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United States Securities and Exchange Commission

Washington, D.C. 20549

Form 10-K

or

Commission File Number 1-6563

Safeco Corporation

State of Incorporation: Washington

I.R.S. Employer I.D. No.: 91-0742146

Address of Principal Executive Offices: Safeco Plaza, Seattle, Washington 98185

Telephone: 206-545-5000

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, No Par Value: 127,175,344 shares were outstanding at February 25, 2005.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark 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.  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  x    NO  ¨

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 30, 2004, was $6,100,000,000.

Documents incorporated by reference: Portions of the registrant’s definitive Proxy Statement for the 2005 annual shareholders meeting are incorporated by reference into Part III.

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Safeco Corporation and Subsidiaries

Index to Financial Statements, Schedules and Exhibits

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Part I

(Dollar amounts in millions except for ratios and per share data unless noted otherwise)

Item 1: OUR BUSINESS

We are a Washington State corporation with headquarters in Seattle. We had 9,200 employees at February 25, 2005. We’ve been in business since 1923 serving the insurance needs of drivers, home owners and small- and medium-sized businesses. Our business helps people protect what they value and deal with the unexpected.

In 2004, we took steps to position Safeco for continued profitable growth. We completed the sale of our Life & Investments business. We rolled out Safeco Now, our unified, Web-based sales-and-service platform. We reorganized our company around the way we operate. With these actions, we are a focused, more nimble company. We’re intent on delivering the best mix of insurance coverages and pricing to our distributors and customers, and fulfilling the promise of our products when a loss occurs.

Our Vision and Strategy

Our vision is to be one of the top-performing property and casualty (P&C) insurance companies in the industry. To achieve our vision, we must be distinctly good at motivating our independent distributors to sell our products. We will do this by continuing to develop and service our insurance products in ways that:

Our strategy reflects how we do business – offering standardized auto, homeowners and small-business insurance products over a unified sales-and-service platform through a common independent distribution network. Here’s a closer look at the key elements of our business model:

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To fully leverage this business model, in 2004 we realigned our organization around these three areas.

The net earned premiums for our standardized products of auto, property and small-and medium-business insurance were:

Our Financial Goals

We measure the success of our strategy by tracking our performance against the following three long-term financial goals:

Our Products

Our revenues come from the premiums earned on the insurance policies we write and the income earned from our investment of these premium dollars. We are the 18^th largest property and casualty insurance company in the United States, based on 2003 direct written premiums as reported by A.M. Best, an insurance rating and information agency. A.M. Best ranks companies based on written premiums, which are premiums charged for policies issued. However, premiums are earned and reported as revenues over the policy term. As a result, the charts below use the net earned premiums measure, which is equivalent to our premium revenues. We use “net” because some of our premiums are ceded to reinsurers, which protect our capital just as insurers protect their customers.

Net earned premiums by our 10 largest states in 2004 were as follows:

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We have four business segments:

Net earned premiums for our business segments were as follows:

Safeco Personal Insurance

Net earned premiums for Safeco Personal Insurance by reportable segment were as follows:

Auto – We are the 13^th largest writer of auto insurance in the United States, based on 2003 direct written premiums as reported by A.M. Best. We provide coverage for the liability of our customers to others for both bodily injury and property damage, for injuries sustained by our customers, and for physical damage to our customers’ vehicles from collision and other hazards.

Our tiered auto product, now available in 43 of the 44 states where we write business, covers more than 95% of all auto insurance applications in our distributors’ offices. We continue to work with the California Department of Insurance to explore potential options to implement our tiered pricing methodology. Our automated underwriting and segmentation reflects both traditional underwriting methods and state-of-the-art predictive modeling techniques. This helps to drive competitive pricing and profitability. Our point-of-sale technology, Safeco Now – the platform for this automated underwriting process – allows distributors to quote and sell policies faster, enabling us to streamline the sales process (see further discussion on page 8).

In 2004, we enhanced Safeco Now to streamline the service process for customers and distributors, allowing online processing of auto policy changes and endorsements such as vehicle additions and deletions, vehicle replacements or updates, and coverage and deductible changes.

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Property – We provide homeowners, dwelling fire, earthquake and inland marine coverage for individuals through our property business. We are the 10^th largest writer of homeowners insurance in the United States, based on 2003 direct written premiums as reported by A.M. Best. Our Property coverages protect homes, condominiums and rental property contents against losses from a wide variety of hazards. We also protect individuals from liability for accidents that occur on their property.

We’ve rolled out our tiered pricing structure for homeowners insurance in 43 of the 44 states where we write business. We continue to work with the California Department of Insurance to explore potential options to implement our tiered pricing methodology. Like auto, our tiered homeowners product allows us to match rates more closely to the risks that we insure, and our distributors can quote and issue our homeowners and dwelling fire products over the unified Safeco Now platform.

Specialty – We also offer umbrella, recreational vehicle, motorcycle and boat owners insurance coverage for individuals. These specialty products round out our personal lines portfolio so we can provide products to meet the majority of our policyholders’ personal insurance needs. These specialty products will be launched on Safeco Now in 2005.

Safeco Business Insurance

Net earned premiums for Safeco Business Insurance by reportable segment were as follows:

SBI Regular – This line offers a variety of commercial insurance products designed for small- and medium-sized businesses (customers who pay annual written premiums of $200,000 or less). Our principal business insurance products include business owner policies (BOP), commercial auto, commercial multi-peril (CMP), workers compensation, commercial property and general liability.

We are one of the largest writers of small-business insurance selling primarily through independent distributors in the United States. This market is highly fragmented. Many companies write small-business insurance, each with a small share of the market. Given the increasing number of small businesses in the United States and the lack of a dominant market leader, we see growth potential in this segment, and our goal is to become the leading small-business insurance writer. Throughout 2003 and 2004, we launched our BOP, commercial auto and workers compensation products on Safeco Now. In November 2004, we began the launch of our CMP product on Safeco Now, and it will be rolled out in all states where we write business by the end of 2005. During the fourth quarter of 2004, we expanded our BOP product by adding 35 additional classes of business.

SBI Special Accounts Facility – We write large-commercial accounts (customers who pay annual written premiums of more than $200,000) for our key distributors who sell our core products. We also write four specialty commercial insurance programs – lender-placed property, agents’ errors and omissions (predominantly for Safeco distribution partners), property and liability insurance for mini-storage and warehouse properties, and professional and general liability insurance for non-profit social service organizations.

Surety

We are the fifth largest writer of surety bonds in the United States, based on 2003 direct written premiums as reported by A.M. Best. We provide surety bonds for construction, performance and legal matters that include appeals, probate and bankruptcies.

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P&C Other

This segment includes results for large-commercial business accounts, commercial specialty programs and London operations we placed in runoff and other product lines that we have exited.

Corporate

In our Corporate segment, we include:

On August 2, 2004, we completed the sale of our life insurance, group stop-loss medical insurance and asset management operations to an investor group led by White Mountains Insurance Group, Ltd. and Berkshire Hathaway, Inc. We completed the sale of Talbot Financial Corporation (our brokerage operation) on July 1, 2004, and the sale of Safeco Trust Company on April 19, 2004. We received $1,499.0 of total sales proceeds. We used $735.2 of these proceeds, including transaction costs, to repurchase $618.4 of debt, resulting in a $121.0 pretax ($78.7 after-tax) loss on debt repurchases. Including transaction costs, we used $625.0 to execute an Accelerated Stock Buyback (ASB) program of 13,247,863 shares of common stock, and we retained the balance for future flexibility and to pay transaction-related expenses. See Note 17 to the Consolidated Financial Statements.

Financial information on our segments can be found in Management’s Discussion and Analysis (MD&A) and Note 16 to the Consolidated Financial Statements.

Our Competition and Distribution

We operate in a highly competitive property and casualty insurance industry. We compete for independent distributors and policyholders with thousands of domestic and foreign insurance companies. Competitive factors include:

Because we focus on selling through independent distributors, we compete not only for business and individual customers, but also for distributors. Our products are sold to our policyholders by others. As a result, our first sale is to the distributor, then to the policyholder. Both are customers to us. Within our distributors’ offices, we compete with:

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Our company differentiates itself through three key ideas:

In 2004, we brought the distribution of our major products together through our Safeco Now unified sales-and-service platform. The Safeco Now platform is Web-based and features a single point of entry for auto, homeowners, small-commercial products and certain surety bonds. It allows distributors to quote and sell these products in minutes and provides them with seamless cross-sell opportunities. Most of our remaining products are scheduled to launch on this platform during 2005. Safeco Now is easy for our independent distributors to use, drives operating efficiencies in their offices and gives us a competitive advantage over smaller regional carriers who have not made (or cannot afford) such investments in technology.

We also want to make buying and owning our products easy for our policyholders. Our claims are handled by professionals with the appropriate technical expertise necessary to handle coverage, liability and damage issues. We recognize the importance of the specialized and extensive training required for efficient claims handling so our policyholders have issues resolved quickly and receive prompt attention.

Our standardized auto, homeowners and small–business products serve the insurance protection needs of the majority of insurance buyers in the U.S. marketplace. Our focus on these products and our investment in automation to sell and service our products over a common platform provide us with a competitive advantage over other multiline carriers.

We believe that providing multiple property and casualty products gives us a “shelf space” advantage in our distributors’ offices over monoline carriers who offer just one product. We focus on the lines that our distributors sell most. This means we can help our distributors meet the vast majority of their customers’ needs in an efficient way.

Service

Like our customers, our independent distribution partners value choice, too. And we give them a choice when it comes to customer service support. If distributors prefer to handle service transactions on their own, we offer extensive online training to maximize efficiency. Through free e-school lessons, our partners learn how to inquire about claims status, account billings and premium payments. We also offer online and phone support if they need help completing a service transaction.

For distributors who want to focus on sales and growth and leave customer service transactions to us, we offer fee-based Gold Service programs for both personal and business insurance. With Gold Service, we provide full-service customer support on behalf of our distribution partners through our regional service centers. We experience higher retention of these policyholders, benefiting both the distributor and us. Either way, we measure ourselves against a “zero-defect” standard in our service transactions.

Claims Administration

For our policyholders, our products come to life at the point of claims. That’s the “moment of truth” when insurance becomes real. Our most visible product is the personalized service and support we provide when customers experience a loss and file a claim – whether it’s a “fender-bender” or the loss of a home.

We have a team of nearly 3,000 claims professionals across the country. They handled approximately 92% of our claims in 2004, excluding those from the devastating hurricanes in Florida and surrounding states (75% including hurricane claims).

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When disaster strikes, our National Catastrophe Team immediately mobilizes to assess the damage, issue payments to cover temporary living expenses and emergency repairs, and provide comfort and support to customers. In most cases, we issue payments to customers on the spot following a disaster. Our job is to help our customers put their lives back together as quickly as possible.

We contract with independent adjusters in remote locations where it’s impractical to have our own employees. Independent adjusters are also available to help us in extreme catastrophes when and where additional adjusters are needed. We supplemented our National Catastrophe Team with independent adjusters to service less-severe claims from customers after the hurricanes. Independent adjusters serviced 44% of the total hurricane claims.

Our claims processing combines the efficiency of centralized claims handling and customer service centers with the flexibility of field representatives. Our client service system supports a paperless claims environment, so our field representatives are not restricted to a specific physical location. We have distinct claims-handling functions to address complex claims such as surety, workers compensation, asbestos, environmental and construction defects.

Customers receive prompt repair estimates and claim checks in hand when their cars are damaged but drivable by visiting one of our drive-in claims centers. With nearly 400 locations in place and more in development, the program represents a significant commitment to customer service and efficient use of our resources. Our claims examiners can handle more claims working in a drive-in location versus the traditional approach of driving to a customer’s home or place of business to assess the damage.

Loss and Loss Adjustment Expense Reserves

Our ability to accurately estimate our loss and loss adjustment expense (LAE) reserves affects the viability and financial strength of our P&C operations. Loss and LAE reserves are management’s best estimates of ultimate losses from claims and related settlement expenses that we have not yet paid to settle both reported and unreported claims. We report these amounts in our Loss and LAE reserves on our Consolidated Balance Sheets.

We record two categories of loss and LAE reserves – case-basis reserves and incurred but not reported (IBNR) reserves.

We estimate case-basis reserves as the amount we will have to pay for losses that have already been reported to us but are not yet fully paid. These amounts include related legal expenses and other costs associated with resolving and settling a particular claim.

We establish IBNR reserves at the end of every reporting period to estimate the amount we will have to pay for:

We use actuarial methods combined with management judgment to estimate IBNR reserves.

Additional information about loss and LAE reserves is included in the Loss and Loss Adjustment Expense Reserves section of our MD&A on page 24.

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Reinsurance

We buy reinsurance to limit our losses on certain individual risks or reduce our exposure to catastrophic events. Our policyholders buy insurance from us to reduce the financial impact of the losses they may suffer. In turn, we buy reinsurance to limit the financial impact of losses on our results from losses of our policyholders.

We buy reinsurance from several providers and are not dependent upon any single reinsurer. Reinsurance does not eliminate our liability to our policyholders. We remain primarily liable to policyholders for the risks we insure.

We primarily buy reinsurance for:

Additional information about reinsurance is included in the Reinsurance section of our MD&A on page 42.

Regulation

Our insurance subsidiaries do business in and operate under the regulations of all 50 states and the District of Columbia. States regulate the insurance industry primarily to protect the interests of policyholders. The regulations cover:

State insurance departments periodically examine the conduct and financial condition of insurance companies. They require insurance companies to file annual and quarterly financial and other reports.

STATUTORY ACCOUNTING – The accounting basis required by the state regulatory authorities is called statutory accounting practices, or SAP. These practices differ in some respects from U.S. generally accepted accounting principles, or GAAP. For example, in reporting loss and LAE reserves on our Consolidated Balance Sheets:

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As a result, our loss and LAE reserves at December 31, 2004, were:

More information about state regulation is included in the Regulatory Considerations section of our MD&A on page 73. More information about our reinsurance recoverables can be found in Note 6 to the Consolidated Financial Statements.

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EXECUTIVE OFFICERS OF THE REGISTRANT

Here are our executive officers as of February 25, 2005. No family relationships exist among our executive officers.

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EXECUTIVE OFFICERS OF THE REGISTRANT (cont.)

We make our periodic and current financial reports and related amendments available on our website at www.safeco.com/ir at the same time as they are electronically filed with the Securities and Exchange Commission (SEC).

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Item 2: PROPERTIES

Our home office is in Seattle, Washington, where we occupy 795,000 square feet of owned property.

In addition, we own a total of 1.6 million square feet in Redmond, Washington. As a result of the sale of our L&I businesses, we are leasing 278,000 square feet of this space to the buyer, and the lease expires in July 2005. We own 246,000 square feet in Pleasant Hill, California; Portland, Oregon; and Spokane, Washington. We also occupy 1.9 million square feet of leased space throughout the United States, 152,000 square feet of which we sublease to third parties. Our leased and owned space totals approximately 4.5 million square feet.

Item 3: LEGAL PROCEEDINGS

Because of the nature of our businesses, we are subject to legal actions filed or threatened in the ordinary course of our operations. Generally, our involvement in legal action involves defending third-party claims brought against our insureds (in our role as liability insurer) or principals on surety bonds and defending policy coverage claims brought against us. We do not believe that such litigation will materially and adversely affect our financial condition, operating results or liquidity.

Our property and casualty insurance subsidiaries are parties to a number of lawsuits for liability coverages related to environmental claims. Estimation of reserves for environmental claims is difficult. However, we do not expect these lawsuits to materially affect our financial condition. (See further information on environmental claims on page 35).

Our P&C companies were sued in the U.S. District Court of Connecticut on January 14, 2003, by a plaintiff seeking back overtime pay for claims adjusters who they claimed should have been considered non-exempt employees under the labor laws. The plaintiff twice attempted to obtain class status for this suit; both attempts were unsuccessful. The plaintiff appealed both decisions. Both appeals were unsuccessful.

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

There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of 2004.

Part II

Item 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is quoted and traded on the NASDAQ Stock Market under the symbol SAFC. Quarterly high and low bid prices for Safeco common shares for the last two years were:

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There were approximately 3,000 holders of record of our common stock at February 25, 2005. This number excludes the beneficial owners of shares (approximately 71,000) held by brokers and other institutions on behalf of shareholders.

Dividends

We have paid cash dividends continuously since 1933. On August 2, 2004, our Board of Directors approved an increase to our quarterly dividend from $0.185 per share to $0.22 per share, an 18.9% increase per share.

We fund dividends paid to shareholders with the dividends paid to our parent company from our operating subsidiaries. Our dividends declared for the last two years were:

We expect to continue paying dividends in the foreseeable future. However, payment of future dividends depends on the discretion of our Board of Directors. Our Board of Directors makes dividend decisions based on factors that include:

Issuer Purchases of Equity Securities

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On July 19, 2004, our Board of Directors approved a plan to repurchase up to 20 million shares of common stock (in addition to the 1,487,088 shares that remained available to repurchase as part of the prior Board authorization). On August 2, 2004, we publicly announced the repurchase of 13,247,863 shares as part of an Accelerated Stock Buyback program.

As of December 31, 2004, 8,239,225 shares remained available for repurchase under these repurchase programs, neither of which is subject to an expiration date.

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Item 6: SELECTED FINANCIAL DATA

This selected consolidated financial data comes from our Consolidated Financial Statements. It should be read in conjunction with the Consolidated Financial Statements and accompanying notes. On August 2, 2004, we completed the sale of our Life & Investments (L&I) businesses. Prior-year amounts have been restated to reflect L&I as a Discontinued Operation.

Summary of Operations (unaudited)

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Item 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollar amounts in millions except for ratios and per share data unless noted otherwise)

This discussion should be read with the Consolidated Financial Statements and Notes to the Consolidated Financial Statements included elsewhere in this report. Certain reclassifications have been made to prior-year financial information to conform with the current-year presentation.

Forward-Looking Information

Forward-looking information contained in this report is subject to risk and uncertainty.

Information contained in this report that relates to anticipated financial performance, business prospects and plans, regulatory developments and similar matters are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Statements in this report that are not historical information are forward-looking. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. The risks and uncertainties include, but are not limited to:

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Summary

The following section builds upon earlier discussion and provides more information about our company and our financial performance.

We are a property and casualty (P&C) insurance company with headquarters in Seattle, Washington. We sell insurance to drivers, home owners and small- and medium-sized businesses through a national network of distributors. Our business helps people protect what they value and deal with the unexpected. We earn revenue from insurance policy premiums and income on our invested assets.

In 2004, we sold our Life & Investments operations. We rolled out Safeco Now, our unified, Web-based sales-and-service platform, and we reorganized our company around the way we operate. With these actions, we are a focused, more nimble P&C company.

Reviewing Our Results of Operations

Our financial results for the last three years have been affected by the major strategic actions we have taken to turn our company around, reshape our business and become a more focused and successful competitor.

2004

In 2004, our major strategic initiatives included:

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Focusing on P&C Operations – During 2004, we completed the sale of our Life & Investments (L&I) businesses.

Four critical ideas led us to pursue the sale of L&I:

We used the $1,499.0 proceeds of the sale to return our debt-to-capital ratios to pre-sale levels and return excess capital to our shareholders. Specifically, we used $735.2, including transaction costs, to repurchase $618.4 of debt, resulting in a $121.0 pretax ($78.7 after-tax) loss on debt repurchases. Including transaction costs we used $625.0 to execute an Accelerated Stock Buyback (ASB) program of 13,247,863 shares and we retained the balance for future flexibility and to pay transaction-related expenses.

Increasing efficiency for our distribution partners – In 2004, we brought our major products together on Safeco Now, our automated sales-and-service platform. Safeco Now features a single point of entry for personal auto, homeowners, most small-commercial products and certain surety bonds. This allows our distributors to quote and issue these products in minutes. Products currently available on Safeco Now include: auto, homeowners, dwelling fire, business owner policies, commercial auto, workers compensation and commercial multi-peril. We also launched our policy change tool for handling certain simple but frequent personal auto policy endorsements.

Meeting the needs of our customers at a fair price – We offer a competitively priced product through the sophistication of our automated underwriting models using Safeco Now, which enables us to appropriately match price to risk. We also focus on outstanding service by measuring ourselves against a “zero-defect” standard in our service transactions. These service transactions include our Gold Service program, which provides fee-based full-service customer support on behalf of our distribution partners through our regional service centers. We deploy a team of nearly 3,000 claims professionals across the country to deliver our most visible product – the personalized service and support we provide when customers experience a loss and file a claim. In addition, our expense reduction efforts that began in 2003 reduced our 2004 operating expenses by approximately $75, primarily by eliminating approximately 500 positions in our corporate departments. Our cost reductions and ongoing expense discipline help us provide competitively priced products.

Refining our business model further – Our market advantage is sustained by how we do business – offering standardized auto, homeowners and small-commercial insurance products over a unified sales-and-service platform through a common independent distribution network. To fully leverage this business model, in 2004, we realigned our organization around these three areas. Here’s a closer look at the key elements of our business model:

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2003

In 2003, our major strategic initiatives included:

Focusing on P&C Operations – On September 29, 2003, we announced our decision to focus on our P&C operations and put our L&I businesses up for sale. This sale was subsequently completed in August 2004.

Reducing Expenses – We identified expense reductions across the company to enable us to better compete in the property and casualty insurance markets. We announced that we would eliminate approximately 500 positions in our corporate departments, and we completed this in March 2004.

Partnering with Independent Distributors – Our strategy focuses on providing more products for our distributors to sell and providing ease-of-doing business tools that drive greater operating efficiencies in their offices. Our distributors can be more profitable selling our products through use of Safeco Now, and our commission programs are structured to incent profitable growth. In short, we offer our distribution partners more products to sell, make it easier for them to sell and service these products, and help our distributors make more money selling our products.

Selling Standardized Products – Our standardized auto, homeowners and small-business products have been designed to serve the insurance needs of the majority of the individuals and small-to medium-sized businesses in the U.S. marketplace.

Offering Multiple P&C Product Lines – We believe our ability to provide multiple P&C products gives us a “shelf space” advantage in our distributors’ offices. Our auto, homeowners and small-business insurance products represent the products our distribution partners sell most. These product lines generally represent more than 95% of the insurance revenues sold in our distributors’ offices.

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2002

In 2002, we reshaped our P&C business to improve profitability and position our company for growth. Our major strategic actions included:

Improving Sales Growth through Independent Distributors – We began the rollout of our automated underwriting platform. This technology made it easier for distribution partners to sell all our primary product lines –auto, homeowners and small-business insurance.

Driving Execution Through Enhanced Metrics – We established financial metrics for the company and each business unit. We developed individual goals that aligned the performance of the workforce with the company and operating unit metrics. We also shifted to a monthly financial close to better understand and act on results.

Improving Service and Claims Handling – We launched a multi-year training effort to drive out errors from our processes involving customers. We initiated projects to eliminate mistakes that degrade service and waste money.

Strengthening Our Financial Position – We took a number of actions, including replacing our short-term commercial paper borrowings with long-term senior notes and developing a plan to refinance $500.0 of long-term debt; issuing common stock and strengthening the capital base of our operations; and repositioning our investment portfolio, reducing risk and volatility.

Investing in Our Employees – We implemented a total performance-management system that encompasses goal setting, employee development and compensation tied to individual and team performance. We also completed work on and began implementation of our diversity strategy, tied to our workforce, distributors, suppliers and customer base.

Overall Results

Our vision is to be one of the top-performing property and casualty companies in the industry. We measure our success by tracking our performance against the following three long-term financial goals:

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The following tables show the trends in these three key measures of our performance:

Segment Results

HOW WE REPORT OUR RESULTS

We manage our businesses in four business and seven reportable segments:

On January 1, 2004, we made minor revisions to our P&C segments to better reflect how these segments are currently managed. Our non-voluntary auto and property results, previously in P&C Other, are now included in SPI Auto and SPI Property. Certain products previously reported in Specialty, primarily earthquake, inland marine and dwelling fire, are now included in Property. Our commercial specialty programs and large-commercial accounts in runoff, previously SBI Runoff, are now included in P&C Other. Prior years have been restated to reflect this revised presentation.

In addition to these segments, certain activities such as interest expense, debt repurchases and intercompany eliminations are reported in Corporate and are not allocated to individual segments.

Along with the sale of our L&I businesses, all results related to L&I are included in Discontinued Operations in our Consolidated Financial Statements.

HOW WE MEASURE OUR PROFITABILITY

We use three measures of our underwriting results to assess the profitability of our business segments. These measures are underwriting profit or loss, combined ratio and net earned premiums.

Underwriting profit or loss is our net earned premiums less our losses from claims, loss adjustment expenses (LAE) and underwriting expenses.

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Combined ratio is our losses, LAE and underwriting expenses divided by our net earned premiums. We report combined ratio as a percentage. For example, a combined ratio of 95% means that for every dollar of premium received, 95 cents is spent on losses, LAE and underwriting expenses and 5 cents is underwriting profit. A lower combined ratio reflects better underwriting results than a higher combined ratio.

We include insurance premiums in revenue as they are earned over the terms of the respective policies.

More information about our segment results can be found on page 46.

Although investment activities are an important part of our business and comprise a significant part of our total revenues, we don’t include our investment portfolio results when measuring the profitability of our individual segments. That’s because we manage the investment portfolio separately from our underwriting activities. We invest the insurance premiums we receive in a diversified portfolio until they’re needed to pay claims. Our first priority is to protect our policyholders, so we invest in a diversified portfolio composed primarily of government securities and high-grade fixed maturities. This strategy generally provides protection for our policyholders and a steady income for our shareholders.

Our investment philosophy is to:

We measure our investment results in two parts – by the net investment income we earn on our invested assets, and the net realized investment gains or losses we recognize when we sell or impair investments.

More information about our investment results can be found on page 62.

Application of Critical Accounting Estimates

We have identified the accounting estimates listed below as critical to understanding our results of operations and financial condition. The application of these accounting estimates requires our management to use judgments involving assumptions and estimates about future results, trends or other developments that could significantly influence our results if actual experience differs from those assumptions and estimates. We review these judgments frequently. An understanding of them may help readers to better understand our Consolidated Financial Statements and Management’s Discussion and Analysis (MD&A). We consider our most critical accounting estimates to be:

LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

Our loss and loss adjustment expense (LAE) reserves reflect management’s estimates of the ultimate amounts for losses from claims and related settlement expenses that we have not yet paid to settle both reported and unreported claims. We report these amounts in our Loss and LAE Reserves on our Consolidated Balance Sheets.

We record two categories of loss and LAE reserves – case basis reserves and incurred but not reported (IBNR) reserves.

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We estimate case-basis reserves as the amount we will have to pay for losses that have already been reported to us but are not yet fully paid. These amounts include related legal expenses and other costs associated with resolving and settling a particular claim.

In addition, at the end of every reporting period, we establish IBNR reserves to estimate the amount we will have to pay for:

We use actuarial methods combined with management judgment to estimate IBNR reserves.

Process and Methodology for Establishing Loss and LAE Reserves – The process for establishing loss and LAE reserves differs for case-basis versus IBNR reserves.

Case-Basis Reserves – For reported losses, we establish a reserve estimate for each claim based on the known facts regarding the claim and the parameters of the coverage that our policy provides. Case-basis reserves are adjusted as additional facts become available to us. Case-basis reserves are reduced as we make payments for our reported claims.

IBNR Reserves – To establish our IBNR reserves, we use different approaches for:

These approaches exclude exceptional loss activity associated with catastrophic weather losses, non- catastrophe weather losses and other large loss or salvage – the amount we recover from property that becomes ours after we pay for a total loss – and subrogation – our right to recover payments from third parties – activity. The methodologies used to establish IBNR reserves differ for the current accident year (the year in which a claim occurs) versus the prior accident years. The methodologies also differ for long-tailed lines of business versus short-tail lines of business. Generally speaking, short-tailed lines of business are those lines where the vast majority of claims from a particular accident year are both reported and settled within two years.

Current Accident Year Losses – For long-tailed lines of business, an annual expected loss ratio approach is used. Under this approach, an expected loss ratio is applied to current period earned premiums resulting in an estimate of ultimate losses. The resulting estimate of ultimate losses is reduced by the current period paid and case-basis reserve activity resulting in the current period IBNR. For short-tailed lines of business, a ratio of IBNR to earned premiums is used. Under this approach, an IBNR percentage is applied to current period earned premiums resulting in current period IBNR.

Expected loss ratios and IBNR to earned premiums percentages are developed based on analysis of prior accident years supplemented with data about changes in our book of business, changes in the external environment in which we operate, changes in our pricing and underwriting and changes in our claims handling practices. We review these ratios throughout the year, and we revise the expected loss ratio periodically based on these analyses. Changes in the selection of the expected loss ratio result in a change in the loss reserve estimate for the current year, which we record in current period earnings.

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Prior Accident Years Losses – For long-tailed lines of business, the beginning IBNR for prior accident years is adjusted for paid and case-basis reserve activity in the current period. This yields ending IBNR, absent an explicit determination to adjust IBNR beyond this activity. For short-tailed lines of business, the beginning IBNR for prior accident years is adjusted for expected emerged losses to calculate IBNR, absent an explicit determination to adjust IBNR beyond this activity.

Allocated Loss Adjustment Expense (ALAE) – ALAE reserves represent an estimate of the claims settlement expenses that can be identified to a specific claim. ALAE reserve estimates are generally established as a function of losses. For some small lines, estimates of ultimate ALAE are established as a percentage of earned premiums. These ALAE factors are established based on historical ratios supplemented for changes in the internal and external environments. ALAE IBNR is determined by subtracting paid and case-basis activity from the ultimate ALAE estimate.

Unallocated Loss Adjustment Expense (ULAE) – ULAE reserves are booked in aggregate for current and prior accident years combined. In general, prior reserves are carried forward and supplemented with either a percentage of earned premiums or with a fixed dollar amount of additional reserves to account for growth in the line of business.

Estimating Loss and LAE Reserves – Estimating loss and LAE reserves is a complex process because the ultimate losses are uncertain. Some claims will be paid out over a number of years, and there may be a significant lag between the time a loss that is insured by us occurs and the time it is reported to us. We make significant judgments and assumptions about many internal variables and external factors. Examples of internal variables include:

Examples of external factors include:

In addition, certain claims may be paid out over a number of years, and there may be a significant lag between the time a loss that is insured by us occurs and the time it is reported to us.

These variables and factors affect in a variety of ways the amounts we have to pay for losses and related expenses. As a result, it is not always possible to quantify their ultimate impact on our future payments. Our process for arriving at our best estimate of ultimate loss and LAE involves both management and actuaries. It involves reviewing actuarial assumptions, holding discussions with claims and underwriting management, and considering changes in the internal and external environment. Because estimating reserves requires us to use assumptions and judgment, our actual future losses will differ from our estimates.

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Some actuarial techniques rely on our past loss and LAE experience to estimate our future payments. The changes we’ve made in our business in recent years, however, will affect our future payments. For instance, we have introduced new products, tightened our underwriting criteria and improved our claims handling practices. As a result, we also consider these changes when estimating future payments.

For most of our lines of business, we use multiple estimation methods that vary depending on the particular facts and circumstances of the claim liabilities being evaluated to establish our estimate of ultimate losses.

Our estimate of IBNR is the difference between our projection of ultimate losses and the payments and case-basis reserves for those losses. Our analyses are applied to historical claim activity and experience, supplemented with data about changes in our book of business, changes in the external environment in which we operate, changes in our pricing and underwriting, and changes in our claims handling practices. The standard actuarial methods we use include: