FORM 10-K

For the Fiscal Year Ended December 31, 2004

OR

Commission File Number: 0-22280

PHILADELPHIA CONSOLIDATED HOLDING CORP.

Registrant’s telephone number, including area code: (610) 617-7900

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value

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.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on March 14, 2005 as reported on the NASDAQ National Market System, was $812,679,971. Shares of Common Stock held by each executive officer and director and by each person who is known by the Registrant to beneficially own 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 14, 2005, Registrant had outstanding 22,811,875 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

(1)	Portions of the definitive Proxy Statement for Registrant’s 2005 Annual Meeting of Shareholders to be held April 28, 2005 are incorporated by reference in Part III.

PART I

Item 1. BUSINESS

GENERAL

          As used in this Annual Report on Form 10-K, (i) “Philadelphia Insurance” refers to Philadelphia Consolidated Holding Corp., (ii) the “Company” refers to Philadelphia Insurance and its subsidiaries, doing business as Philadelphia Insurance Companies; (iii) the “Insurance Subsidiaries” refers to Philadelphia Indemnity Insurance Company (“PIIC”), Philadelphia Insurance Company (“PIC”), Mobile USA Insurance Company (“MUSA”) and Liberty American Insurance Company (“LAIC”), collectively; (iv) “MIA” refers to Maguire Insurance Agency, Inc., a captive underwriting manager; (v) “MHIA” refers to Mobile Homeowners Insurance Agencies, Inc., a managing general agency; (vi) “Premium Finance” refers to Liberty American Premium Finance Company; and (vii) “PCHC Investment” refers to PCHC Investment Corp., an investment holding company. Philadelphia Insurance was incorporated in Pennsylvania in 1984 as an insurance holding company. Liberty American Insurance Group, Inc., a Delaware insurance holding company, and its subsidiaries MUSA, LAIC, MHIA and Premium Finance, are sometimes referred to herein collectively as “Liberty”.

The Company’s core strategy consists of three major principles:

	•	Adhering to an underwriting philosophy aimed at consistently generating underwriting profits through sound risk selection and pricing discipline.
	•	Distributing products through a “mixed” marketing platform, combining direct sales, an extensive network of independent agents and a subset of this network, known as “preferred agents”, with whom the company has established special distribution arrangements.
	•	Seeking to create value-added coverage and service features not found in typical property and casualty policies that the Company believes differentiates and enhances the marketability and appeal of its products relative to its competitors.

     During 2004, the Company continued its growth through adherence to its core principles of profitable underwriting, mixed marketing and specialization. 2004 gross written premiums increased 29.3% to $1,171.3 million. Premium growth was primarily attributable to the Company capitalizing on continuing turmoil in the property and casualty market, as well as better “brand” recognition with agents and brokers, its A+ (“Excellent”) A.M. Best Company rating (for PIIC and for PIC) and differentiated policy forms. The Company’s GAAP basis combined ratio (the sum of the net loss and loss adjustment expenses and acquisition costs and other underwriting expenses divided by net earned premiums) was 89.6%, which was substantially lower than the combined ratio of the property and casualty industry as a whole. The Company’s combined ratio is inclusive of $46.7 million in net catastrophe losses ($659.8 million gross catastrophe losses) it experienced from the four hurricanes which made land fall in Florida during 2004. During 2004 total assets increased to $2.5 billion, and shareholders’ equity increased to $644.2 million.

INDUSTRY TRENDS

          A tumultuous environment has existed in the property and casualty insurance industry during the last few years due in large part to: the significant losses caused by the terrorists events of September 11, 2001; continued rating downgrades and insolvencies, and lower interest rates resulting in reduced investment income. Through 2003 these factors resulted in a general environment of rate increases and conservative risk selection. Increased reinsurance costs, to some extent, offset the benefits of these trends. The four destructive Florida hurricanes which made landfall within a six-week time period during 2004 had a significant impact on many property and casualty insurance companies. We were adversely impacted by the hurricanes with an estimated $659.8 million in gross losses and $46.7 million in net losses incurred principally in its personal lines segment.

          The industry appears to have rebounded steadily from the contraction of capacity caused by significant losses that resulted from the terrorist events of September 11, 2001. Also, the 2004 Florida hurricanes which, although significant, have not appeared to alter this trend. Industry loss ratios have improved to a level that has caused increased competition. Despite improved industry loss ratios, the current low interest rate environment limiting the investment income realized by insurance companies has mitigated the severity of price declines historically experienced by the industry in past transitions from hard markets to soft markets.

2

BUSINESS OVERVIEW AND STRATEGY

          The Company designs, markets and underwrites specialty commercial and personal property and casualty insurance products incorporating value-added coverages and services for select target markets or niches. The company targets markets and niches with specialized areas of demand, designing innovative policy features. The company believes this approach allows it to compete on coverage and customized solutions, rather than just price. Insurance products are distributed through a diverse multi-channel delivery system centered around the Company’s direct production underwriting organization. A select group of 133 “preferred agents” and a broader network of approximately 8,700 independent agents supplement the production underwriting organization, which consisted of 234 professionals located in 36 regional and field offices across the United States as of December 31, 2004.

          The Company’s commercial products include commercial multi-peril package insurance targeting specialized niches, including, among others, non-profit organizations, sports and recreation centers, homeowners’ associations, condominium associations, private, vocational and specialty schools, mental health facilities and day care facilities; commercial automobile insurance targeting the leasing and rent-a-car industries; property insurance for large commercial accounts such as shopping centers, business parks, hotels and medical facilities; and inland marine products targeting larger risks such as new builders’ risk and miscellaneous property floaters.

          The Company also writes select classes of professional liability and management liability products, as well as personal property and casualty products for the manufactured housing and homeowners’ markets.

          The Company maintains detailed systems, records and databases that enable the monitoring of its book of business in order to identify and react swiftly to positive or negative developments and trends. The Company is able to track performance, including loss ratios, by segment, product, region, state, producer and policyholder. Detailed profitability reports are produced and reviewed on a routine (primarily monthly) basis as part of the policy of regularly analyzing and reviewing the Company’s book of business.

          The Company maintains a local presence to more effectively serve its producer (independent agents and brokers) and customer base, operating through 12 regional offices and 24 field offices throughout the country, which report to the regional offices. These offices are staffed with marketers, field underwriters, accounts receivable and, in some cases, claim personnel, who interact closely with home office management in making key decisions. This approach allows the Company to adapt its marketing and underwriting strategies to local conditions and build value-added relationships with its customers and producers.

          The Company selects and targets industries and niches that require specialized areas of expertise where it believes it can grow business through creatively developing insurance products with innovative features specially designed to meet those areas of demand. The Company believes that these features are not included in typical property and casualty policies, enabling it to compete based on the unique or customized nature of the coverage provided.

Business Segments

          The Company’s operations are classified into three reportable business segments:

	•	The Commercial Lines Underwriting Group, which has underwriting responsibility for the commercial multi-peril package, commercial automobile and specialty property and inland marine insurance products;
	•	The Specialty Lines Underwriting Group, which has underwriting responsibility for the professional liability and management liability insurance products; and
	•	The Personal Lines Underwriting Group, which has underwriting responsibility for personal property and casualty insurance products for the manufactured housing and homeowners’ markets, principally in Florida.

3

          The following table sets forth, for the years ended December 31, 2004, 2003 and 2002, the gross written premiums for each of the Company’s business segments and the relative percentages that such premiums represented.

Commercial Lines:

          Commercial Package: The Company has provided commercial multi-peril package policies to targeted niche markets for over 16 years. The primary customers for these policies include:

	•	non-profit and social service organizations;
	•	sports and recreation centers;
	•	homeowners’ associations;
	•	condominium associations;
	•	private, vocational and specialty schools;
	•	boat dealerships;
	•	mobile home parks;
	•	day care facilities;
	•	mental health facilities;
	•	amateur sports facilities;
	•	bowling centers;
	•	golf clubs; and
	•	public entity.

          The package policies provide a combination of comprehensive liability, property and automobile coverage with limits of up to $1.0 million for casualty, $50.0 million for property, and umbrella limits on an optional basis up to $10.0 million. The Company believes its ability to provide professional liability and general liability coverages in one policy is advantageous and convenient to producers and policyholders.

          Commercial Automobile and Commercial Excess: The Company has provided primary, excess, contingent, interim and garage liability; physical damage; and property; to targeted markets for over 35 years. The primary customers for these policies include:

	•	rental car companies;
	•	leasing companies;
	•	banks; and
	•	credit unions.

4

     Specialty Property & Inland Marine: The Company has provided property and inland marine coverage to targeted markets for the past 5 years. The primary customers for these policies include:

	•	shopping centers;
	•	business parks;
	•	medical facilities;
	•	hotels and motels;
	•	new construction (inland marine); and
	•	builders risk.

Specialty Lines:

     The Company has provided management liability (directors and officers (D&O) liability, employment practices liability, fiduciary liability, kidnap and ransom, work place violence and internet liability) and errors and omissions (professional) to targeted classes of business for approximately 14 years. The professional liability products provide errors and omissions coverage primarily for:

	•	lawyers;
	•	accountants;
	•	miscellaneous (marketing, management, computer, marriage/family counseling) consultants; and
	•	excess liability.

The management liability products are offered to:

	•	non-profit (501(c)(3) companies);
	•	for-profit public and private companies; and
	•	excess liability.

Personal Lines:

     The Company entered the personal lines property and casualty business through the acquisition of Liberty American Insurance Group, Inc. (“Liberty”) in 1999. This personal lines platform produces and underwrites specialized manufactured housing and homeowners’ property and casualty business principally in Florida, and to a lesser extent, in California and New Jersey. Liberty also produces and services federal flood insurance under the National Flood Insurance Program for both personal and commercial policyholders.

     Products offered include manufactured housing insurance for senior citizen retirees in “preferred” parks, a program for newly constructed manufactured homes on private property; a preferred homeowners’ program that targets newer homes valued between $100,000 and $375,000, and a homeowners’ program excluding wind exposure in Florida coastal counties. As a result of Florida’s increased number of seasonal residents during the winter months, approximately 50% of the in-park manufactured housing business is written in the first four calendar months of the year. Management expects that this seasonality will be less pronounced in 2005 and forward due to a planned shift in product mix which contemplates reducing manufactured housing product policies and increasing homeowners’ product policies. The Company plans to reduce its manufactured housing exposures by restricting new business and further limiting exposure concentrations. The preferred homeowner’s program underwriting criteria is being expanded to increase the maximum eligible home values from $375,000 to $750,000.

5

Geographic Distribution

     The following table provides the geographic distribution of direct earned premiums for all reportable business segments of the Company’s risks insureds, as represented by direct earned premiums for the year ended December 31, 2004. No other state accounted for more than 2% of total direct earned premiums for the year ended December 31, 2004. (dollars in thousands).

See Note 17 to the Company’s financial statements included with this Form 10-K for information concerning the revenues, net income and assets of the Company’s business segments.

Underwriting and Pricing

     The Company’s business segments are organized around its three underwriting divisions: Commercial Lines, Specialty Lines, and Personal Lines. Each underwriting division’s responsibilities include pricing, managing the risk selection process, and monitoring loss ratios by product insured.

     The Company attempts to adhere to conservative underwriting and pricing practices. The Company’s underwriting strategy is detailed in a document which is signed by each underwriting professional. Written underwriting guidelines are maintained and updated regularly for all classes of business underwritten and adherence to these underwriting guidelines is maintained through underwriting audits conducted by the Company. Product pricing levels are monitored utilizing a system which measures the aggregate price level of a book of business. This system assists management and underwriters to promptly recognize and respond to price deterioration. When necessary, the Company re-underwrites, sharply curtails or discontinues a product deemed to present unacceptable risks.

     The Commercial Lines Underwriting Group has underwriting responsibility for the Company’s commercial multi-peril package, commercial automobile and large property and inland marine products. The Group currently consists of 63 home office and 59 regional office underwriters who are supported by underwriting assistants, raters, and other policy administration personnel. The Commercial Lines home office underwriting unit is responsible for underwriting, auditing, servicing renewal business, and authorizing quotes for new business which are in excess of the regional office underwriters limits. The regional office underwriters have the responsibility for pricing, underwriting, and policy issuance for new business. The commercial lines underwriting group is under the immediate direction of Product Managers and Assistant Vice Presidents who report to the Vice Presidents of Commercial Lines Underwriting. Overall management responsibility for the book of business resides in the home office with the senior underwriting officers. The Company believes that its ability to deliver excellent service and build long lasting relationships is enhanced through its management structure.

     The Specialty Lines Underwriting Group has the underwriting responsibility for the errors and omissions and management liability products. The Group consists of 32 home office underwriters and underwriter trainees and 28 regional underwriters. These underwriters and underwriter trainees are supported by underwriting assistants and other policy administration personnel. The home office underwriting unit is responsible for underwriting, auditing and servicing renewal business, as well as an authority referral for the regional office underwriters for quoting new business. The regional office underwriters have the responsibility for pricing, underwriting, and policy issuance of new business. The Specialty Lines Group is managed by a Vice President who reports directly to the Chief Underwriting Officer.

     The Personal Lines Underwriting Group is located in Pinellas Park, Florida. The underwriting staff consists of 10 professionals who are under the direction of the Personal Lines Underwriting Vice President. Much of the underwriting

6

function is automated through internet accessed rating software. Underwriting guidelines are embedded within this software which prohibit binding of accounts if a risk does not meet the underwriting guidelines. The Company has a proactive exposure distribution management system in place to aid in portfolio optimization. The risk portfolio is managed at a zip code level through the use of in-house software and external modeling tools. The Company inspects the properties for its new preferred homeowners program and manufactured homes on private property product.

     The Company uses a combination of Insurance Services Office, Inc. (“ISO”) coverage forms and rates and independently filed forms and rates. Coverage forms and rates are independently developed for situations where the line of business is not supported by ISO or where management believes the ISO forms and rates do not adequately address the risk. Departures from ISO forms are also used to differentiate the Company’s products from its competitors.

Reinsurance

     The Company has entered into various reinsurance agreements for the purpose of limiting loss exposure and managing capacity constraints as described below:

     The Company’s casualty excess of loss reinsurance agreement (“Excess Treaty”) provides that the Company bears: the first $1.0 million primary layer of liability on each occurrence and the first $1.0 million layer of liability on umbrella risks for policies where the Company provides the first $1.0 million primary layer of coverage. Casualty, fidelity, professional liability and fiduciary liability risks in excess of $1.0 million up to $11.0 million are reinsured under the Excess Treaty which has been placed through a reinsurance broker. As of January 2005 the reinsurers participating on the Excess Treaty are Allied World Assurance Company, LTD, American Reinsurance Company, ACE Property and Casualty Insurance Company , and Liberty Mutual Insurance Company, with a pro rata participation of 25%, 30%, 20% and 25%, respectively. Facultative reinsurance (reinsurance which is provided on an individual risk basis) is placed for each casualty risk in excess of $11.0 million.

     The Company’s property excess of loss reinsurance treaty provides that the Company bears the first $2.0 million of loss on each risk with its reinsurers bearing two layers of loss up to $50.0 million on each risk. General Reinsurance Corporation provides limits of $8.0 million in excess of $2.0 million, and Swiss Reinsurance American Corporation, provides limits of $40.0 million in excess of $10.0 million. The Company also has automatic facultative excess of loss reinsurance with General Reinsurance Corporation for each property loss in excess of $50.0 million up to $100.0 million. To mitigate potential exposures to losses arising from terrorist acts, the Company has purchased per risk reinsurance coverage for terrorism with a $48.0 million aggregate policy limit for 2004. Under this reinsurance coverage the Company bears the first $2.0 million layer of loss on each risk and coverage.

     Effective April 1, 2003, the Company entered into a quota share reinsurance agreement. Under this agreement, the Company ceded 22% of its net written premiums and loss and loss adjustment expenses for substantially all lines of business on policies effective April 1, 2003 through December 31, 2003, and 10% of its commercial and specialty lines net written premiums and loss and loss adjustment expenses for policies effective January 1, 2004 and through December 31, 2004. The Company received a provisional commission of 33.0% adjusted pro-rata based upon the ratio of losses incurred to premiums earned. Pursuant to this reinsurance agreement the Company withheld the reinsurance premiums due the reinsurers reduced by the reinsurers’ expense allowance and the Company’s ceding commission allowance in a Funds Held Payable to Reinsurer account. This Funds Held Payable to Reinsurer account is also reduced by ceded paid losses and loss adjustment expenses under this agreement, and increased by an interest credit. In addition, the agreement allows for a profit commission to be paid to the Company upon commutation. Effective as of January 1, 2005 the Company entered into a Reinsurance Commutation and Release Agreement with respect to the 2003 quota share reinsurance agreement.

     The Company purchases property catastrophe reinsurance covering both its commercial and personal lines catastrophe losses. The Company’s primary catastrophe reinsurance program provides coverage for a one year period with a June 1 renewal date. For its personal lines catastrophe losses the Company’s reinsurance coverage is approximately $336.3 million in excess of the Company’s $3.5 million per occurrence retention. Of this total amount, the Florida Hurricane Catastrophe Fund (the “FHCF”) provides on an aggregate basis for Mobile USA Insurance Company and Liberty American Insurance Company 90% coverage for approximately $194.5 million excess $52.4 million. Additionally, a 15% quota share reinsurance arrangement provides $24.7 million of the $336.3 million in coverage. Both the FHCF and the quota share arrangements inure to the benefit of the Company’s open-market catastrophe program. The coverage provided by the open-market catastrophe program (large reinsurers that are rated at least “A” (excellent) by A.M. Best Company) includes one mandatory reinstatement but the FHCF coverage does not reinstate. Since the FHCF coverage cannot be reinstated, the Company’s open-market program is structured such that catastrophe reinsurance coverage excess of the FHCF coverage will

7

“drop down” and fill in any portion of the FHCF coverage which has been utilized. The quota share reinsurance arrangement provides 15% coverage for catastrophe losses without limit. Based upon the various modeling methods utilized by the Company to estimate its probable maximum loss for its personal lines business, the 100 year storm event is estimated at $171.4 million and the 250 year storm event is estimated at $283.3 million. These loss estimates were calculated using the personal lines in-force exposures as of June 30, 2004.

     For its commercial lines catastrophe losses the company’s catastrophe reinsurance coverage is $108.0 million in excess of the Company’s $7.0 million per occurrence retention. Based upon the various modeling methods utilized by the Company to estimate its probable maximum loss for its commercial lines business, the 100 year storm event is estimated at $67.1 million and 250 year storm event is estimated at $108.0 million.

     The company also purchased reinstatement premium protection reinsurance contracts, effective July 1, 2004, which pay 100% of the reinstatement premium for the one mandatory reinstatement which the Company becomes liable to pay as a result of loss occurrences under both of its personal and commercial lines open-market catastrophe reinsurance programs.

     As a result of the four hurricanes which made landfall in Florida during August and September 2004, the Company purchased the following additional catastrophe reinsurance coverages during September and October 2004 to replace property catastrophe coverage which had been utilized. These agreements are effective through May 31, 2005.

	•	Additional personal lines excess reinsurance coverage providing $50.0 million of catastrophe reinsurance coverage excess $140.0 million.
	•	Third and fourth catastrophe event reinsurance coverage on the first four layers ($46.5 million excess the Company’s $3.5 million retention) of the personal lines catastrophe reinsurance program.
	•	Third catastrophe event reinsurance coverage on the first two layers ($13.0 million excess the Company’s $7.0 million retention) of the commercial lines catastrophe reinsurance program.
	•	Additional personal lines excess reinsurance coverage providing $50.0 million of catastrophe reinsurance coverage excess of $190.0 million.
	•	Fifth event personal lines catastrophe reinsurance coverage which in the aggregate provides $6.5 million of catastrophe reinsurance coverage excess $3.5 million.
	•	Additional personal lines excess reinsurance coverage providing $50.0 million of coverage excess of $240.0 million.
	•	$50.0 million of coverage excess $140.0 million in excess $50.0 million otherwise recoverable which provides an additional $50.0 million of reinsurance coverage excess $140.0 million after the first $50.0 million of loss is recovered under the $50.0 million excess $140.0 million personal lines catastrophe program.
	•	$40.0 million excess $50.0 million in excess $80.0 million otherwise recoverable which provides a third $40.0 million limit of reinsurance coverage after the $40.0 million in excess $50.0 million under the personal lines catastrophe program has been exhausted.

     The Company also has an excess casualty reinsurance agreement which provides an additional $18.0 million of coverage excess of a $2.0 million Company retention for protection from exposures such as extra-contractual obligations and judgments in excess of policy limits. An errors and omissions insurance policy provides an additional $10.0 million of coverage with respect to these exposures.

     The Company seeks to limit the risk of a reinsurer’s default in a number of ways. First, the Company principally contracts with large reinsurers that are rated at least “A” (Excellent) by A.M. Best Company. Secondly, the Company seeks to collect the obligations of its reinsurers on a timely basis. This collection effort is supported through the regular monitoring of reinsurance receivables. Finally, the Company typically does not write casualty policies in excess of $11.0 million or property policies in excess of $50.0 million.

     Although the Company purchases reinsurance to limit its loss exposure by transferring the risk to its reinsurers, reinsurance doesn’t relieve the Company of its liability to policyholders.

     The Company regularly assesses its reinsurance needs and seeks to improve the terms of its reinsurance arrangements as market conditions permit. Such improvements may involve increases in retentions, modifications in premium rates, changes in reinsurers and other matters.

8

Marketing and Distribution

     Proactive risk selection based on sound underwriting criteria and relationship selling in clearly defined target markets continues to be the foundation of the Company’s marketing plan. Within this framework, the Company’s marketing effort is designed to promote a systematic and disciplined approach to developing business which is anticipated to be profitable.

     The Company distributes its products through its direct production underwriting organization, an extensive network of approximately 8,700 independent brokers and its “preferred agent” program. The Company’s most important distribution channel is its production underwriting organization. Although the Company has always written business directly, the production underwriting organization was established by the Company to stimulate new sales through independent agents. The production underwriting organization is currently comprised of 234 professionals located in 36 offices in major markets across the country. The field offices are focused daily on interacting with prospective and existing insureds. In addition to this direct prospecting, relationships with approximately 8,700 brokers have been formed, either because the broker has a preexisting relationship with the insured or has sought the Company’s expertise in one of its specialty products. This mixed marketing concept provides the Company with the flexibility to respond to changing market conditions and, when appropriate, shift its emphasis to different product lines to take advantage of opportunities as they arise. In addition, the production underwriting organization’s ability to gather market intelligence enables the rapid identification of soft markets and redeployment to firmer markets, from a product line or geographic perspective. The Company believes that its mixed marketing platform provides a competitive edge, not only in stable market conditions.

     The Company’s preferred agent program, in which business relationships are formed with brokers specializing in certain of the Company’s business niches, consisted of 133 preferred agents at year-end 2004. Preferred agents are identified by the Company based on productivity and loss experience, and receive additional benefits from the Company in exchange for meeting defined production and profitability criteria.

     The Company supplements its marketing efforts through affinity programs, trade shows, direct mailings, eflyers and national advertisements placed in trade magazines serving industries in which the Company specializes, as well as links to industry web sites. The Company has also enhanced its marketing with Internet-based initiatives, such as the Personal Lines Division’s “Liberty American In Touch^SM” real-time policy inquiry system, which allows agents to view account data, process non-dollar endorsements, rate, quote and issue a policy over the Internet.

Product Development

     The Company continually evaluates new product opportunities, consistent with its strategic focus on selected market niches. Direct contacts between the Company’s field and home office personnel, preferred agent council and its customers have produced a number of new product ideas. All new product ideas are presented to the Product Development Committee for consideration. Such Committee, currently composed of the Company’s President and members of senior management, meets regularly to review the feasibility of products from a variety of perspectives, including profitability, underwriting risk, marketing and distribution, reinsurance, long-term viability and consistency with the Company’s culture and philosophy. For each new product, an individualized test market plan is prepared, addressing such matters as the appropriate distribution channel (e.g., a limited number of selected production underwriters), an appropriate cap on premiums to be generated during the test market phase and reinsurance requirements for the test market phase. Test market products may involve lower retentions than customarily utilized. After a new product is approved for test marketing, the Company monitors its success based on specified criteria (e.g., underwriting results, sales success, product demand and competitive pressures). If expectations are not realized, the Company either moves to improve results by initiating adjustments or abandons the product.

Claims Management and Administration

     In accordance with its emphasis on underwriting profitability, the Company actively manages claims under its policies in an effort to investigate reported incidents at an early stage, service insureds and reduce fraud. Claim files are regularly audited by claims supervisors in an attempt to ensure that claims are being processed properly and that reserves are being set at appropriate levels.

     The Company’s experienced staff of claims management professionals is assigned to dedicated claim units within specific niche markets. Each of these units receive supervisory direction and news, legislative and product development updates from the unit director. Claims management personnel have an average of approximately twenty years of experience

9

in the industry. The dedicated claim units meet regularly to communicate changes within their assigned specialty. Staff within the dedicated claim units have an average of ten years experience in the industry.

     The claims department also maintains a Special Investigations Unit to investigate suspicious claims and to serve as a clearinghouse for information concerning fraudulent practices. The Special Investigations Unit works closely with a variety of industry contacts, including attorneys and investigators to identify fraudulent claims.

Loss and Loss Adjustment Expenses

     The Company is liable for losses and loss adjustment expenses under its insurance policies and reinsurance treaties. While the Company’s professional liability policies are written on claims-made forms, and while claims on its other policies are generally reported promptly after the occurrence of an insured loss, in many cases several years may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company’s payment of the loss. The Company reflects its liability for the ultimate payment of all incurred losses and loss adjustment expenses by establishing loss and loss adjustment expense reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events that have occurred.

     When a claim involving a probable loss is reported, the Company establishes a case reserve for the estimated amount of the Company’s ultimate loss and loss adjustment expense. This estimate reflects an informed judgment, based on the Company’s reserving practices and the experience of the Company’s claims staff. Management also establishes reserves on an aggregate basis to provide for losses incurred but not reported (“IBNR”), as well as future development on claims reported to the Company.

     As part of the reserving process, historical data are reviewed and consideration is given to the anticipated effect of various factors, including known and anticipated legal developments, changes in societal attitudes, inflation and economic conditions. Reserve amounts are necessarily based on management’s estimates and judgments; as new data become available and are reviewed, these estimates and judgments are revised, resulting in increases or decreases to existing reserves. The Insurance Subsidiaries’ actuary provides the Companies with an annual statement of opinion for the statutory filings with regulators.

     The following table sets forth a reconciliation of beginning and ending reserves for unpaid loss and loss adjustment expenses, net of amounts for reinsured losses and loss adjustment expenses, for the years indicated.

10

     During 2004 the Company increased its estimated total gross and net ultimate losses and loss adjustment expenses, primarily for accident years 1997 through 2002, and decreased its estimated total gross and net ultimate losses and loss adjustment expenses for accident year 2003 by the following amounts:

(In millions)

(In millions)

     The increase for accident years 1997 through 2002 is principally attributable to case reserve development above expectations primarily across various professional liability products in the specialty lines segment and general liability and commercial automobile coverages in the commercial lines segment. The decrease for accident year 2003 is principally attributable to better than expected claim frequency, primarily for general liability and commercial automobile coverages in the commercial lines segment.

     During 2003 the Company increased the liability for unpaid loss and loss adjustment expenses by $51.7 million ($44.6 million net of reinsurance recoverables), primarily for accident years 1997 through 2001. This increase in the liability for unpaid loss and loss adjustment expense, net of reinsurance recoverables, was primarily due to the following:

- -

The Company increased the estimated gross and net loss for unreported claims incurred and related claim adjustment expenses on residual value polices issued during the years 1998 through 2002 by $38.8 million. The residual value policies provide coverage guaranteeing the value of a leased automobile at the lease termination, which can be up to five years from lease inception. The increase in the estimated gross and net loss was a result of:

	•	Adverse trends further deteriorating in both claims frequency and severity for leases expiring in 2003. During the second quarter of 2003, the Company engaged a consulting firm to aid in evaluating the ultimate potential loss exposure under these policies. Based upon the study and subsequent evaluation by the Company, the Company changed its assumptions relating to future frequency and severity of losses, and increased the estimate for unpaid loss and loss adjustment expenses by $33.0 million. The Company primarily attributes this deterioration to the following factors that led to a softening of prices in the used car market subsequent to the September 11, 2001 terrorist attacks: prolonged 0% new car financing rates and other incentives which increased new car sales and the volume of trade-ins and daily rental units being sold into the market earlier and in greater numbers than expected, further adding to the oversupply of used cars and the overall uncertain economic conditions.
	•	The Company entering into an agreement with U.S. Bank, N.A. d/b/a Firstar Bank (“Firstar”) relating to residual value insurance policies purchased by Firstar from the Company. Under the terms of the agreement, the Company paid Firstar $27.5 million in satisfaction of any and all claims made or which could have been made by Firstar under the residual value policies. The Company increased the gross and

11

net reserves for loss and loss adjustment expenses from $21.7 million to $27.5 million pursuant to this agreement.

- -

The Company increased its estimate for unpaid loss and loss adjustment expenses for non-residual value policies by $43.5 million ($30.8 million net of reinsurance recoverables), primarily for accident years 1999 to 2001, and decreased its estimate of the unpaid loss and loss adjustment expenses for such policies by $30.6 million ($25.0 million net of reinsurance recoverables) for the 2002 accident year. The increase in accident years 1999 to 2001 is principally attributable to:

•

$19.6 million ($13.7 million net of reinsurance recoverables) of development in claims made professional liability products as a result of case reserves developing greater than anticipated from the year-end 2002 ultimate loss estimate; $18.1 million ($11.1 million net of reinsurance recoverables) of development in the automobile and general liability coverages for commercial package products due to the frequency and severity of the losses developing beyond the underlying pricing assumptions; and $5.8 million ($6.0 million net of reinsurance recoverables) of development in the commercial automobile excess liability insurance and GAP commercial automobile products due to losses developing beyond the underlying pricing assumptions.

- -

The decrease in unpaid loss and loss adjustment expenses in accident year 2002 is principally attributable to:

•

$4.2 million ($4.7 million net of reinsurance recoverables) and $26.4 million ($20.3 million net of reinsurance recoverables) of favorable development in professional liability products and commercial package products, respectively, due to favorable loss experience as a result of favorable product pricing.

During 2002, the Company increased the estimated loss for unreported claims incurred and related claim adjustment expenses on residual value polices issued during the years 1998 through 2001 by $30.2 million ($20.7 million net of reinsurance). As of December 31, 2001 the Company had estimated a total liability for unpaid loss and loss adjustment expenses for these policies of $14.5 million ($8.7 million net of reinsurance recoverables). During 2002 adverse trends further deteriorated in both frequency and severity on leases expiring in 2002. As part of the Company’s monitoring and evaluation process, consulting firms were engaged during the third quarter of 2002 to aid in evaluating this deterioration and the ultimate potential loss exposure under these policies. As a result of the indications and subsequent evaluation by the Company and changes in the Company’s assumptions relating to future frequency and severity of losses, the estimate for unpaid loss and loss adjustment expenses was increased. The Company primarily attributes this deterioration to the following factors that led to a softening of prices in the used car market subsequent to the September 11, 2001 terrorist attacks: prolonged 0% new car financing rates and other incentives which increased new car sales and the volume of trade-ins, daily rental units being sold into the market earlier and in greater numbers than expected further adding to the over supply of used cars; and the overall uncertain economic conditions.

The Company also increased the liability for unpaid loss and loss adjustment expenses on the Commercial Automobile Excess Liability Insurance (“Excess Liability”) product sold to rental car companies (Commercial Lines Underwriting Segment) primarily for the 2000 and 2001 accident years by $6.9 million ($4.9 million net of reinsurance). As of December 31, 2001 the Company had estimated a total liability for unpaid loss and loss adjustment expenses for the Excess Liability policies issued in these years of $23.0 million ($21.6 million net of reinsurance). Excess Liability provides automobile liability coverage in excess of the state mandated limits which are provided by the rental car company. During the third quarter of 2002, pursuant to a routine underwriting review focusing on price adequacy and loss experience, the Company non-renewed a significant Excess Liability customer as a result of an unacceptable underwriting risk profile. This adverse loss development was primarily due to pricing inadequacy and the adverse loss experience of this customer. Additionally, the Company has experienced a delay in both the reporting of claims and the claim litigation discovery process as a result of this policyholder and another Excess Liability policyholder filing for bankruptcy protection during the third quarter 2002 and fourth quarter 2001, respectively.

The following table presents the development of unpaid loss and loss adjustment expenses, net of amounts for reinsured losses and loss adjustment expenses, from 1994 through 2004. The top line of the table shows the estimated reserve for unpaid loss and loss adjustment expenses at the balance sheet date for each of the indicated years. These figures represent the estimated amount of unpaid loss and loss adjustment expenses for claims arising in the current year and all prior years that were unpaid at the balance sheet date, including IBNR losses. The table also shows the re-estimated amount of the previously recorded unpaid loss and loss adjustment expenses based on experience as of the end of each succeeding year. The estimate may change as more information becomes known about the frequency and severity of claims for individual years.

12

13

     The cumulative redundancy (deficiency) represents the aggregate change in the reserve estimated over all prior years, and does not present accident year loss development. Therefore, each amount in the table includes the effects of changes in reserves for all prior years.

     The unpaid loss and loss adjustment expense of the Insurance Subsidiaries, as reported in their Annual Statements prepared in accordance with statutory accounting practices and filed with state insurance departments, differ from those reflected in the Company’s financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) with respect to recording the effects of reinsurance. Unpaid loss and loss adjustment expenses under statutory accounting practices are reported net of the effects of reinsurance, whereas under GAAP these amounts are reported without giving effect to reinsurance. Under GAAP, reinsurance receivables, with a corresponding increase in unpaid loss and loss adjustment expense, have been recorded. (See footnote (1) on Page 13 for amounts). There is no effect on net income or shareholders’ equity due to the difference in reporting the effects of reinsurance between statutory accounting practices and GAAP as discussed above.

Operating Ratios

Statutory Combined Ratio

     The statutory combined ratio, which is the sum of (a) the ratio of loss and loss adjustment expenses incurred to net earned premiums (loss ratio) and (b) the ratio of policy acquisition costs and other underwriting expenses to net written premiums (expense ratio), is the traditional measure of underwriting profit and loss for insurance companies. If the combined ratio is below 100%, an insurance company has an underwriting profit, and if it is above 100%, the insurer has an underwriting loss.

     The following table reflects the consolidated loss, expense and combined ratios of the Insurance Subsidiaries, together with the property and casualty industry-wide combined ratios after policyholders’ dividends.

Premium-to-Surplus Ratio:

     While there are no statutory provisions governing premium-to-surplus ratios, regulatory authorities regard this ratio as an important indicator as to an insurer’s ability to withstand abnormal loss experience. Guidelines established by the National Association of Insurance Commissioners (the “NAIC”) provide that an insurer’s net written premium-to-surplus ratio is satisfactory if it is below 3 to 1.

     The following table sets forth, for the periods indicated, net written premiums to surplus as regards policyholders for the Insurance Subsidiaries (statutory basis):

14

Investments

     The Company’s investment objective is the realization of relatively high levels of investment income while generating competitive after-tax total rates of return within a prudent level of risk and within the constraints of maintaining adequate securities in amount and duration to meet cash requirements of current operations and long-term liabilities, as well as maintaining and improving the Company’s A.M. Best rating. The Company utilizes external independent professional investment managers for its fixed maturity and equity investments.

     At December 31, 2004, the Company had total investments with a carrying value of $1,428.2 million, and 91.0% of the Company’s total investments were fixed maturity securities, including U.S. treasury securities and obligations of U.S. government corporations and agencies, obligations of states and political subdivisions, corporate debt securities, asset backed securities, mortgage pass-through securities and collateralized mortgage obligations, with a weighted average quality of “AAA”. The asset backed, mortgage pass-through and collateralized mortgage obligation securities are amortizing securities possessing favorable prepayment risk and/or extension profiles. The remaining 9.0% of the Company’s total investments consisted primarily of publicly-traded common stocks.

     The following table sets forth information concerning the composition of the Company’s total investments at December 31, 2004:

     At December 31, 2004, approximately 99.4% of the Insurance Subsidiaries’ fixed maturity securities (cost basis) consisted of U.S. government securities or securities rated “1” (“highest quality”) or “2” (“high quality”) by the NAIC.

     The cost and estimated market value of fixed maturity securities at December 31, 2004, by remaining original contractual maturity, is set forth below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations, with or without call or prepayment penalties:

     Investments of the Insurance Subsidiaries must comply with applicable laws and regulations which prescribe the type, quality and diversification of investments. In general, these laws and regulations permit investments, within specified

15

limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, secured obligations, preferred and common equity securities, real estate mortgages and real estate.

Regulation

     General: The Company is subject to extensive supervision and regulation in the states in which it operates. Such supervision and regulation relate to numerous aspects of the Company’s business and financial condition. The primary purpose of the supervision and regulation is the protection of insurance policyholders and not the Company’s investors. The extent of regulation varies but generally is governed by state statutes. These statutes delegate regulatory, supervisory and administrative authority to state insurance departments. This system of regulation covers, among other things:

	•	issuance, renewal, suspension and revocation of licenses to engage in the insurance business;
	•	standards of solvency, including risk-based capital measurements;
	•	restrictions on the nature, quality and concentration of investments;
	•	restrictions on the types of terms that the Company can include in the insurance policies it offers;
	•	certain required methods of accounting;
	•	maintenance of reserves for unearned premiums, losses and other purposes; and
	•	potential assessments for the provision of funds necessary for the settlement of covered claims under certain insurance policies provided by impaired, insolvent or failed insurance companies.

     The regulations and any actions taken by the state insurance departments, may affect the cost or demand for the Company’s products and may present impediments to obtaining rate increases or taking other actions to increase profitability. Also, regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If the Company does not have the requisite licenses and approvals, or does not comply with applicable regulatory requirements, the insurance regulatory authorities could stop or temporarily suspend the Company from carrying on some or all of its activities. In light of several recent significant property and casualty insurance company insolvencies, it is possible that assessments paid to state guaranty funds may increase. Because the Insurance Subsidiaries are domiciled in Pennsylvania and Florida, the Pennsylvania Department of Insurance and the Florida Office of Insurance Regulation have primary authority over the Company.

     Regulation of Insurance Holding Companies: Pennsylvania and Florida, like many other states, have laws governing insurance holding companies (such as Philadelphia Insurance). Under these laws, a person generally must obtain the applicable Insurance Department’s approval to acquire, directly or indirectly, 5% to 10% or more of the outstanding voting securities of Philadelphia Insurance or the Insurance Subsidiaries. Such Department’s determination of whether to approve any such acquisition would be based on a variety of factors, including an evaluation of the acquirer’s financial stability, the competence of its management, the effect of rates on coverages provided, if any, and whether competition in Pennsylvania or Florida would be reduced.

     The Pennsylvania and Florida statutes require every Pennsylvania and Florida domiciled insurer which is a member of an insurance holding company system to register with Pennsylvania or Florida, respectively, by filing and keeping current a registration statement on a form prescribed by the NAIC.

     The Pennsylvania statute also specifies that at least one-third of the board of directors, and each committee thereof, of either the domestic insurer or its publicly owned holding company (if any), must be comprised of outsiders (i.e., persons who are neither officers, employees nor controlling shareholders of the insurer or any affiliate). In addition, the domestic insurer or its publicly held holding company must establish one or more committees comprised solely of outside directors, with responsibility for recommending the selection of independent certified public accountants; reviewing the insurer’s financial condition, the scope and results of the independent audit and any internal audit; nominating candidates for director; evaluating the performance of principal officers; and recommending to the board the selection and compensation of principal officers.

     Under the Florida statute, a majority of the directors of a Florida insurer must be citizens of the United States. In addition, no Florida insurer may make any contract whereby any person is granted or is to enjoy in fact the management of the insurer to the substantial exclusion of its board of directors or to have the controlling or preemptive right to produce substantially all insurance business for the insurer, unless the contract is filed with and approved by the Florida Office of

16

Insurance Regulation. A Florida insurer must give the Department written notice of any change of personnel among the directors or principal officers of the insurer within 45 days of such change. The written notice must include all information necessary to allow the Department to determine that the insurer will be in compliance with state statutes.

     Dividend Restrictions: As an insurance holding company, Philadelphia Insurance will be largely dependent on dividends and other permitted payments from the Insurance Subsidiaries to pay any cash dividends to its shareholders. The ability of the Insurance Subsidiaries to pay dividends to the Company is subject to certain restrictions imposed under Pennsylvania and Florida insurance laws. Accumulated statutory profits of the Insurance Subsidiaries from which dividends may be paid totaled $257.5 million at December 31, 2004. Of this amount, the Insurance Subsidiaries are entitled to pay a total of approximately $58.6 million of dividends in 2005 without obtaining prior approval from the Pennsylvania Insurance Department or Florida Office of Insurance Regulation. During 2004 the insurance subsidiaries did not pay any dividends.

     The National Association of Insurance Commissioners: In addition to state-imposed insurance laws and regulations, the Insurance Subsidiaries are subject to Statutory Accounting Principles (“SAP”) as codified by the NAIC in the “Accounting Practices and Procedures Manual” which was adopted by the Pennsylvania Insurance Department and Florida Office of Insurance Regulation effective January 1, 2001. The NAIC also promulgates model insurance laws and regulations relating to the financial and operational regulation of insurance companies. These model laws and regulations generally are not directly applicable to an insurance company unless and until they are adopted by applicable state legislatures or departments of insurance. However, NAIC model laws and regulations have become increasingly important in recent years, due primarily to the NAIC’s state regulatory accreditation program. Under this program, states which have adopted certain required model laws and regulations and meet various staffing and other requirements are “accredited” by the NAIC. Such accreditation is the cornerstone of an eventual nationwide regulatory network, and there is a certain degree of political pressure on individual states to become accredited by the NAIC. Because the adoption of certain model laws and regulations is a prerequisite to accreditation, the NAIC’s initiatives have taken on a greater level of practical importance in recent years. The NAIC accredited both Pennsylvania and Florida under the NAIC Financial Regulation Standards.

     All the states have adopted the NAIC’s financial reporting form, which is typically referred to as the NAIC “Annual Statement”, and most states, including Pennsylvania and Florida, generally defer to the NAIC with respect to SAP. In this regard, the NAIC has a substantial degree of practical influence and is able to accomplish certain quasi-legislative initiatives through amendments to the NAIC annual statement and applicable accounting practices and procedures. For instance, the NAIC requires all insurance companies to have an annual statutory financial audit and an annual actuarial certification as to loss reserves by including such requirements within the annual statement instructions.

     Capital and Surplus Requirements: PIC’s eligibility to write insurance on a surplus lines basis in most jurisdictions is dependent on its compliance with certain financial standards, including the maintenance of a requisite level of capital and surplus and the establishment of certain statutory deposits. In recent years, many jurisdictions have increased the minimum financial standards applicable to surplus lines eligibility. For example, California and certain other states have adopted regulations which require surplus lines companies operating therein to maintain minimum capital of $15 million, calculated as set forth in the regulations. PIC maintains capital to meet these requirements.

     Risk-Based Capital: Risk-based capital is designed to measure the acceptable amount of capital an insurer should have, based on the inherent specific risks of each insurer. Insurers failing to meet this benchmark capital level may be subject to scrutiny by the insurer’s domiciliary insurance department, and ultimately rehabilitation or liquidation. Based on the standards currently adopted, the policyholders’ surplus of each of the Insurance Subsidiaries at December 31, 2004 is in excess of the minimum prescribed risk-based capital requirements.

     Insurance Guaranty Funds: The Insurance Subsidiaries are subject to guaranty fund laws which can result in assessments, up to prescribed limits, for losses incurred by policyholders as a result of the impairment or insolvency of unaffiliated insurance companies. Typically, an insurance company is subject to the guaranty fund laws of the states in which it conducts insurance business; however, companies which conduct business on a surplus lines basis in a particular state are generally exempt from that state’s guaranty fund laws.

     Shared Markets: As a condition of its license to do business in various states, PIIC, MUSA and LAIC are required to participate in mandatory property-liability shared market mechanisms or pooling arrangements which provide various insurance coverages to individuals or other entities that otherwise are unable to purchase coverage voluntarily provided by private insurers. In addition, some states require automobile insurers to participate in reinsurance pools for claims that exceed a certain amount. PIIC’s, MUSA’s and LAIC’s participation in such shared markets or pooling mechanisms is

17

generally in proportion to the amount of their direct writings for the type of coverage written by the specific pooling mechanism in the applicable state.

     Mold Contamination: The property-casualty insurance industry experienced an increase in claim activity in the last few years pertaining to mold contamination. Significant plaintiffs’ verdicts and increased media attention to the subject have caused insurers to develop and/or refine relevant insurance policy language that excludes mold coverage. The Company will closely monitor litigation trends in 2005, and continue to review relevant insurance policy exclusion language. The Company has experienced an immaterial impact from mold claims and attaches a mold exclusion to policies where applicable.

     Health Insurance Portability and Accessibility Act: Regulations under the Health Insurance Portability and Accessibility Act of 1996 (HIPAA) were adopted on April 14, 2003 to protect the privacy of individual health information. While property/casualty insurers are not required to comply with the various administrative requirements of the act, the regulations have an impact on obtaining information within the context of claims information. The Company continues to monitor regulatory developments under HIPAA.

     Certain Legislative Initiatives and Developments: A number of new, proposed or potential legislative or industry developments could further increase competition in the insurance industry. These developments include:

	•	the enactment of the Gramm-Leach-Bliley Act of 1999 (which permits financial services companies such as banks and brokerage firms to engage in the insurance business), which could result in increased competition from new entrants to the Company’s markets;
	•	the formation of new insurers and an influx of new capital in the marketplace as existing companies attempt to expand their business as a result of better pricing and/or terms;
	•	programs in which state-sponsored entities provide property insurance in catastrophe-prone areas; and
	•	changing practices caused by the Internet, which have led to greater competition in the insurance business.

     These developments could make the property and casualty insurance marketplace more competitive by increasing the supply of insurance capacity. In that event, recent favorable industry trends that have reduced insurance and reinsurance supply and increased demand could be reversed and may negatively influence the Company’s ability to maintain or increase rates. Accordingly, these developments could have an adverse effect on the Company’s earnings.

     The federal Terrorism Risk Insurance Act of 2002 (the “Act”) established a temporary federal program that provides for a system of shared public and private compensation for insured commercial property and casualty losses resulting from acts of terrorism, as defined in the Act. The Terrorism Insurance Program (the “Program”) requires all commercial property and casualty insurers licensed in the United States to participate. The Program provides that in the event of a terrorist attack, as defined, resulting in insurance industry losses exceeding $5 million, the U.S. government will provide funding to the insurance industry on an annual aggregate basis of 90% of covered losses up to $100 billion. Each insurance company is subject to a deductible based upon a percentage of the previous year’s direct earned premium, with the percentage increasing each year. The Program requires that insurers notify in-force commercial policyholders by February 24, 2003 that coverage for terrorism acts is provided and the cost for this coverage. It also requires notices to be given at certain specified times to insureds to which policies are issued after the date of the Act’s enactment. Policyholders have the option to accept or decline the coverage, or negotiate other terms. Property and casualty insurers, including the Company, are required to offer this coverage at each subsequent renewal even if the policyholder elected to exclude this coverage in the previous policy period. The Program became effective upon enactment and runs through December 31, 2005. With the signing of the Act, all previously approved exclusions for terrorism in any contract for property and casualty insurance in force as of November 26, 2002 are excluded. However, an insurer may reinstate a preexisting provision in a contract for property and casualty insurance that is in force on the date of enactment and that excludes coverage for an act of terrorism only:

     (1) if the insurer has received a written statement from the insured that affirmatively authorizes such reinstatement; or

     (2) if

          (A) the insured fails to pay any increased premium charged by the insurer for providing such terrorism coverage; and

          (B) the insurer provided notice, at least 30 days before any such reinstatement, of (i) the increased premium for such terrorism coverage; and (ii) the rights of the insured with respect to such coverage, including any date upon which the exclusion would be reinstated if no payment is received.

18

     Sarbanes-Oxley Act of 2002: The Sarbanes-Oxley Act of 2002, enacted on July 30, 2002, presents a significant expansion of securities law regulation of corporate governance, accounting practices, reporting and disclosure that affects publicly traded companies. The Act, in part, sets forth requirements for certification by company CEOs and CFOs of certain reports filed with the SEC, disclosures pertaining to the adoption of a code of ethics applicable to certain management personnel, and safeguards against actions to fraudulently influence, manipulate or mislead independent public or certified accountants of the issuer’s financial statements. It also requires stronger guidance for development and evaluation of internal control procedures, as well as provisions pertaining to a company’s audit committee and other committees of the board of directors.

Competition

     The Company competes with a large number of other companies in its selected lines of business, including major U.S. and non-U.S. insurers and other regional companies, as well as mutual companies, specialty insurance companies, underwriting agencies and diversified financial services companies. Some of these competitors have greater financial and marketing resources than the Company. Profitability could be adversely affected if business is lost due to competitors offering similar or better products at or below the Company’s prices. In addition, a number of new, proposed or potential legislative or industry developments could further increase competition. New competition from these developments could cause the demand for the Company’s products to fall, which could adversely affect profitability.

     The current business climate remains competitive from a solicitation standpoint. The Company will “walk away”, if necessary, from writing business that does not meet established underwriting standards and pricing guidelines. Management believes though that the Company’s mixed marketing strategy is a strength in that it provides the flexibility to quickly deploy the marketing efforts of the Company’s direct production underwriters from soft market segments to market segments with emerging opportunities. Additionally, through the mixed marketing strategy, the Company’s production underwriters have established relationships with approximately 8,700 brokers, thus facilitating a regular flow of submissions.

Employees

     As of February 22, 2005, the Company had 997 full-time employees and 46 part-time employees. The Company actively encourages its employees to continue their educational efforts and aids in defraying their educational costs (including 100% of education costs related to the insurance industry). Management believes that the Company’s relations with its employees are generally excellent.

Company Website and Availability of Securities and Exchange Commission (“SEC”) Filings

     The Company’s Internet website is www.phly.com. Information on the Company’s website is not a part of this Form 10-K. The Company makes available free of charge on its website, or provides a link to, the Company’s Forms 10-K, 10-Q and 8-K filed or furnished on or after May 14, 1996, and any amendments to these Forms, that have been filed with the SEC on or after May 14, 1996 as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to the SEC. To access these filings, go to the Company’s website and click on “Investor Relations”, then click on “SEC Filings.”

Item 2. PROPERTIES

The Company leases certain office space at One Bala Plaza, Bala Cynwyd, PA which serves as its headquarters location, and also leases 36 offices for its field marketing organization.

Item 3. LEGAL PROCEEDINGS

The Company is not subject to any material pending legal proceedings, other than ordinary routine litigation incidental to its business.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of 2004.

19

PART II

		The Company did not declare cash dividends on its common stock in 2004 or 2003, and currently intends to retain its earnings to enhance future growth. Any future payment of dividends by the Company will be determined by the Board of Directors and will be based on general business conditions and legal and regulatory restrictions.
		As a holding company, the Company is dependent upon dividends and other permitted payments from its subsidiaries to pay any cash dividends to its shareholders. The ability of the Company’s insurance subsidiaries to pay dividends to the Company is subject to regulatory limitations (see Item 7.-Liquidity and Capital Resources and Note 2 to the Consolidated Financial Statements).
		(b) During the three years ended December 31, 2004, the Company did not sell any of its securities which were not registered under the Securities Act of 1933.
		(c) The Company’s purchases of its common stock during the fourth quarter of 2004 are shown in the following table:

20

Item 6. SELECTED FINANCIAL DATA

21

22

GENERAL

Overview

     The Company designs, markets, and underwrites specialty commercial and personal property and casualty insurance products for select markets or niches. The Company’s operations are classified into three reportable business segments which are organized around its three underwriting divisions: The Commercial Lines Underwriting Group, which has underwriting responsibility for the commercial multi-peril package, commercial automobile and specialty property and inland marine insurance products; The Specialty Lines Underwriting Group, which has underwriting responsibility for the professional and management liability insurance products; and The Personal Lines Group, which has responsibility for personal property and casualty insurance products for the manufactured housing and homeowners markets. The Company operates solely within the United States through its 12 regional and 24 field offices.

     The Company generates most of its revenues through the sale of commercial and personal property and casualty insurance policies. The commercial insurance policies are sold through the Company’s five distribution channels which include direct sales, retail insurance agents/open brokerage, wholesalers, preferred agents and the Internet. The Company believes that consistency in its field office representation has created excellent relationships with local insurance agencies across the country. The personal insurance policies are almost exclusively sold over the Internet via the Company’s proprietary In-Touch system.

     The Company also generates revenue from its investment portfolio, which approximated $1.5 billion at December 31, 2004 and generated $51.2 million in gross pre-tax investment income during 2004. The Company utilizes external independent professional investment managers with the objective of realizing relatively high levels of investment income while generating competitive after-tax total rates of return within duration and credit quality targets.

     Management measures the results of operations through monitoring certain measures of growth and profitability, including, but not limited to: number of policies written, pricing, risk selection, loss ratio (sum of net loss and loss adjustment expenses divided by net earned premiums) and expense levels.

     Although further premium rate increases were realized during 2004, the increases moderated from those realized in 2003. The increases resulted primarily from the significant property and casualty industry losses as a result of the tragic terrorist attacks of September 11, 2001, lower interest rates, and diminished risk capacity.

     During 2004, the Company experienced catastrophe losses attributable to Hurricanes Charley, Frances, Ivan and Jeanne. These catastrophe losses, as noted in the table below, impacted both the Company’s personal and commercial lines segments. Loss estimates may still change in the future due in part to the number of claims which have not yet been completely remediated or for which the property covered by the claim has not been repaired.

23

     Under the Company’s catastrophe reinsurance programs in place for these hurricanes, the Company had a $3.5 million pre-tax per occurrence loss retention for its personal lines catastrophe losses and a $7.0 million pre-tax per occurrence loss retention for its commercial lines catastrophe losses. The Company’s loss retention by hurricane is summarized in the table below:

     The Company revised its original estimates as of December 31, 2004 for gross losses due to Hurricanes Charley, Frances, Ivan and Jeanne as noted below (in millions):

     The higher loss estimate for Hurricane Frances, which, when combined with the aggregate loss estimates for Hurricanes Charley and Jeanne, resulted in $8.3 million of Hurricane Jeanne losses to be in excess of the aggregate $80.0 million coverage limit available on the $40.0 million excess $50.0 million loss layer of the Company’s catastrophe reinsurance program. This $8.3 million of losses is in addition to the Company’s per occurrence loss retention under its catastrophe reinsurance program. The additional $8.3 million in Hurricane Jeanne losses reduced net income for the fourth quarter 2004 by $5.4 million.

     Based upon the current catastrophe loss estimates, recoveries for Hurricane Frances are approaching the limit of the Company’s catastrophe reinsurance program. Catastrophe reinsurance recoveries available to the Company for development on Hurricane Frances beyond current estimates are dollar for dollar for approximately the next $3.5 million of additional increase in catastrophe losses, and 34% of the next $50.0 million of additional increase in catastrophe losses. Because of the interaction of the Florida Hurricane Catastrophe Fund (FHCF) and the Company’s open market reinsurance program, development on Hurricane Charley would reduce the coverage limit available from the FHCF for Hurricane Frances. Additionally since the hurricane losses currently exceed the aggregate $80.0 million coverage limit available on the $40.0 million excess $50.0 million coverage loss layer of the Company’s catastrophe reinsurance program, each dollar of additional development on Hurricane Charley in this layer would diminish coverage available for Hurricane Jeanne losses and result in approximately an additional $.085 of losses being retained by the Company.

     Due to the multiple hurricane events the Company purchased additional reinsurance coverages to supplement the original catastrophe reinsurance coverage in 2004 which was utilized. These multiple hurricane events resulted in accelerating the recognition of $26.0 million in catastrophe reinsurance premium expense as a result of utilizing certain of the catastrophe reinsurance coverages. Of this $26.0 million in accelerated reinsurance premium expense, $10.3 million of the accelerated premium expense was attributable to the additional reinsurance coverages which were purchased.

     As a result of the active 2004 hurricane season there have been a small number of insurers that have announced their intention to either withdraw from the Florida Marketplace or reduce homeowners and related product writings. The Company doesn’t believe these events will have a material impact on its marketing plan. However, the Company plans to shift its product mix by reducing manufactured housing product policies and increasing homeowners’ product policies. The Company plans to reduce its manufactured housing exposures by restricting new business and further limiting exposure concentrations. Although one Florida Company has declared insolvency as a result of losses incurred during the 2004 hurricane season, the Company is not aware of any pending assessment from the Florida Insurance Guarantee Association (“FIGA”) to pay for losses resulting from the insolvency. Any assessment from FIGA is recoverable through policy surcharges. Additionally, Citizens Property Insurance Company (“CPIC”) is the Florida market mechanism for homeowners’ coverage. CPIC experienced significant losses from the 2004 hurricanes and has indicated the

24

possibility of an assessment. As of this date no assessment has been levied, and any such CPIC assessment will be recoverable through policy surcharges.

     Gross written premium growth was strong during 2004 across all the Company’s business segments with in-force policy counts increasing 14.7%, 30.0% and 16.0% for the commercial, specialty and personal lines segments, respectively. Weighted average premium rate increases on renewal business approximated 2.2%, 2.7% and 7.1% for the commercial, specialty and personal lines segments, respectively.

     The Company believes its core strategy of adhering to an underwriting philosophy of sound risk selection and pricing discipline, a mixed marketing platform for its product distribution and the creation of value added features not typically found in property and casualty products have also contributed to generating premium growth above industry averages, as well as enabling the Company to produce combined ratios (the sum of net loss and loss adjustment expenses and acquisition costs and other underwriting expenses, divided by net earned premiums) well below industry averages.

     The GAAP combined ratio for the year ended December 31, 2004 was 89.6%, which, once again, was substantially lower than the property and casualty industry as a whole. Included in the 2004 calendar year net loss and loss adjustment expenses was $35.1 million of prior accident year development. The following table illustrates the 2004 calendar year and accident year loss ratios by segment.

In October, 2004, the New York Attorney General’s office filed a complaint in New York state court against Marsh & McClennan Companies, Inc. (“Marsh”), the nation’s largest insurance broker. The complaint accuses Marsh of participating in bid-rigging schemes and improper disclosure to its customers of the fact that Marsh was receiving contingent commissions from insurers which issued insurance policies to such customers. These commissions are based on the volume and/or profitability of business placed by Marsh. The complaint also asserted that a number of insurers engaged in bid rigging. Shortly after this complaint was filed, Marsh and a number of the insurers named in the complaint publicly announced that they would be terminating their contingent commission arrangements. Marsh has agreed to pay a significant amount in settlement of the matters referred to in the complaint.

     The Pennsylvania Insurance Department and insurance regulatory agencies in other states are currently reviewing this practice. One or more of such agencies may in the future issue regulations concerning the payment of contingent commissions and/or the disclosure thereof to customers. In 2004, the Company, as well as many other Pennsylvania domiciled insurance companies, received an inquiry from the Pennsylvania Insurance Department requesting information concerning compensation and other arrangements with our brokers and agents, and the Company has responded to that inquiry.

25

     Insurance regulatory agencies are likely to impose requirements on the insurance industry with respect to the payment of contingent commissions and/or the disclosure of contingent commissions to customers and proposed customers. If these requirements are imposed, they may impact the manner in which the Company compensates its brokers and may have an impact on the Company’s business. In November 2004, the National Association of Insurance Commissioners Executive Task Force on Broker Activities proposed model legislation that would impose disclosure requirements on brokers, and would require brokers to obtain the insured’s written consent before receiving compensation from an insurance company for the same transaction.

     The California and Oregon Insurance Departments have also proposed new regulations which would require disclosure of brokerage fees to customers, and would require brokers to advise clients regarding the best available insurer.

     The Company has arrangements with approximately 56 agents and 77 brokers (collectively “Preferred Agents”) under which the Company pays profit share based on the profitability to the Company of business placed by these Preferred Agents with the Company. Approximately 25% of the Company’s gross written premiums are produced through Preferred Agents with which the Company has profit share arrangements. It is possible that the filing of the complaint against Marsh and the settlement thereof and/or future legislation, regulations and/or case law could affect these arrangements. The Company is not able at this time to predict the impact of such matters, if any, on the Company.

     As of September 30, 2004, the Company’s four insurance subsidiaries participated in an intercompany reinsurance pooling agreement and were rated “A+” (Superior) by A.M. Best Company. According to A.M. Best Company, companies rated “A+” (Superior) have, on balance, superior financial strength, operating performance and market profile, when compared to the standards established by A.M. Best Company, and have a very strong ability to meet their ongoing obligations to policyholders. Effective October 1, 2004 the Company’s four insurance subsidiaries entered into a new intercompany reinsurance pooling arrangement. The Company’s insurance subsidiaries, Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company, entered into an intercompany reinsurance pooling arrangement which includes substantially all the Company’s commercial and specialty lines business. The Company’s two other insurance subsidiaries, Mobile USA Insurance Company and Liberty American Insurance Company, also entered into an intercompany reinsurance pooling arrangement which substantially includes all the Company’s personal lines segment business. As a result of this arrangement, A.M. Best Company assigned an “A–” (Excellent) rating to these two companies. The rating of Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company remained at “A+”.

     A.M. Best Company continually reviews the ratings it assigns to insurance companies and has advised the Company that it must enhance the capital position of its Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company insurance subsidiaries in order for them to maintain their rating. The Company anticipates that it will be able to do so in order to maintain the A.M. Best Company “A+” (Superior) rating for Philadelphia Indemnity Insurance Company and Philadelphia Insurance Company.

Investments

The Company’s investment objective is the realization of relatively high levels of after-tax net investment income while generating competitive after-tax total rates of return within a prudent level of risk and within the constraints of maintaining adequate securities in amount and duration to meet cash requirements of current operations and long-term liabilities, as well as maintaining and improving the Company’s A.M. Best rating. The Company utilizes external independent professional investment managers for its fixed maturity and equity investments. These investments consist of diversified issuers and issues, and as of December 31, 2004, approximately 84.9% and 7.3% of

26

the total invested assets (total investments plus cash equivalents) on a cost basis consisted of investments in fixed maturity and equity securities, respectively, versus 87.8% and 6.6%, respectively, at December 31, 2003.

Of the total investments in fixed maturity securities, asset backed, mortgage pass-through, and collateralized mortgage obligation securities, on a cost basis, amounted to $96.0 million, $229.6 million and $62.6 million, respectively, as of December 31, 2004 and $183.0 million, $159.2 million and $53.8 million, respectively, as of December 31, 2003. The asset backed, mortgage pass-through, and collateralized mortgage obligation investments are amortizing securities possessing favorable prepayment risk and/or extension profiles.

The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for all securities, except interests in securitized assets, meeting predetermined thresholds to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other than temporary include, but are not limited to: whether the issuer is in financial distress; the performance of the collateral underlying a secured investment; whether a significant credit rating action has occurred; whether scheduled interest payments have been delayed or missed; whether changes in laws and/or regulations have impacted an issuer or industry; an assessment of the timing of a security’s recovery to fair value; and an ability and intent to hold the security to recovery of fair value. The amount of any write down is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $2.5 million and $1.0 million for the years ended December 31, 2004 and 2003, respectively. The Company attributes these other than temporary declines in fair value primarily to issuer specific conditions, except for as noted in the following paragraph.

During 2004 the Company’s Investment Committee (The “Committee”) engaged an investment consulting firm under a full service retainer relationship. The Committee initially directed the investment firm to review the Company’s common stock portfolio and managers with respect to style, diversification and performance. Based upon the results of this review and recommendations of the investment firm, the Committee conducted an investment manager search for a large cap growth and large cap value manager. Upon conclusion of the interview process the Committee, in December 2004, decided to change three of its current common stock managers and engaged a new large cap growth and large cap value manager. As a result of this decision $1.4 million in non-cash investment losses was realized in the fourth quarter due to writing down certain common stock securities, for which there was no longer an intent to hold such securities to recovery of cost.

Additionally, the Company conducts its impairment evaluation and recognition for interests in securitized assets in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board (the “EITF”). Under this guidance, impairment losses on securities must be recognized if both the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent estimation date. If these criteria are met, an impairment charge, calculated as the difference between the current book value of the security and its fair value, is included in earnings as a realized loss in the period the impairment arose. This evaluation resulted in non-cash realized investment losses of $7.3 million and $9.3 million for the years ended December 31, 2004 and 2003, respectively. These non-cash realized investment losses were from investments primarily in collateralized bond obligations which were impacted by recent years’ non investment grade default rates that were higher than historic averages and from investments in other asset backed securities which experienced extension of cash flows on the underlying collateral.

The Company’s fixed maturity portfolio amounted to $1,299.7 million and $1,081.7 million, as of December 31, 2004 and December 31, 2003, respectively, of which 99.3% and 98.6% of the portfolio as of December 31, 2004 and December 31, 2003, respectively, was comprised of investment grade securities. The Company had fixed maturity investments with unrealized losses amounting to $4.9 million and $10.6 million as of December 31, 2004 and December 31, 2003, respectively. Of these amounts, interests in securitized assets had unrealized losses amounting to $1.3 million and $9.2 million as of December 31, 2004 and December 31, 2003, respectively. This decrease in fixed maturity unrealized losses between December 31, 2003 and December 31, 2004 can be largely attributed to the impairment losses on interests in securitized assets recognized in the third quarter of 2004. The remaining unrealized losses are attributable largely to market price changes due to interest rate increases, since the investments were

27

purchased, and are not considered to be other than temporary impairments, given the ability and intent to hold the securities to recovery. As discussed above, the Company’s impairment evaluation and recognition for interests in securitized assets is conducted in accordance with the guidance provided by the EITF.

The following table identifies the period of time securities with an unrealized loss at December 31, 2004 have continuously been in an unrealized loss position. Included in the amounts displayed in the table are $0.1 million of unrealized losses due to non-investment grade fixed maturity securities having a fair value of $1.2 million. No issuer of securities or industry represents more than 3.6% and 16.0%, respectively, of the total estimated fair value, or 4.6% and 11.9%, respectively, of the total gross unrealized loss included in the table below. As mentioned above, there are certain risks and uncertainties inherent in the Company’s impairment methodology, including, but not limited to, the financial condition of specific industry sectors and the resultant effect on any such underlying security collateral values and changes in accounting, tax, and/or regulatory requirements which may have an effect on either, or both, the investor and/or the issuer. Should the Company subsequently determine a decline in the fair value below the cost basis to be other than temporary, the security would be written down to its fair value and the difference would be included in earnings as a realized loss for the period such determination was made.

Based upon the Company’s impairment evaluation as of December 31, 2004, it was concluded that the remaining unrealized losses in the table above are not other than temporary.

During 2004 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $1.3 million and $1.9 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $30.7 million and $7.5 million, respectively. During 2003 the Company’s gross loss on the sale of fixed maturity and equity securities amounted to $0.7 million and $0.8 million, respectively. The fair value of the fixed maturity and equity securities at the time of sale was $20.1 million and $4.4 million, respectively.

The decision to sell these securities was based upon an assessment of economic conditions and ongoing portfolio management objectives of maximizing the Company’s after-tax net investment income.

Market Risk of Financial Instruments

The Company’s financial instruments are subject to the market risk of potential losses from adverse changes in market rates and prices. The primary market risks to the Company are equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. The Company has established, among other criteria, duration, asset quality and asset allocation guidelines for managing its investment

28

portfolio market risk exposure. The Company’s investments are held for purposes other than trading and consist of diversified issuers and issues.

The table below provides information about the Company’s financial instruments that are sensitive to changes in interest rates and shows the effect of hypothetical changes in interest rates as of December 31, 2004. The selected hypothetical changes do not indicate what could be the potential best or worst case scenarios (dollars in thousands). Loan balances outstanding under the Company’s borrowing agreement with the Federal Home Loan Bank of Pittsburgh are not included in the table below. Interest rates on the amounts outstanding under this agreement are reset frequently, which limits the impact of changing interest rates. The Company does not have any derivative financial instruments. The information is presented in U.S. dollar equivalents, which is the Company’s reporting currency.

29

Certain Critical Accounting Estimates and Judgments

•	Investments

	- -	Fair values
		The carrying amount for the Company’s investments approximates their estimated fair value. The Company measures the fair value of investments based upon quoted market prices or by obtaining quotes from third party broker-dealers. Material assumptions and factors utilized by such broker-dealers in pricing these securities include: future cash flows, constant default rates, recovery rates and any market clearing activity that may have occurred since the prior month-end pricing period. The Company’s total investments include $4.7 million in securities for which there is no readily available independent market price.
	- -	Other than temporary impairment, excluding interests in securitized assets
		The Company regularly performs various analytical procedures with respect to its investments, including identifying any security whose fair value is below its cost. Upon identification of such securities, a detailed review is performed for all securities, meeting predetermined thresholds, to determine whether such decline is other than temporary. If the Company determines a decline in value to be other than temporary, based upon its detailed review, or if a decline in value for an equity investment has persisted continuously for nine months, the cost basis of the security is written down to its fair value. The factors considered in reaching the conclusion that a decline below cost is other-than-temporary include, but are not limited to, whether: the issuer is in financial distress; the performance of the collateral underlying a secured investment; a significant credit rating action has occurred; scheduled interest payments have been delayed or missed; changes in laws and/or regulations have impacted an issuer or industry; and assessment of the timing of a security’s recovery to fair value; and an ability and intent to hold. The amount of any write-down is included in earnings as a realized loss in the period the impairment arose (see Investments). Gross unrealized losses for investments excluding interests in securitized assets at December 31, 2004 were $4.0 million.
	- -	Impairment recognition for investments in securitized assets
		The Company conducts its impairment evaluation and recognition for interests in securitized assets in accordance with the guidance provided by the Emerging Issues Task Force of the Financial Accounting Standards Board. Under this guidance, impairment losses on securities must be recognized if both the fair value of the security is less than its book value and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent (prior) estimation date. If these criteria are met, an impairment charge, calculated as the difference between the current book value of the security and its fair value, is included in earnings as a realized loss in the period the impairment arose (see Investments). Gross unrealized losses for investments in securitized assets at December 31, 2004 were $1.3 million.

•	Liability for Unpaid Loss and Loss Adjustment Expenses:
	The liability for unpaid loss and loss adjustment expenses (gross basis — $996.7 million and $627.1 million as of December 31, 2004 and 2003, respectively; net basis — $671.7 million and $481.5 million as of December 31, 2004 and 2003, respectively) reflects the Company’s best estimate for future amounts needed to pay losses and related settlement expenses with respect to insured events. Based upon the past ten year experience the estimate for the net liability for unpaid loss and loss adjustment expenses has been redundant by as much as 18.6% and deficient by as much as 45.1%. The process of establishing the liability for property and casualty unpaid loss and loss adjustment expenses is a complex and imprecise process, requiring the use of informed estimates and judgments. This liability includes an amount determined on the basis of claim adjusters’ evaluations with respect to insured events that have occurred and an amount for losses incurred that have not been reported to the Company. In some cases significant periods of time, up to several years or more, may elapse between the occurrence of an insured loss and the reporting of such to the Company. Estimates for unpaid loss and loss adjustment expenses are based on management’s assessment of known facts and circumstances, review of past loss experience and settlement patterns, and consideration of other factors such as legal, social, and economic

30

	developments. These estimates are reviewed regularly and any adjustments resulting therefrom are made in the accounting period in which the adjustment arose.
•	Deferred Acquisition Costs:
	Policy acquisition costs ($91.6 million and $56.3 million as of December 31, 2004 and 2003, respectively) which include commissions (net of ceding commissions), premium taxes, fees, and certain other costs of underwriting policies, are deferred and amortized over the same period in which the related premiums are earned. Deferred acquisition costs are limited to the estimated amounts recoverable after providing for losses and expenses that are expected to be incurred, based upon historical and current experience. Anticipated investment income is considered in determining whether a premium deficiency exists. The methods of making such estimates and establishing the deferred costs are continually reviewed by the Company, and any adjustments therefrom are made in the accounting period in which the adjustment arose.
•	Goodwill
	The carrying amount of goodwill is subject, at a minimum, to an annual impairment test to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized (if any). This annual test is performed at December 31 of each year or more frequently if events or circumstance change that require the Company to perform the impairment analysis on an interim basis. Goodwill impairment testing requires the evaluation of the fair value of each reporting unit to its carrying value, including the goodwill, and recording of an impairment charge if the carrying amount of the reporting unit exceeds its estimated fair value. The determination of a reporting unit’s fair value is based on management’s best estimate, which generally considers the unit’s expected future cash flows. The primary assumptions used in the expected future cash flow calculations include premium growth and premium rates, loss ratios, expenses, reinsurance rates and discount rates. Should the assumptions used in the calculation of the expected future cash flows differ substantially from the actual results the estimated fair value of the applicable reporting unit could fall below its carrying value and result in the recognition of an impairment loss. As of December 31, 2004 and 2003, the carrying amount of goodwill was $25.7 million.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has no off-balance sheet arrangements (as that term is defined in Item 303(a) (4) of Regulation S-K) that have or are reasonably likely to have a current or, as of December 31, 2004, future effect on its financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors as of December 31, 2004.

RESULTS OF OPERATIONS
(2004 versus 2003)

Premiums: Premium information relating to the Company’s business segments is as follows (in millions):

The overall growth in gross written premiums is primarily attributable to the following:

•

Consistent prospecting efforts by marketing personnel in conjunction with long term relationships formed by the Company’s marketing Regional Vice Presidents continue to result in additional prospects and increased premium writings, most notably for the Company’s various commercial package and non-profit management liability product lines.

31

•

The displacement of certain competitor property and casualty insurance companies and their independent agency relationships continues to result in new agency relationship opportunities for the Company. These relationship opportunities have resulted in additional policyholders and premium writings for the Company’s commercial and specialty lines segments.

	•	Continued expansion of marketing efforts relating to commercial lines and specialty lines products through the Company’s field organization and preferred agents.
	•	The insurance subsidiaries of Liberty American Insurance Group, Inc. (a subsidiary of the Company) have recently commenced writing a previously brokered homeowners product on a direct basis due to a recent termination of a brokerage agreement. Gross written premiums from this homeowners product approximated $17.1 million for the year ended December 31, 2004.
	•	In-force policy counts have increased 14.7%, 30.0%, and 16.0% for the commercial lines, specialty lines and personal lines segments, respectively, primarily as a result of the factors discussed above.
	•	Realized average rate increases on renewal business approximating 2.2%, 2.7%, and 7.1% for the commercial, specialty and personal lines segments, respectively.
	•	This growth was offset in part as a result of Liberty American Insurance Group, Inc. suspending the acceptance of applications for new personal lines insurance policies the day prior to Hurricane Charley making landfall in Florida to restrict an increase in exposure during hurricane season. It is estimated that gross written premiums were reduced by approximately $9.5 million due to this restriction. The Company resumed underwriting new preferred homeowners business effective January 1, 2005.

The respective net written premium changes for commercial lines, specialty lines and personal lines segments for the year ended December 31, 2004 vs. December 31, 2003 were (in millions):

The differing percentage changes in net premiums versus gross premiums for the commercial lines, specialty lines and personal lines segments during the year results primarily from the following:

•	A change in the Company’s reinsurance program whereby, effective April 1, 2003, the Company entered into a Quota Share reinsurance agreement covering substantially all of the Company’s lines of business. Under this agreement:

	•	The Company ceded 22% of its net written premiums and loss and loss adjustment expenses for policies effective April 1, 2003 through December 31, 2003 and 10% of its commercial and specialty lines net written premiums and loss and loss adjustment expenses for policies effective January 1, 2004 through December 31, 2004. During the years ended December 31, 2004 and 2003, the Company ceded $94.5 million and $199.4 million of net written premiums, respectively, and $132.5 million and $116.8 million of net earned premiums, respectively.
	•	Of the $199.4 million of net written premiums ceded during the year ended December 31, 2003, $63.5 million represents 22% of the Company’s April 1, 2003 unearned premium reserve which was ceded upon entering into the quota share agreement. This cession of the unearned premium reserve reduced net written premiums which approximated the following by segment: commercial lines ($44.0 million), specialty lines ($13.3 million), and personal lines ($6.2 million).

32

	•	Certain of the Company’s reinsurance contracts have provisions whereby the Company is entitled to a return profit commission based on the ultimate experience of the underlying business ceded to the contracts. Under the terms of these contracts, the Company accrued profit commissions of $15.6 million and $10.5 million for the years ended December 31, 2004 and 2003, respectively. The profit commissions reduce ceded written and earned premiums and increase net written and earned premiums.
	•	The Company experienced catastrophe losses attributable to Hurricanes Charley, Frances, Ivan and Jeanne. Due to these multiple hurricane events, the Company purchased additional catastrophe reinsurance coverages (which provide coverage from the inception date of the coverage through May 31, 2005) to supplement its original catastrophe reinsurance program. The estimated aggregate pre-tax cost of these additional catastrophe reinsurance coverages is $22.9 million. Additionally, these multiple hurricane events resulted in accelerating the recognition of $26.0 million (Commercial Lines Segment ($2.2 million), and Personal Lines Segment ($23.8 million)) catastrophe reinsurance premium expense during 2004 due to the utilization of certain of the catastrophe reinsurance coverages. Of this $26.0 million, $10.3 million was attributable to the additional reinsurance coverages referred to above. This acceleration of reinsurance premium expense increased reinsurance ceded written and earned premiums and reduced net written and earned premiums.
	•	On December 31, 2004 the Company terminated a quota share reinsurance agreement where under it ceded 15% of its mobile homeowners and homeowners business (personal lines segment). Upon termination the Company increased its unearned premium reserve and net written premium by $5.7 million.

          Net Investment Income Net investment income approximated $43.5 in 2004 and $38.8 in 2003. Total investments grew to $1,428.2 million at December 31, 2004 from $1,172.1 million at December 31, 2003. The growth in investment income is due to investing net cash flows provided from operating activities. The Company’s average duration of its fixed income portfolio was 4.1 years at December 31, 2004, compared to 4.0 years at December 31, 2003. The Company’s taxable equivalent book yield on its fixed income holdings approximated 4.7% at December 31, 2004, compared to 4.9% at December 31, 2003. Net investment income was reduced by $4.9 million and $2.3 million for the years ended December 31, 2004 and 2003, respectively, due to the interest credit on the Funds Held Account balance pursuant to the Company’s quota share reinsurance agreement (see Premiums).

          The total return, which includes the effects of both income and price returns on securities, of the Company’s fixed income portfolio was 4.05% and 4.36% for the years ended December 31, 2004 and 2003, respectively, as compared to the Lehman Brothers Intermediate Aggregate Bond Index (“the Index”) total return of 3.76% and 3.81% for the same periods, respectively. The Company expects some variation in its portfolio’s total return compared to the Index because of the differing sector, security and duration composition of its portfolio compared to the Index.

          Net Realized Investment Gain (Loss): Net realized investment gains were $0.8 million for the years ended December 31, 2004 and 2003. The Company realized net investment gains of $4.2 million and $6.4 million from the sale of fixed maturity and equity securities, respectively, for the year ended December 31, 2004, and $6.1 million and $3.7 million in non-cash realized investment losses for fixed maturity and common stock investments, respectively, as a result of the Company’s impairment evaluation. $1.4 million of the $3.7 million non-cash realized investment losses is due to a December 2004 decision to change certain of the Company’s common stock investment managers. As a result of this decision the Company wrote down certain common stock securities since there was no longer an intent to hold the securities to recovery.

          The Company realized net investment gains of $7.1 million and $4.0 million from the sale of fixed maturity and equity securities, respectively, for the year ended December 31, 2003, and $4.0 million and $6.3 million in non-cash realized investment losses for fixed maturity and common stock investments, respectively, as a result of the Company’s impairment evaluation.

          Other Income: Other income approximated $4.4 million for the year ended December 31, 2004 and $5.5 million for the same period of 2003. Other income primarily consists of commissions earned on brokered personal lines business, and to a lesser extent brokered commercial lines business. The decrease in other income is due primarily to reduced commissions earned on brokered personal lines business due to terminations of certain brokering agreements.

33

          Net Loss and Loss Adjustment Expenses: Net loss and loss adjustment expenses increased $116.9 million (32.5%) to $476.1 million for the year ended December 31, 2004 from $359.2 million for the same period of 2003 and the loss ratio decreased to 61.8% in 2004 from 62.5% in 2003. This increase in net loss and loss adjustment expenses and/or loss ratio was primarily due to:

•	A 34.1% growth in net earned premiums

•	Multiple hurricane events which resulted in:

	•	$46.7 million of hurricane catastrophe losses incurred; and
	•	Acceleration of the recognition of $26.0 million of catastrophe reinsurance premium expense, which reduced net earned premiums, due to the utilization of certain of the catastrophe reinsurance coverages. The hurricane losses and associated accelerated catastrophe reinsurance premium expense contributed 8.8 percentage points to the combined ratio.

•

Reserve actions taken during the year ended December 31, 2004 wherein the estimated gross and net unpaid loss and loss adjustment expenses for accident years 1996 through 2002 were increased by $84.8 million and $69.4 million, respectively, due principally to continued case reserve development above expectations primarily across various professional liability products in the specialty lines segment and general liability and commercial automobile liability coverages in the commercial lines segment.

These increases to the loss and loss adjustment expenses and/or loss ratio were offset in part by:

•	Reserve actions taken during the year ended December 31, 2004 wherein:

•

The estimated gross and net unpaid loss and loss adjustment expenses for accident year 2003 were decreased by $37.5 million and $34.3 million, respectively, due principally to continued better than expected claim frequency primarily for general liability and commercial automobile coverages in the commercial lines segment.

Reserve actions taken during the year ended December 31, 2003 wherein the estimated gross and net liability for residual value policies were increased by $38.8 million and a $5.8 million net increase in the estimated gross and net loss reserves for loss and loss adjustment expenses primarily for claims made professional liability and commercial automobile lines of business in prior accident years.

          Additionally, during the years ended December 31, 2004 and 2003, the Company ceded $132.5 million and $116.8 million of net earned premium, respectively, and $59.7 million and $62.7 million in net loss and loss adjustment expenses, respectively, pursuant to a quota share reinsurance agreement (see Premiums).

          Acquisition Costs and Other Underwriting Expenses: Acquisition costs and other underwriting expenses increased $51.5 million (31.6%) to $214.4 million for the year ended December 31, 2004 from $162.9 million for the same period of 2003, and the expense ratio decreased to 27.8% in 2004 from 28.4% in 2003. This increase in acquisition costs and other underwriting expenses was due primarily to the 34.1% growth in net earned premiums. The decrease in the expense ratio is due primarily to an increase in ceding commissions earned and an increase in the ceding commission percentage earned under a quota share reinsurance agreement (see Premiums). This decrease was offset in part by the accelerated recognition of $26.0 million in catastrophe reinsurance expense which reduced net earned premiums. For the years ended December 31, 2004 and 2003, the Company ceded $132.5 million and $116.8 million, respectively, of net earned premiums and earned $61.5 million and $46.7 million, respectively, in ceding commission under a quota share reinsurance agreement. The quota share reinsurance agreement lowered the reported expense ratio by 3.1 and 2.0 percentage points during 2004 and 2003, respectively.

          Other Operating Expenses: Other operating expenses increased $1.6 million to $9.4 million for the year ended December 31, 2004 from $7.8 million for the same period of 2003. The increase in the level of expenses is primarily due to the growth of the business, offset in part by reduced commission paid on brokered personal lines business (see Other Income).

34

     Income Tax Expense: The Company’s effective tax rate for the years ended December 31, 2004 and 2003 was 29.6% and 30.7%, respectively. The effective rates differed from the 35% statutory rate principally due to investments in tax-exempt securities and the relative proportion of tax-exempt income to total income before tax.

RESULTS OF OPERATIONS
(2003 versus 2002)

Premiums: Premium information relating to the Company’s business segments is as follows (in millions):