UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

OR

Commission file number 0-25508

RTW, INC.

8500 Normandale Lake Boulevard, Suite 1400
Bloomington, MN       55437
(Address of principal executive offices and zip code)

(952) 893-0403
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ü No      

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

Yes       No ü

At October 28, 2004, approximately 5,295,000 shares of Common Stock were outstanding.

TABLE OF CONTENTS

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PART I — FINANCIAL INFORMATION

Item 1:                      FINANCIAL STATEMENTS

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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RTW, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2004 AND DECEMBER 31, 2003
(In thousands, except share data)

See notes to consolidated financial statements.

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RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2004 AND 2003
(Unaudited; in thousands, except share and per share data)

See notes to consolidated financial statements.

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RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTH PERIODS ENDED SEPTEMBER 30, 2004 AND 2003
(Unaudited, in thousands)

See notes to consolidated financial statements.

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RTW, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2004 AND 2003
(Unaudited)

NOTE A — BASIS OF PRESENTATION

The accompanying consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles applied on a basis consistent with the financial statements included in the RTW, Inc. 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission, except that the consolidated financial statements included herein were prepared in conformity with the instructions to Form 10-Q for interim financial information and, accordingly, do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. We have prepared the consolidated financial information included herein, other than the Consolidated Balance Sheet at December 31, 2003, without audit by an independent registered public accounting firm. We derived the Consolidated Balance Sheet at December 31, 2003 from the audited Consolidated Financial Statements for the year ended December 31, 2003; however, this report does not include all the disclosures contained therein.

     The information furnished includes all adjustments and accruals, consisting only of normal, recurring accrual adjustments, which are, in our opinion, necessary for a fair statement of results for the interim period. The results of operations for any interim period are not necessarily indicative of results for the full year. The unaudited interim Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto contained in the 2003 Annual Report on Form 10-K.

NOTE B — STOCK OPTIONS AND STOCK-BASED BENEFIT PLANS

We measure compensation expense for our stock-based employee compensation plans using the intrinsic value method in accordance with the provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and comply with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure — an amendment of FAS 123”. The fair value of the options granted has been estimated at the date of grant using the Black-Scholes option-pricing model.

     Had we calculated compensation expense for our option grants under the 1994 Stock Plan and stock issuances under our Employee Stock Purchase Plan based on the fair value method described in SFAS No. 123, our net income and basic and dilutive net income per share would approximate the following pro forma amounts (in 000’s, except per share data):

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NOTE C — COMPREHENSIVE INCOME (LOSS)

The change in comprehensive income totaled $1.2 million in the third quarter of 2004 compared to a loss of $1.7 million for the same period in 2003. Comprehensive loss totaled $565,000 for the nine months ended September 30, 2004 compared to a loss of $697,000 for the same period in 2003. Accumulated other comprehensive income was $973,000 at December 31, 2003. The difference between net income and comprehensive income is the result of unrealized gains (losses) that arise during the period on our investments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Investments”.

NOTE D — LETTER OF CREDIT

On July 30, 2004, we entered into a Letter of Credit Reimbursement Agreement (“Agreement”) for $2.0 million with our primary bank to collateralize a performance bond required as part of a service contract with the Minnesota Workers’ Compensation Assigned Risk Plan. The Agreement is collateralized by the stock of American Compensation Insurance Company (ACIC), our wholly-owned insurance company subsidiary, and contains a restrictive covenant that requires ACIC to maintain at least a B+ rating from A. M. Best Company.

NOTE E — INVESTMENT SECURITIES AVAILABLE FOR SALE

The following tables present amortized cost, gross unrealized gains and losses and estimated fair values of our available-for-sale securities (000’s):

Management believes that the unrealized losses on fixed maturity securities are related to interest rate changes and do not represent other than temporary impairments.

NOTE F — ACCOUNTING CHANGE

In October, 2004, the Financial Accounting Standards Board (“FASB”) concluded that Statement 123R, “Share-Based Payment”, which will require all companies to measure and record in the income statement compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. The FASB plans to issue the final statement on or around December 15, 2004. We do not expect the adoption of Statement 123R will have a material effect on our financial statements.

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Item 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The Company: RTW, Inc. (RTW) and its wholly-owned insurance subsidiary, American Compensation Insurance Company (ACIC), provide disability management services to employers. Collectively, “we,” “our” and “us” refer to these entities in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

     We have developed two proprietary management systems: (i) ID15®, designed to identify those injured employees who are likely to become inappropriately dependent on disability system benefits, including workers’ compensation; and (ii) The RTW Solution®, designed to lower employers’ disability system costs and return injured employees to work as soon as reasonably possible. We provide disability management services, primarily workers’ compensation management services: (i) to employers insured through our insurance subsidiary; (ii) to self-insured employers on a fee-for-service basis; (iii) to the Minnesota Workers’ Compensation Assigned Risk Plan on a percent of premium basis; (iv) to other insurance companies; and (v) on a consulting basis, charging hourly fees. During the first nine months of 2004, we operated primarily in Minnesota, Michigan and Colorado and began servicing non-insurance customers in California.

     On March 9, 2004, our A.M. Best financial rating was upgraded from B (Fair, Vulnerable) to B+ (Very Good, Secure) as a result of: (i) our continued profitable operating performance in 2003; and (ii) improved capitalization in ACIC as statutory surplus increased to $33.0 million at December 31, 2003 from $26.8 million at December 31, 2002 due to our earnings in 2003. Although we believe that our B+ rating from A.M. Best may increase the number of employers to which we provide our products, there are some employers that will only do business with insurers rated A- or better.

     Additional information about RTW is available on our website, www.rtwi.com.

Challenges, risks, uncertainties and trends:

     We derive our revenue almost entirely from workers’ compensation insurance premiums and investment income, including gains and losses from sales of securities. A small portion of our revenue is derived from non-insurance workers’ compensation services. We are subject to the challenges, risks, uncertainties and trends that affect the workers’ compensation property and casualty insurance and the disability management sectors of our economy including the following:

	•		Workers’ compensation is a state regulated industry. Workers’ compensation is governed and regulated by state governmental agencies. We are, and will be, subject to state regulation in any state in which we provide workers’ compensation products and services, now and in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. Legislation covering insurance companies and the regulations adopted by state agencies are subject to change and any change may adversely affect our operations;
	•		Workers’ compensation claims and related expenses can be volatile. Workers’ compensation is a long-tailed property and casualty insurance line. Claims for a given year are open on average for twelve to thirteen years and it is not unusual for workers’ compensation insurers to have some claims open for thirty or more years. We have operated our insurance company since 1992 and therefore have relatively limited experience (twelve years), and accordingly, are subject to volatility. See further discussion under “Claim and Claim Settlement Expenses”;
	•		Workers’ compensation is subject to inflationary pressures. Worker’s compensation is subject to both medical and wage inflation. The cost of medical care has increased in excess of 10% per annum in recent years. This has resulted in reduced profitability in the workers’ compensation insurance line. New medical procedures could evolve and new legal theories develop that could cause older claims to re-open and increase expense. See further discussion under “Claim and Claim Settlement Expenses”;
	•		Workers’ compensation pricing is cyclical. For the first nine months of 2004, we were able to increase premium rates on renewing policies 1.8%. This compares to rate increases of 1.4%, 8.7%, 18.5% and 11.7% in 2003, 2002, 2001 and 2000, respectively. These increases came after many years of rate decreases that unfavorably affected the industry in the late 1990’s. If we are unable to maintain rate

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			increases or decrease our costs, our profit margin will be adversely affected. See further discussion under “Premiums in Force and Gross Premiums Earned”;
	•		Reinsurance costs for workers’ compensation have increased. Reinsurance costs increased over the prior year continuing a pattern of cost increases beginning in 2001. These higher costs, if not recovered through increased rates from our customers, will adversely affect our profit margin. See further discussion under “Premiums Ceded”;
	•		Low interest rates reduce our investment income. Interest rates for investment-grade instruments have increased in recent months moving only slightly from historic lows. Our investment income is directly affected by the interest rate at which we invest our free cash flow. The historical low interest rate environment contributed to a significant mortgage refinancing boom, resulting in prepayment of our mortgage-backed investments and an increase in our cash on hand in ACIC. We continue to invest these funds in short-term instruments. An ongoing low interest rate environment will adversely affect our investment income. See further discussion under “Investment Income and Net Realized Investment Gains”; and
	•		Profitable service revenue growth could be difficult. The national market for disability management services is highly competitive and includes national, regional and local providers of services. We do not have a national presence limiting our ability to service national accounts. Any infrastructure changes to support growth in our non-insurance revenues could be expensive and diminish our earnings in the short-term.

Significant Accounting Policies

Our significant accounting policies are summarized in Note 1 — “Summary of Significant Accounting Policies” included in our Consolidated Financial Statements and notes thereto in our 2003 Annual Report on Form 10-K. Our significant accounting policies include those policies related to our accounting for: (i) premiums earned; (ii) unpaid claim and claim settlement expenses, including reserves for incurred but not reported claims and the related reinsurance recoverables; (iii) policy acquisition costs; (iv) income taxes and deferred income taxes; and (v) investments. These accounting policies are discussed within each section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Service revenue includes revenues for services that are: (i) billed as a percent of premium of insurance policies issued by non-affiliated third party insurers; (ii) billed based on the number and type of claims serviced; (iii) billed on an hourly basis based on direct activity; or (iv) billed based on contract duration. Service revenue earned as a percent of premium is recognized over the life of the underlying insurance policy and the related claims in a manner consistent with RTW’s Premiums Earned revenue recognition policy. Service revenue related to claims management is recognized over the expected duration of the claims management activity. Other service revenue is recognized as performed or over the life of the contract. The excess of billed service revenue over earned amounts is recognized as a liability and included in “Accrued expenses and other liabilities” on our Consolidated Balance Sheet.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Financial Summary

This financial summary presents our discussion and analysis of the consolidated financial condition and results of operations of RTW, Inc. This review should be read in conjunction with our consolidated financial statements and notes thereto at September 30, 2004 and December 31, 2003 and the three and nine-month periods ended September 30, 2004 and 2003.

The following table provides an overview of our key operating results (amounts in 000’s except per share data):

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     We reported net income of $1.1 million in the third quarter of 2004 compared to net income of $3.1 million in the third quarter of 2003 and reported net income of $3.0 million for the nine months ended September 30, 2004 compared to $4.3 million for the same period in 2003. Diluted net income per share was $0.20 in the third quarter of 2004 compared to $0.59 for the third quarter of 2003 and was $0.54 for the nine months ended September 30, 2004 compared to $0.83 for the same period in 2003. The primary factors affecting our 2004 operating results included the following:

	•		Our gross premiums earned increased to $16.7 million in the third quarter of 2004 from $13.7 million in the third quarter of 2003 and increased to $47.0 million for the nine months ended September 30, 2004 from $39.3 million for the same period in 2003 due primarily to an increase in premiums in force from comparable periods in 2003. See further discussion under “Premiums In Force and Gross Premiums Earned”;
	•		Premiums earned increased to $14.2 million in the third quarter of 2004 from $11.7 million in the third quarter of 2003 and increased to $40.0 million for the nine months ended September 30, 2004 from $33.6 million for the same period in 2003 reflecting the increase in gross premiums earned from the comparable 2003 period offset by an increase in premiums ceded as our cost of excess of loss reinsurance increased in 2004;
	•		In addition to the factors affecting premiums earned, total revenues increased as we recorded $705,000 of net realized investment gains during the first nine months of 2004 compared to $685,000 recorded entirely in the third quarter of 2003;
	•		Claim and claim settlement expenses increased to $10.1 million in the third quarter of 2004 from $6.4 million in the third quarter of 2003 and increased to $28.3 million for the nine months ended September 30, 2004 compared to $20.3 million for the same period in 2003. Favorable development for prior accident years reduced claim and claim settlement expenses by $300,000 in the third quarter of 2004 compared to $2.0 million for the third quarter of 2003 and by $1.4 million for the nine months ended September 30, 2004 compared to $4.7 million for the same period in 2003. Claim and claim settlement expenses also increased in 2004 due to the increase in gross premiums earned in 2004 compared to 2003. See further discussion under “Claim and Claim Settlement Expenses”; and
	•		Income tax expense for the three and nine-month periods ended September 30, 2003 was favorably affected by a $1.2 million deferred income tax valuation allowance adjustment. There was no similar adjustment in 2004.

     We expect premiums in force to increase moderately from levels reported at September 30, 2004 for the remainder of the year as we focus on writing profitable business at the right price. We will focus on increasing profitability in our markets by: (i) aggressively managing and closing claims; (ii) reviewing policy profitability at renewal and removing unprofitable accounts; and (iii) aggressively managing policy acquisition costs and general and administrative expenses.

     We expect that service fee income will increase in the fourth quarter of 2004 as we continue providing services to employers insured through the Minnesota Assigned Risk Plan and as we add new customers.

     In the following pages, we discuss the operating results for the three and nine-month periods ended September 30, 2004 and 2003 for items in our Consolidated Statements of Income and also explain key balance sheet accounts in greater detail.

Results of Operations

Total revenues: Our total revenues include premiums earned, investment income, net realized investment (losses) gains and service revenue. The following tables summarize the components of our revenues and premiums in force (000’s):

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Premiums In Force and Gross Premiums Earned: Premiums on workers’ compensation insurance policies are our largest source of revenue. Premiums earned are the gross premiums earned by us on in force workers’ compensation policies, net of the effects of ceded premiums under reinsurance agreements.

     The premium we charge a policyholder is a function of the policyholders’ payroll, industry and prior workers’ compensation claims experience. In underwriting a policy, we receive policyholder payroll estimates for the ensuing year. We record premiums written on an installment basis matching billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy based on the payroll estimate. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet. When a policy expires, we audit policyholder payrolls for the policy period and adjust the estimated payroll to its actual value. The result is a “final audit” adjustment recorded to premiums earned when the adjustment becomes known. Final audit premiums recognized during the period include billed final audit premiums plus (or minus) the change in estimate for premiums on unexpired and expired unaudited policies.

     Our premiums in force increased $5.4 million or 9.4% to $62.8 million at September 30, 2004 from $57.4 million at September 30, 2003 and increased $4.7 million or 8.1% from $58.1 million at December 31, 2003. A significant portion of the increase in premiums in force since September 30, 2003 occurred in our Minnesota region with a modest increase in our Michigan region, offset by a decrease in our Colorado region. In order to continue to improve profitability, we aggressively target policies that do not meet our underwriting profit margin standards for non-renewal or re-underwriting at increased rates at policy expiration.

     Our gross premiums earned increased 21.5% to $16.7 million in the third quarter of 2004 from $13.7 million in the third quarter of 2003 and increased 19.6% to $47.0 million for the nine months ended September 30, 2004 from $39.3 million for the same period in 2003 due primarily to the increase in premiums in force. Final audit premiums increased gross premiums earned by $643,000 for the nine months ending September 30, 2004. In contrast, final audit premiums decreased gross premiums earned by $93,000 for the same period in 2003.

     Renewal premium rates increased 2.8% in the third quarter of 2004 and 1.8% for the nine months ended September 30, 2004, while renewal premium rates increased 5.0% in the third quarter of 2003, but were flat for the nine months ended September 30, 2003. We file our rates at the high end of the market in each region in which we operate, usually at or near the rates charged by the residual markets in these regions.

     Premiums Ceded: Reinsurance agreements enable us to share certain risks with other insurance companies. We purchase reinsurance to protect us from potential losses in excess of the level we are willing to accept. We expect the companies to which we have ceded reinsurance to honor their obligations. In the event that these companies are unable to honor their obligations to us, we will be required to pay the underlying obligations ourselves. We are not aware of any developments with respect to any of our reinsurers that would result in our current reinsurance balances becoming uncollectible.

     Under our excess of loss reinsurance policies, we pay reinsurers to limit our per-incident exposure and record this cost to premiums ceded as a reduction of gross premiums earned. In Minnesota, we are required to purchase

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excess of loss coverage for our Minnesota policies from the Minnesota Workers’ Compensation Reinsurance Association (WCRA). We purchased reinsurance for 2004 in our non-Minnesota regions from three reinsurers. The following table summarizes our reinsurance coverage (all losses ceded on a per occurrence basis):

     Premiums ceded to reinsurers were $2.5 million in the third quarter of 2004 compared to $2.0 million in the third quarter of 2003 and were $7.0 million for the nine months ended September 30, 2004 compared to $5.7 million for the same period in 2003. As a percent of gross premiums earned, premiums ceded increased to 15.1% for the three months ended September 30, 2004 compared to 14.9% for the same period in 2003 and to 15.0% for the nine months ended September 30, 2004 compared to 14.4% for the same period in 2003. The higher percentage in the 2004 periods reflect that the rates we are charged for excess of loss reinsurance coverage increased in all regions in 2004 and the rates we are charged are lower for Minnesota risks compared to non-Minnesota risks.

Premiums Earned Outlook: The outlook for premiums in force, gross premiums earned and premiums ceded for the remainder of 2004 include the following factors:

	•		We expect premium rates on renewing policies to increase slightly or remain flat for the remainder of 2004. Premium rate increases realized in 2003 will continue to favorably affect profitability in 2004 as we earn more premiums on those policies. We expect premiums in force to increase moderately for the remainder of 2004;
	•		Our 2004 gross premiums earned will move in the same direction as our premiums in force, lagging slightly as premiums are earned over the term of the insurance policy; and
	•		We expect that premiums ceded under excess of loss policies will increase when compared to 2003, but remain consistent with the first nine months of 2004 as a percentage of gross premiums earned.

Investment Income and Net Realized Investment (Losses) Gains: Investment income includes earnings from our investment portfolio and our net realized investment (losses) gains, which include (losses) gains from sales of securities, and are displayed separately on our accompanying Consolidated Statements of Income.

     We currently invest entirely in U.S. domiciled investment-grade taxable and tax-exempt fixed maturity investments and classify our investments as available-for-sale. Our primary investment objective is to maintain a diversified, high-quality, fixed-investment portfolio structured to maximize our after-tax investment income without taking inappropriate credit risk. For further discussion of investments, see the “Investments” section of this Management’s Discussion and Analysis.

     Investment income decreased to $970,000 in the third quarter of 2004 from $1.1 million in the third quarter of 2003 and decreased to $2.8 million for the nine months ended September 30, 2004 from $3.5 million for the same period in 2003 as our investment portfolio decreased to $83.4 million at September 30, 2004 from $87.7 million at September 30, 2003. Investment income also declined as a result of the decrease in our average book investment

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yield to 4.0% at September 30, 2004 from 4.5% at September 30, 2003. Interest rates declined early in 2003, reaching a low point in June 2003 before returning to beginning of the year levels by December 2003. Approximately $20.3 million of mortgage-backed securities in our investment portfolio were repaid earlier than expected in 2003 due to the significant consumer mortgage refinancing that occurred in 2003. The funds that came available could not be reinvested at comparable rates, causing the book investment yield to decline. In order to reduce the near-term interest rate risk on the portfolio, we built our cash position throughout 2003 by holding cash received on mortgage-backed security pre-payments and through sales of securities in 2003 expecting that interest rates would rise in 2004. Subsequent to December 31, 2003, we began to diversify our portfolio by investing in tax-exempt municipal securities to take advantage of the tax benefits of those securities and existing interest rate spreads. Additionally in the first nine months of 2004, we reinvested proceeds from maturing securities, pre-payments of mortgage-backed securities and a portion of our cash and cash equivalents into taxable and tax-exempt securities. The investment income realized in future periods will be affected by yields attained on new investments.

     In 2004, we sold certain securities within the portfolio to take advantage of favorable interest rates. We realized net investment gains of $705,000 for the nine months ended September 30, 2004 compared to $685,000 for the same period in 2003.

Investment Income and Net Realized Investment (Losses) Gains Outlook: Barring significant changes in interest rates or operational cash flows, we expect that income from our investment portfolio for the remainder of 2004 will be affected by the following:

	•		Our investment in tax-exempt municipal bonds will result in reduced investment yields but will favorably affect net income as the rates will be lower on a pre-tax basis but will be higher on a tax-adjusted basis;
	•		We expect interest rates to increase during the remainder of 2004; however, the timing of any such rate increase is unknown at this time. We intend to invest our excess cash into higher yielding investments as rates increase;
	•		Funds from our operating cash flows and investment cash flows provide growth in our investment portfolio. Cash flows for the remainder of 2004 will be affected by: (i) premiums ceded net of reinsurance reimbursements under our excess of loss treaties; and (ii) net cash flows resulting from claim payments on claims from 2004 and prior years offset by cash flows from current in-force policies;
	•		Future recognition of realized investment gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements or as we replace securities to manage our portfolio risks and returns and will also be affected by the implementation of Emerging Issues Task Force position 03-1, “The Meaning of Other than Temporary Impairment”. See further discussion under “Effect of Recent Accounting Pronouncements”; and
	•		New and renegotiated reinsurance treaties may affect our future cash flow and future investment income.

Service Revenue: Service revenue includes revenues for services that are: (i) billed as a percent of premium of insurance policies issued by non-affiliated third party insurers; (ii) billed based on the number and type of claims serviced; (iii) billed on an hourly basis based on direct activity; or (iv) billed based on contract duration. Our customers include the Minnesota Workers’ Compensation Assigned Risk Plan (ARP), self-insured employers, other insurance companies, insurance agents and local governmental units. Service revenue grew to $143,000 in the third quarter of 2004 from $23,000 in the same quarter in 2003 and increased to $283,000 for the nine months ended September 30, 2004 from $79,000 for the nine months ended September 30, 2003.

Service Revenue Outlook: Service revenue realized for the balance of 2004 will be affected by the following:

	•		In March 2004, we were awarded a three-year contract to service 25% of the Minnesota Workers’ Compensation Assigned Risk Plan (ARP). We are paid a fee based on a percent of the premium we service and began servicing new ARP business on July 1, 2004 and renewal ARP business on September 1, 2004. The estimated annual premium for the entire ARP is in excess of $100 million. This contract is currently expected to produce service revenue in excess of $4.0 million during the first 14 months of the contract and approximately $250,000 of earned service revenue during 2004; and
	•		We currently have 19 additional non-insurance customers in Minnesota, California and Michigan that will generate approximately $800,000 of additional annualized service revenue over the term of their contracts. We continue to market our alternative products aggressively inside and outside the regions in which we

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currently operate. We expect service revenue will increase as new customers become aware of and purchase these services. The ultimate effect of this on service revenue is not known at this time.

Total expenses: Our expenses include claim and claim settlement expenses, policy acquisition costs, general and administrative expenses, interest expense and income taxes.

Claim and Claim Settlement Expenses: Claim expenses refer to medical and indemnity benefits that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, to claim and claim settlement expenses in the accompanying Consolidated Statements of Income.

     Claim and claim settlement expenses are our largest expense and result in our largest liability. We establish reserves that reflect our estimates of the total claim and claim settlement expenses we will ultimately have to pay under our workers’ compensation insurance policies. These include claims that have been reported but not yet settled and claims that have been incurred but not yet reported to us. For further discussion of reserve determination, see the “Unpaid Claim and Claim Settlement Expenses” section of this Management’s Discussion and Analysis.

     Claim and claim settlement expenses increased to $10.1 million in the third quarter of 2004 from $6.4 million in the third quarter of 2003 and to $28.3 million for the nine months ended September 30, 2004 from $20.3 million for the same period in 2003. As a percent of gross premiums earned, claim and claim settlement expenses increased to 60.3% for the third quarter of 2004 from 46.8% for the third quarter of 2003 and to 60.2% for the nine months ended September 30, 2004 from 51.7% for the same period in 2003. These changes are due to the following:

	•		Claim and claim settlement expenses increased in total due to the overall increase in premiums in force and the related increase in gross premiums earned;
	•		We recorded a $300,000 reduction in claim and claim settlement expenses in the third quarter of 2004 and $1.4 million through the first nine months of 2004 to reflect favorable claim development for 2003 and prior accident years. The 2003 results included a $2.0 million reduction in the third quarter of 2003 and a $4.7 million reduction through the first nine months of 2003;
	•		Continued improvements in our ability to manage claims; and
	•		Offsetting these decreases, claim costs continued to reflect increasing medical and indemnity costs in accident year 2004 as compared to accident year 2003 resulting from inflationary pressures.

Claim and Claim Settlement Expense Outlook: We expect that claim and claim settlement expenses will be affected by the following factors:

	•		Claim costs will continue to be affected by: (i) increases in medical and indemnity costs resulting from inflationary changes; (ii) severity experienced in current and future periods in our policyholder base; (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems; and (iv) legislative changes that affect benefits payable under workers’ compensation laws;
	•		Increases (decreases) in premium rates will result in increasing (decreasing) gross premiums earned without a corresponding increase (decrease) in claim and claim settlement expenses, ultimately decreasing (increasing) claim and claim settlement expense as a percent of premiums earned. Legislative changes in estimated loss costs, increased competition and changes in customer loss experience may offset or eliminate the effect of any rate improvement; and
	•		Continued application of our claims management technology and methods to all open claims.

The ultimate effect of the above factors on claim and claim settlement expenses as a percent of premiums earned for the remainder of 2004 is unknown at this time.

Policy Acquisition Costs: Policy acquisition costs are costs directly related to writing an insurance policy and include commissions, state premium taxes, underwriting personnel costs and expenses, sales and marketing costs and other underwriting expenses, less ceding commissions received from our reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing reinsurance with them.

     The following table summarizes policy acquisition costs (000’s):

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     Under certain of our excess of loss reinsurance policies, the reinsurer returns a portion of the premiums we cede as ceding commissions to reimburse us for our cost of placing and managing these policies. Ceding commissions received under these excess of loss reinsurance policies totaled $612,000 for the third quarter of 2004 compared to $378,000 for the third quarter of 2003 and $1.8 million for the nine months ended September 30, 2004 compared to $1.1 million for the nine months ended September 30, 2003. These ceding commissions reduced our policy acquisition costs. Excluding the effect of ceding commissions, policy acquisition costs increased to $2.1 million in the third quarter of 2004 from $1.9 million in the third quarter of 2003 and increased to $6.7 million for the nine months ended September 30, 2004 from $6.4 million for the same period in 2003. As a percent of gross premiums earned, direct policy acquisition costs decreased to 12.9% in the third quarter of 2004 from 13.6% in the third quarter of 2003 and to 14.2% for the nine months ended September 30, 2004 from 16.2% for the same period in 2003. The first nine months of 2004 reflect the following:

	•		Gross premiums earned increased in the nine months ended September 30, 2004 compared to the same period in 2003 resulting in a corresponding increase in policy acquisition costs;
	•		Commission expense decreased to 6.9% and 7.2% of gross premiums earned for the three and nine-month periods ended September 30, 2004, respectively, from 7.4% and 7.3% for the same periods in 2003, respectively. This decrease in commission rates is the result of our new business growth that was experienced in the second half of 2003 on which we paid higher commission rates and the focus in 2004 on reducing the commissions we pay. In all of our markets, we believe the commission rates we pay are marketplace competitive;
	•		Premium tax expense was 2.0% of gross premiums earned for the third quarters of 2004 and 2003 and 1.7% for the nine months ended September 30, 2004 and September 30, 2003;
	•		We recorded a $478,000 increase in other policy acquisition costs in the second quarter of 2004 reflecting a reapportionment of 2003 mandatory reinsurance pools expenses compared to a $1.3 million increase recorded in the second quarter of 2003 reflecting a reapportionment for 2002; and
	•		Other policy acquisition costs consist of payroll audit vendor costs, various state assessments related to second injury funds and the net effect of assigned risk plan activity in the states in which we have operated. Other policy acquisition costs decreased to 3.9% of gross premiums earned in the third quarter of 2004 compared to 4.1% in the third quarter of 2003. Excluding the mandatory pool reallocation discussed above, other policy acquisitions costs increased to 4.3% for the nine months ended September 30, 2004 from 4.0% for the same period in 2003.

Policy Acquisition Cost Outlook: We expect that policy acquisition costs in 2004 will be affected by the following:

	•		Our commission expense will continue to be affected by how much new business we write relative to renewal business as we pay higher commissions on new policies. We had significant new business growth in the latter half of 2003 and the first half of 2004 and we expect new business to grow moderately for the remainder of 2004;
	•		Premium tax accrual rates will return to their normal level of 2.0% for the balance of 2004;
	•		Other underwriting expenses will continue to be affected by pool reimbursements offset by pool disbursements, the effect of which is not known at this time.

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General and Administrative Expenses: Our general and administrative expenses include personnel costs, office rent, certain state administrative assessments based on premiums and other costs and expenses not specific to claim and claim settlement expenses or policy acquisition costs.

     General and administrative expenses decreased to $2.2 million in the third quarter of 2004 from $2.5 million in the third quarter of 2003 and to $6.4 million for the nine months ended September 30, 2004 from $7.5 million for the same period in 2003. As a percent of gross premiums earned, general and administrative expenses decreased to 13.3% in the third quarter of 2004 from 18.5% in the third quarter of 2003 and to 13.5% for the nine months ended September 30, 2004 from 19.0% for the same period in 2003. General and administrative expenses, as a percentage of gross premiums earned, are expected to decrease since we will earn more premium in 2004 and will have more premium to cover our relatively fixed costs. General and administrative expenses continue to be managed aggressively and reduced where appropriate.

General and Administrative Expenses Outlook: We expect that general and administrative expenses will be affected by the following:

	•		Our contract to manage the Minnesota Workers’ Compensation Assigned Risk Plan business will require staff additions and increase our general and administrative expense;
	•		We will make appropriate investments in infrastructure to position us for future growth of our service revenue and to continue to support and enhance our core insurance operations;
	•		We have no plans to open additional offices in 2004. We will continually monitor reported claim counts for 2004 and re-examine staffing needs as necessary; and
	•		All expenses will continue to be aggressively managed and reduced where appropriate.

Interest Expense: We incurred interest charges on our note payable in the first nine months of 2003. The note payable was paid in full in September 2003. We expect to incur no interest charges in 2004.

Income Taxes: We incur federal income taxes on our combined service organization (RTW) operations and insurance (ACIC) operations. We incur state income taxes on the results of our service organization’s operations and incur premium taxes in lieu of state income taxes for substantially all of our insurance operations. In certain instances, we may incur state income taxes on our insurance operations. Additionally, certain provisions of the Internal Revenue Code adversely affect our taxable income by accelerating recognition and payment of income taxes. Adjustments to book income generating current tax liabilities include limitations on the deductibility of unpaid claim and claim settlement expenses, limitations on the deductibility of unearned premium reserves and limitations on deductions for bad debt reserves.

     In assessing our ability to realize deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. We consider recent operating results, the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. At December 31, 2001, we established a $14.5 million valuation allowance (allowance) against deferred tax assets resulting in a corresponding increase in income tax expense. This allowance decreased by $7.9 million to $6.6 million at December 31, 2002 as a result of the income we earned in 2002 and federal tax refunds totaling $3.8 million resulting from a change in Federal tax law. This allowance was further decreased by $3.0 million in 2003 to $3.6 million as a result of the income we earned in 2003 and analysis of our projected taxable income and available tax planning strategies. We expect any remaining deferred tax assets, net of the allowance, at September 30, 2004, to be realized as a result of the future income and the reversal of existing taxable temporary differences.

     Income tax expense for the third quarter of 2004 was $361,000, or 24.8% of income before income taxes, compared to an income tax benefit of $144,000 for the same period in 2003. Income tax expense for the nine months ended September 30, 2004 was $1.3 million, or 29.9% of income before income taxes, compared to $415,000, or 8.7% of income before income taxes for the same period in 2003. The third quarter of 2003 included a $1.2 million reduction in our deferred income tax valuation allowance, which favorably affected our income tax expense for that period and 2003. After adjusting for the allowance benefit recorded, income tax expense was 35.3% and 34.0% of income before income taxes for the three and nine-month periods ended September 30, 2003. The decreased tax rates in 2004 are primarily the result of the benefit of tax-exempt investment income realized in 2004. Further, the income tax expense percentages for the three and nine months ended September 30, 2004 and 2003 have been affected by: (i) our income from operations and (ii) changes in taxable net income from our insurance subsidiary (ACIC) which is subject to only federal income taxes.

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Income Tax Outlook: Income tax expense will vary based on: (i) our results from operations for the remainder of 2004; (ii) the amount of tax exempt income we earn in 2004; and (iii) changes in our analysis of the income tax valuation allowance recorded during the remainder of 2004. The ultimate change is unknown at this time.

Investments

Our portfolio of fixed maturity securities at September 30, 2004 included U.S. government securities (44.1%), mortgage-backed securities (30.6%), municipal securities (22.9%) and asset-backed securities (2.4%). Our portfolio is managed by an independent investment manager to maximize our after-tax investment income without taking inappropriate credit risk. In 2004, we sold securities within the portfolio to take advantage of favorable interest rates and realized net investment gains totaling $705,000 through the first nine months of 2004. In September 2003, we sold certain securities within the portfolio to take advantage of favorable interest rates and realized investment gains totaling $685,000. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. All securities in our portfolio were rated AAA or AA at September 30, 2004 and December 31, 2003. We do not invest in derivative securities.

     Operating cash flows consist of the excess or deficit of premiums collected over claim and claim settlement expenses paid reduced by payments for reinsurance premiums as well as other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly reinsurance premiums under that agreement. Reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement offset similar payments to claimants for those years in 2004. Our investment portfolio decreased $4.3 million to $83.4 million at September 30, 2004 from $87.7 million at September 30, 2003. Our investment portfolio was $79.2 million at December 31, 2003. During 2003, interest rates declined, leading to a significant mortgage refinancing by consumers, resulting in significant prepayment or early redemption of our mortgage-backed securities. Cash and cash equivalents were $39.5 million, $39.7 million and $30.3 million at September 30, 2004, December 31, 2003 and September 30, 2003, respectively. We expect that cash will decrease for the remainder of 2004 as we pay claims for 2003 and prior years, years in which we earned higher premiums and incurred a higher number of claims reported and as we reinvest into tax-exempt municipal bonds and other fixed-income securities.

     We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders’ equity as accumulated other comprehensive income, net of taxes. Because value is based on the relationship between the portfolio’s stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of classifying our securities as available-for-sale, and thus carrying them at fair value, we expect to encounter adjustments in shareholders’ equity as market interest rates and other factors change. Prevailing market interest rates increased from levels at September 30, 2003 through the first nine months of 2004, resulting in a $618,000 net unrealized gain on investments at September 30, 2004 compared to a $2.3 million net unrealized gain at September 30, 2003 and a $1.5 million net unrealized gain at December 31, 2003.

Unpaid Claim and Claim Settlement Expenses

At September 30, 2004, the liability for unpaid claim and claim settlement expenses totaled $147.4 million, and our reinsurance recoverables on unpaid claim and claim settlement expenses totaled $66.7 million, resulting in net reserves totaling $80.7 million. Net reserves at September 30, 2003 totaled $81.2 million and included the liability for unpaid claim and claim settlement expenses totaling $154.4 million, net of reinsurance recoverables on unpaid claim and claim settlement expenses of $73.2 million.

     Accounting for workers’ compensation insurance operations requires us to estimate the liability for unpaid claim and claim settlement expenses (reserves) and the related reinsurance recoverables, (together, net reserves) at each balance sheet date. Our reserves represent the estimated total unpaid cost of claim and claim settlement expenses, which cover events that occurred to date in 2004 and prior years. These reserves reflect our estimates of the total costs of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported (IBNR). For reported claims, we establish reserves on a “case” basis. For IBNR claims, we calculate the difference between: (i) projected ultimate claim and claim settlement expenses as determined using generally accepted actuarial standards; and (ii) case reserves and carry the difference as an IBNR reserve. By using both estimates of reported claims and IBNR claims, we estimate the ultimate net reserves for unpaid claim and claim settlement expenses.

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     The amount by which estimated net reserves, measured subsequently by reference to payments and additional estimates, differ from those originally reported for a period is known as “development.” Development is unfavorable (deficient) when losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on open claims. Development is favorable (redundant) when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on open claims. Favorable or unfavorable development of loss reserves is reflected in earnings in the year recognized.

     Both internal and independent external actuaries review net reserves for adequacy on a periodic basis. These reviews assume that past experience, adjusted for the effects of current events and anticipated trends, is an appropriate basis for predicting future events. When reviewing net reserves, actuaries analyze historical data and estimate the effect of various factors on estimated ultimate reserves including: (i) trends in general economic conditions, including the effects of inflation; (ii) estimates of trends in claims frequency and severity; (iii) our industry historical loss experience; and (iv) legislative enactments, legal developments and changes in social and political attitudes. Variables in the reserve estimation process can be affected by both internal and external events, including changes in claims handling procedures, economic inflation, legal trends and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. There is no precise method for subsequently evaluating the effect of any specific factor on the adequacy of reserves because the eventual redundancy or deficiency is affected by many factors. Additionally, there may be significant reporting lags between the occurrence of the loss and the time it is actually reported to the insurer. Due to our commencing operations in 1992, we have limited historical data to estimate our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses and, accordingly, we supplement our experience with external industry data, as adjusted, to reflect anticipated differences between our results and the industry.

     Estimating the effect that inflation will have on the ultimate cost of claims is a major risk factor in our workers’ compensation reserve estimates. Future earnings will be affected by reserve development associated with any changes in our inflation assumptions. Estimates for the 2003 and 2002 accident years represent the majority of the uncertainty because these claims have the lowest proportionate amount of paid loss as of September 30, 2004. Our reserve estimates are most sensitive to changes in the assumption about inflation for the 2003 and 2002 accident years. Each one percent (1%) increase or decrease in the inflation rate for each of these accident years would increase or decrease our net loss reserve estimates at December 31, 2003 by approximately $390,000. Information about the 2004 accident year is still very immature and any estimate of a one percent (1%) change would be premature.

     Our independent actuary provides management with an opinion annually regarding the acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines. We record our net reserves by considering a range of estimates bounded by the high and low point of the range. Within that range, we record our best estimate. At December 31, 2003, we established recorded reserves in the upper end of the actuary’s range and we continue to believe that recorded reserves remain in that range at September 30, 2004. The ultimate actual liability may be higher or lower than reserves established.

     Our reserves are primarily undiscounted; however, we discounted reserves for selected claims that have fixed and determinable future payments at rates ranging from 3.5% to 8.0% in 2003 and 2002. The discount rates in 2004 are subject to change as market interest rates change. We use the same rates for Generally Accepted Accounting Principles as we do for Statutory Accounting Practices in determining our liability. We also reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.

     We continually monitor loss development trends and data to establish adequate premium rates and to determine reasonable reserve estimates. Reserves that are based on estimates are inherently uncertain and represent a significant risk to the business. We attempt to mitigate this risk by continually improving and refining our workers’ compensation claims processing practices and by continual monitoring through actuarial estimation methods.

     After taking into account all relevant factors, we believe our reserves for unpaid claim and claim settlement expenses and reinsurance recoverables on unpaid claim and claim settlement expenses at September 30, 2004 are adequate to cover the ultimate net costs of claim and claim settlement expenses at that date. The ultimate cost of claim and claim settlement expenses may differ materially from the established reserves, particularly when claims may not be settled for many years. Establishing appropriate reserves is an inherently uncertain process and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience.

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     Income for the three and nine months ended September 30, 2004 included a $300,000 and a $1.4 million, respectively, reduction of projected claim and claim settlement expenses resulting from favorable development of claims for 2003 and prior accident years. Income for the three and nine months ended September 30, 2003 included a $2.0 million and a $4.7 million, respectively, reduction of projected claim and claim settlement expenses resulting from favorable development of claims for 2002 and prior accident years.

Liquidity and Capital Resources

     Liquidity refers to our ability to generate sufficient cash flows to meet the short- and long-term cash requirements of our operations. Capital resources represent those funds deployed or available to be deployed to support our business operations.

     Our primary sources of cash from operations are premiums collected, reimbursements under reinsurance contracts and investment income. Our primary cash requirements consist of payments for: (i) claim and claim settlement expenses; (ii) reinsurance; (iii) policy acquisition costs; (iv) general and administrative expenses; (v) capital expenditures; and (vi) income taxes. We generate cash from or use cash in operations based on timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. Selected reinsurance retention levels also use cash as a result of “pre-funding” premiums under the policies or provide cash upon reimbursement of claim payments. In 2003 and the first nine months of 2004, reinsurance reimbursements from our $25,000 to $300,000 excess of loss reinsurance agreement, which began in mid 1998 and ran-off in 2001, offset similar payments to claimants for those years. This trend will continue through the remainder of 2004. We further expect that cash and cash equivalents will decrease from levels reported at December 31, 2003 and September 30, 2004 during the remainder of 2004 as we take advantage of the anticipated increase in interest rates to purchase investments. Available cash is invested in either short-term cash and cash equivalents or longer-term available-for-sale securities pending future payments for such expenses as medical and indemnity benefits and other operating expenses. Cash and cash equivalents consist of cash, a money market fund that invests primarily in short-term U.S. Government securities and overnight repurchase agreements secured by U.S. Treasury or U.S. Government Agency securities.

     Cash provided by operating activities for the nine months ended September 30, 2004 was $4.7 million. This is primarily a result of net income of $3.0 million, a decrease of $5.1 million in reinsurance recoverables, an increase of $1.5 million in unearned premiums, net of premiums receivable and depreciation and amortization expense of $727,000 offset by a decrease of $2.6 million in unpaid claim and claim settlement expenses which are non-cash accruals for future claims, a decrease of $1.2 million in accrued expenses and other liabilities, an increase in other assets totaling $1.1 million and net realized investment gains totaling $705,000. Net cash used in investing activities was $5.1 million due to $36.5 million in purchases of securities and $315,000 in purchases of furniture and equipment offset by $20.4 million in proceeds from sales of and pre-payments on securities and $11.3 million from the maturity of securities. Net cash from financing activities was $350,000 due to the exercise of stock options.

     Our need for additional capital is primarily the result of regulations that require certain ratios of regulatory or statutory capital to premiums written in our insurance subsidiary as defined by state regulatory bodies and insurance rating agencies. Raising additional permanent capital, while difficult in the current environment in which we operate, would further reduce our ratio of premium to capital and provide a more solid base for the future growth of our insurance subsidiary. As an alternative to raising additional permanent capital, certain reinsurance contracts could be used on an interim basis that would have the effect of reducing the ratio of premiums to capital and surplus in ACIC to satisfy state regulatory requirements.

     Minnesota state insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. Under Minnesota insurance law regulating the payment of dividends, in any twelve month period, ACIC can pay a dividend to us from its earned surplus (unassigned surplus) not to exceed the greater of 10% of ACIC’s total surplus or ACIC’s prior years’ net income reduced for realized capital gains net of income taxes. At September 30, 2004, ACIC could pay a dividend to RTW of $3.2 million without the approval of the Minnesota Department of Commerce. ACIC has never paid a dividend to RTW, and we intend to retain capital in the insurance subsidiary.

     Investments held as statutory deposits and pledged as collateral do not have an adverse effect on our liquidity. We believe that cash flow generated by our operations and our cash and investment balances will be sufficient to fund continuing operations and capital expenditures for the next twelve months.

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Interest Rate Risk

     Our fixed maturity investments are subject to interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of these instruments. Also, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, pre-payment options, relative values of alternative instruments, the liquidity of the instrument and other general market conditions. We regularly evaluate interest rate risk in order to evaluate the appropriateness of our investments.

     An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $3.9 million at September 30, 2004.

     The effect of interest rate risk on potential near-term fair value was determined based on commonly used models. The models project the effect of interest rate changes on factors such as duration, pre-payments, put options and call options. Fair value was determined based on the net present value of cash flows or duration estimates, using a representative set of likely future interest rate scenarios.

NAIC Risk-based Capital Standards

     The National Association of Insurance Commissioners (NAIC) has risk-based capital standards to determine the capital requirements of a property and casualty insurance carrier based upon the risks inherent in its operations. These standards require computing a risk-based capital amount that is compared to a carrier’s actual total adjusted capital. The computation involves applying factors to various financial data to address four primary risks: (i) asset risk; (ii) insurance underwriting risk; (iii) credit risk; and (iv) off-balance sheet risk. These standards provide for regulatory intervention when the percent of total adjusted capital to authorized control level risk-based capital is below certain levels. Based upon the risk-based capital standards, our percent of total adjusted capital is substantially in excess of authorized control level risk-based capital.

Regulation

     Our insurance subsidiary is subject to substantial regulation by governmental agencies in the states in which we operate, and will be subject to such regulation in any state in which we provide workers’ compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments we may hold. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. At September 30, 2004, our insurance subsidiary was licensed to do business in Minnesota, South Dakota, Wisconsin, Colorado, Missouri, Illinois, Kansas, Michigan, Indiana, Massachusetts, Connecticut, Rhode Island, Pennsylvania, Tennessee, Maryland, Arkansas, Iowa, Florida, Georgia, New Jersey, North Carolina, Texas and Oklahoma.

Effect of Recent Accounting Pronouncements

     In March 2004, the Financial Accounting Standards Board (“FASB”) reached consensus on the guidance provided by Emerging Issues Task Force Issue 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. The guidance is applicable to debt and equity securities that are within the scope of FASB Statement of Financial Accounting Standard (“SFAS”) No. 115, “Accounting for Certain Investments In Debt and Equity Securities” and certain other investments. EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. EITF 03-1 cost method investment and disclosure provisions were effective for reporting periods ending after June 15, 2004. The measurement and recognition provisions relating to debt and equity securities have been delayed until the FASB issues additional guidance. The Company adopted the disclosure provisions of EITF 03-1 on June 30, 2004. The adoption did not have a material impact on the consolidated financial statements, results of operations or liquidity of the Company.

     In October, 2004, the Financial Accounting Standards Board (“FASB”) concluded that Statement 123R, “Share-Based Payment”, which will require all companies to measure and record in the income statement compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. The FASB plans to issue the final statement

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on or around December 15, 2004. We do not expect the adoption of Statement 123R will have a material effect on our financial statements.

Forward Looking Statements

Information included in this Report on Form 10-Q which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue” or the negative thereof or other variations thereon or comparable terminology constitutes “forward-looking information” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. The following important factors, among others, in some cases have affected and in the future could affect our actual results and could cause our actual financial performance to differ materially from that expressed in any forward-looking statement: (i) our ability to retain renewing policies and write new business with a B+ (Very Good, Secure) rating from A.M. Best; (ii) our ability to extend our workers’ compensation services to self-insured employers and other alternative markets and to operate profitably in providing these services; (iii) our ability to continue to maintain or increase rates on insured products in the markets in which we remain or alternatively non-renew or turn away improperly priced business; (iv) the ability of our reinsurers to honor their obligations to us; (v) our ability to accurately predict claim development; (vi) our ability to provide our proprietary products and services to customers successfully; (vii) our ability to manage both our existing claims and new claims in an effective manner; (viii) our experience with claims frequency and severity; (ix) medical inflation; (x) competition and the regulatory environment in which we operate; (xi) general economic and business conditions; (xii) our ability to obtain and retain reinsurance at a reasonable cost; (xiii) changes in workers’ compensation regulation by states, including changes in mandated benefits or insurance company regulation; (xiv) interest rate changes; and (xv) other factors as noted in our other filings with the Securities and Exchange Commission. This discussion of uncertainties is by no means exhaustive but is designed to highlight important factors that may affect our future performance.

Item 3:       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Information with respect to Disclosures about Market Risk is contained in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Interest Rate Risk” under Item 2 of this Report on Form 10-Q and is incorporated herein by reference.

Item 4:       CONTROLS AND PROCEDURES

(a)       Evaluation of Disclosure Controls and Procedures

The Company’s President and Chief Executive Officer, Jeffrey B. Murphy, and Chief Financial Officer, Alfred L. LaTendresse, have evaluated the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that review, they have concluded that these controls and procedures are effective in ensuring that material information related to the Company is made known to them by others within the Company.

(b)       Changes in Internal Control Over Financial Reporting

There have been no significant changes in internal control over financial reporting that occurred during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1.       LEGAL PROCEEDINGS
                     None

Item 2.       UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
                     None

Item 3.       DEFAULTS UPON SENIOR SECURITIES
                     None

Item 4.       SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
                     None

Item 5.       OTHER INFORMATION
                     None.

Item 6.       EXHIBITS

                     (a)       Listing of Exhibits

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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