehensive income), net of related deferred policy acquisition costs and deferred income taxes. Marketable equity securities include common stocks and non-redeemable preferred stocks.

Derivative financial instruments are carried at fair value in accordance with the provisions of SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” Derivatives that are highly effective and designated as either fair value or cash flow hedges, receive hedge accounting treatment under SFAS 133. For derivatives designated as fair value hedges, the changes in the fair value of both the derivative and the hedged transactions are recognized in current earnings. For derivatives designated as cash flow hedges, the changes in fair value of the derivative are recognized as a component of other comprehensive income, net of deferred income taxes, until the hedged transaction affects current earnings. If a derivative is highly effective, but does not perfectly offset the changes in fair value of the hedged transaction, the ineffective portion is recognized in current earnings. For derivatives that do not qualify for hedge accounting treatment under SFAS 133, the changes in the fair value of these derivatives are recorded in current earnings.

When the collectibility of interest income for fixed maturity investments is considered doubtful, they are placed on non-accrual status and thereafter interest income is recognized only when payment is received.

We analyze all investments with a fair value below cost as of each quarterly reporting date to determine if an other than temporary decline in value has occurred. The determination of whether a decline is other than temporary is made based on the relevant facts and circumstances related to the security. These considerations include: (1) the length of time and the extent to which the fair value has been less than cost; (2) the financial condition and near-term prospects of the issuer, including any specific events that influence the operations of the issuer or that affect its future earnings potential; (3) our intent and ability to retain the investment for a period of time sufficient to allow for a recovery in value; (4) a review of any downgrades of the security by a rating agency; and (5) any reduction or elimination of dividends or non-payment of scheduled interest payments. Determining what constitutes an other than temporary decline involves judgment. Declines in fair value below cost not considered other than temporary in the current period could be considered other than temporary in a future period and reduce earnings to the extent of the impairment.

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Fair value amounts for financial instruments are determined using available third-party market information. When such information is not available, the fair value amounts are determined using appropriate valuation methodologies including discounted cash flows and market prices of comparable instruments. Our investment portfolio includes $281.0 of fixed maturities that are not publicly traded at March 31, 2003. Fair values for these securities have been estimated using quoted market prices of comparable instruments based on industry sector, credit quality and maturity and/or internally prepared valuations using third party modeling tools, which also typically use comparable-instrument pricing techniques based on industry sector, credit quality and maturity. Judgment is required in developing certain of these estimates of fair value and the estimates may not represent amounts at March 31, 2003 that would be realized in a current market exchange.

Safeco’s investment portfolio includes $23.1 of equity securities that are not publicly traded at March 31, 2003. Values for these securities are primarily determined using independent pricing sources.

The cost of security investments sold is determined by the “identified cost” method.

Mortgage loans are carried at outstanding principal balances, less an allowance for mortgage loan losses. A mortgage loan is considered impaired when it is probable that Safeco will be unable to collect principal and interest amounts due according to the contractual terms of the mortgage loan agreement. For mortgage loans that are determined to be impaired the difference between the amortized cost and fair value of the underlying collateral is charged to the reserve.

Cash equivalents consist of short-term investments with original maturities of less than three months at the time of purchase. Short-term investments are carried at cost, which approximates fair value.

Safeco engages in securities lending whereby certain securities from its portfolio are loaned to other institutions for short periods of time. Initial collateral is required at 102% of the market value of a loaned security. The collateral is deposited by the borrower with a lending agent and retained and invested by the lending agent to generate additional income according to Safeco’s guidelines. The market value of the loaned securities is monitored on a daily basis, with additional collateral obtained if it drops below 100% of the market value of the loaned securities. The securities lending collateral and the corresponding securities lending payable are reported on the Consolidated Balance Sheets as assets and liabilities, respectively.

New Accounting Standards

SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”

SFAS 148 was issued in December 2002 and amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation under SFAS 123. Effective January 1, 2003, Safeco adopted the fair value method using the prospective basis transition method. For the three month period ending March 31, 2003, Safeco did not make any stock option grants. The estimated impact of the adoption of this standard for the remainder of 2003 will be approximately $5.0 in after-tax stock compensation expense.

FIN 46, “Consolidation of Variable Interest Entities”

FASB Interpretation 46 (FIN 46), “Consolidation of Variable Interest Entities,” was issued in January 2003. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiary if the entities do not effectively disperse risks among parties involved. The interpretation explains how to identify variable interest entities, and how an enterprise assesses its interest in a variable interest entity in order to determine whether to consolidate that entity. FIN 46 is effective immediately for variable interests created or obtained after January 31, 2003, and in the interim period after June 15, 2003 for variable interests acquired before February 1, 2003. We expect that the adoption of this interpretation will have no impact on our consolidated financial statements.

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NOTE 2 – FINANCIAL INSTRUMENTS

See Note 3 of Safeco’s 2002 Annual Report on Form 10-K for discussion of Safeco’s use of derivative and financial instruments.

Fair Value Hedges

Safeco uses interest rate swaps to offset the change in value of certain fixed rate assets and liabilities. In calculating the effective portion of the fair value hedge, the changes in the fair value of the hedge and the hedged item are recognized in net realized investment gains or losses in the Consolidated Statements of Income. There was no fair value hedge ineffectiveness for the three months ended March 31, 2003. Fair value hedge ineffectiveness for the three months ended March 31, 2002 resulted in a $1.2 net realized investment loss.

Cash Flow Hedges

Safeco also uses interest rate swaps to hedge the variability of future cash flows arising from changes in interest rates associated with certain variable rate assets and forecasted transactions. The changes in the fair value of the hedge are recognized in the Consolidated Statements of Comprehensive Income. Differences between the changes in the fair value of the hedge and the hedged item represent hedge ineffectiveness and are recognized as interest expense in the Consolidated Statements of Income. There was no cash flow hedge ineffectiveness for the three months ended March 31, 2003 and 2002.

Amounts related to derivatives qualifying as cash flow hedges are recorded in accumulated Other Comprehensive Income (OCI) and recognized in earnings contemporaneously with the effect of the hedged item. An estimated $9.4 is expected to be reclassified into net investment income over the next 12 months.

SFAS 133 requires amounts recorded in OCI that relate to forecasted transactions that are no longer probable of occurring within a specified time period to be recognized in earnings immediately. There were no amounts released from OCI into earnings during the three months ended March 31, 2003 and 2002 relating to forecasted transactions that were no longer probable.

At March 31, 2003 and 2002, the maximum length of time over which Safeco was hedging its exposure to future cash flows for forecasted transactions was approximately three to 15 months, respectively.

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NOTE 3 – DEBT AND CAPITAL SECURITIES

The total amount, current portions and maturities of debt and capital securities at March 31, 2003 and December 31, 2002 are as follows:

Debt

On January 27, 2003, Safeco issued $200.0 of senior notes with a coupon of 4.200% that mature in 2008 and $300.0 of senior notes with a coupon of 4.875% that mature in 2010. The notes are unsecured and rank equally with all other unsecured senior indebtedness of Safeco. The proceeds from the notes were used to repay $300.0 principal amount of 7.875% medium term notes due in March 2003 and to call and repay $200.0 principal amount of 7.875% notes maturing in 2005 that were callable at par on April 1, 2003.

Safeco renewed its bank credit facility in September 2002 with $500.0 available through September 2005. This replaced the $800.0 facility that expired in September 2002. Safeco pays a fee to have the facility available and does not maintain deposits as compensating balances. Similar to its previous facility, the new facility carries certain covenants that require Safeco to maintain a specified minimum level of shareholders’ equity and a maximum debt-to-capitalization ratio. There were no borrowings under the facility as of March 31, 2003 and December 31, 2002, and Safeco was in compliance with all covenants.

NOTE 4 – RESTRUCTURING CHARGES

In July 2001, Safeco announced that it would eliminate approximately 1,200 jobs by the end of 2003. Since the beginning of 2001 through the end of 2002, Safeco’s total employment decreased by approximately 1,200, excluding the reduction due to the sale of Safeco Credit and the increase associated with the acquisition of Swiss Re’s stop- loss medical business. Positions eliminated were in the corporate headquarters and regional Property & Casualty operations. Total restructuring charges and period costs associated with this restructuring were $66.1 and these actions were completed in 2002.

For the three months ended March 31, 2002, period costs associated with the restructuring totaled $6.6. These period costs included stay bonuses, employee transfer costs, recruiting and training expenses, related consulting fees and certain office closure costs.

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NOTE 5 – COMPREHENSIVE INCOME

Comprehensive income is defined as all changes in shareholders’ equity, except those arising from transactions with shareholders. Comprehensive income includes net income and other comprehensive income, which for Safeco consists of changes in net unrealized gains or losses on available for sale securities, deferred policy acquisition costs valuation allowance, net unrealized gains or losses on derivatives, changes in foreign currency translation gains or losses, minimum pension liability and the deferred taxes applicable to these items.

The components of accumulated other comprehensive income or loss were as follows: