UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2004

OR

For the transition period from                 to                .

000-50641
(Commission File Number)

PROCENTURY CORPORATION

(614) 895-2000
(Registrant’s telephone number, including area code)

     Indicate by check mark whether 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 report(s)), and (2) has been subject to such filing requirements for the past 90 days.

YES o NO x

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

YES o NO x

     As of June 4, 2004, the registrant had 13,101,195 outstanding Common Shares, without par value.

PROCENTURY CORPORATION

QUARTERLY REPORT ON FORM 10-Q
For the Quarterly Period Ended March 31, 2004

INDEX

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PART I: FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation)

Consolidated Condensed Balance Sheets

See accompanying notes to the unaudited consolidated condensed financial statements.

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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation)

Consolidated Condensed Statements of Operations

(Unaudited)

See accompanying notes to the unaudited consolidated condensed financial statements.

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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation)

Consolidated Condensed Statements of Shareholders’ Equity
and Comprehensive Income

(Unaudited)

See accompanying notes to the unaudited consolidated condensed financial statements.

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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation)

Consolidated Condensed Statements of Cash Flows
(Unaudited)

See accompanying notes to the unaudited consolidated condensed financial statements.

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PROCENTURY CORPORATION AND SUBSIDIARIES
(Formerly ProFinance Holdings Corporation)

Notes to Consolidated Condensed Financial Statements

March 31, 2004

(Unaudited)

       All significant intercompany balances and transactions have been eliminated.

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The amortized cost, gross unrealized gains and losses, and estimated fair value of fixed maturity and equity securities classified as available-for-sale were as follows:

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

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those statements included in this Form 10-Q. The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors described in “Cautionary Statement Regarding Forward-Looking Statements” that could cause our actual growth, results of operations, performance and business prospects and opportunities in 2004 and beyond to differ materially from those expressed in, or implied by, those forward-looking statements.

Overview

     ProCentury is a holding company that underwrites selected property and casualty and surety insurance through its subsidiaries. On April 26, 2004, we issued 8,000,000 common shares in the IPO. Immediately prior to the closing of the IPO we disposed of our subsidiaries, Evergreen and Continental and the related surety segment. However, the following management’s discussion and analysis covers the financial results of ProCentury prior to the issuance of the common shares and the disposition of Evergreen and Continental and, therefore, includes the results of Evergreen and Continental and the related surety segment.

     As a “niche” company, we offer specialty insurance products designed to meet specific insurance needs of targeted insured groups. The excess and surplus lines market provides an alternative market for customers with hard-to-place risks and risks that insurance companies licensed by the state in which the insurance policy is sold, which are also referred to as “admitted insurers,” specifically refuse to write. When we underwrite within the excess and surplus lines market, we are selective in the lines of business and types of risks we choose to write. Typically, the development of these specialty insurance products is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients.

     We evaluate our insurance operations by monitoring key measures of growth and profitability. We measure our growth by examining our gross written premiums. We generally measure our operating results by examining our net income, return on equity and loss, expense and combined ratios. The following provides further explanation of the key measures that we use to evaluate our results:

     Gross Written Premiums. Gross written premiums is the sum of direct written premiums and assumed written premiums. We use gross written premiums, which excludes the impact of premiums ceded to reinsurers, as a measure of the underlying growth of our insurance business from period to period.

     Net Written Premiums. Net written premiums is the sum of direct written premiums and assumed written premiums less ceded written premiums. We use net written premiums, primarily in relation to gross written premiums, to measure the amount of business retained after cessions to reinsurers.

     Loss Ratio. Loss ratio is the ratio (expressed as a percentage) of losses and loss expenses incurred to premiums earned. Loss ratio generally is measured on both a gross (direct and assumed) and net (gross less ceded) basis. We use the gross loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. Our net loss ratio is meaningful in evaluating our financial results, which are net of ceded reinsurance, as reflected in the accompanying unaudited consolidated condensed financial statements

     Expense Ratio. Expense ratio is the ratio (expressed as a percentage) of net operating expenses to premiums earned and measures a company’s operational efficiency in producing, underwriting and administering its insurance business. We reduce our operating expenses by ancillary income (excluding net investment income and realized gains (losses) on securities) to calculate our net operating expenses. Due to our historically high levels of reinsurance, we calculate our expense ratio on both a gross basis (before the effect of ceded reinsurance) and a net basis (after the effect of ceded reinsurance). Although the net basis is meaningful in evaluating our financial results that are net of ceded reinsurance, as reflected in the accompanying unaudited consolidated condensed financial statements, we believe that the gross expense ratio better reflects the operational efficiency of the underlying business and is a better measure of future trends. Interest expense is not included in the calculation of the expense ratio.

     Combined Ratio. Combined ratio is the sum of the loss ratio and the expense ratio and measures a company’s overall underwriting profit. If the combined ratio is at or above 100, an insurance company cannot be profitable without investment income (and may not be profitable if investment income is insufficient). We use the GAAP combined ratio in evaluating our overall underwriting profitability and as a measure for comparing our profitability relative to the profitability of our competitors.

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Critical Accounting Policies

     It is important to understand our accounting policies in order to understand our financial statements. Management considers certain of these policies to be critical to the presentation of our financial results, since they require management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the financial reporting date and throughout the period being reported upon. Certain of the estimates result from judgments that can be subjective and complex, and consequently actual results may differ from these estimates, which would be reflected in future periods.

     Our most critical accounting policies involve the reporting of loss and loss expense reserves (including losses that have occurred but were not reported to us by the financial reporting date (“IBNR”)), reinsurance recoverables, the impairment of invested assets, deferred policy acquisition costs and deferred taxes.

     Loss and Loss Expense Reserves. Loss and loss expense reserves represent an estimate of the expected cost of the ultimate settlement and administration of losses, based on facts and circumstances then known. We use actuarial methodologies to assist us in establishing these estimates, including judgments relative to estimates of future claims severity and frequency, length of time to develop to ultimate resolution, judicial theories of liability and other third-party factors that are often beyond our control. Due to the inherent uncertainty associated with the cost of unsettled and unreported claims, the ultimate liability may be different from the original estimate. Such estimates are regularly reviewed and updated and any resulting adjustments are included in the current period’s results. See Note 3 to our unaudited consolidated condensed financial statements included in this Form 10-Q.

     Reinsurance Recoverables. Reinsurance recoverables on paid and unpaid losses, net, are established for the portion of our loss and loss expense reserves that are ceded to reinsurers. Reinsurance recoverables are determined based in part on the terms and conditions of reinsurance contracts which could be subject to interpretations that differ from our own based on judicial theories of liability. In addition, we bear credit risk with respect to our reinsurers which can be significant considering that certain of the reserves remain outstanding for an extended period of time. We are required to pay losses even if a reinsurer fails to meet its obligations under the applicable reinsurance agreement. See Note 4 to our unaudited consolidated condensed financial statements included in this Form 10-Q.

     Impairment of Invested Assets. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. We regularly review our fixed maturity and equity securities portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. A number of criteria are considered during this process including, but not limited to: the current fair value as compared to amortized cost or cost, as appropriate, of the security; the length of time the security’s fair value has been below amortized cost or cost and specific credit issues related to the issuer and current economic conditions. In general, we focus our attention on those securities whose fair value was less than 80% of their amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, we also consider the current fair value compared to amortized cost or cost, as appropriate, our intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery in value, specific credit issues related to the issuer and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction of the cost basis of the underlying investment. Significant changes in the factors we consider when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the unaudited consolidated condensed financial statements. See Note 2 to our unaudited consolidated financial statements including in this Form 10-Q.

     Deferred Policy Acquisition Costs. We defer commissions, premium taxes and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, anticipated losses and settlement expenses and certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the written premiums. See Note 5 to our unaudited consolidated condensed financial statements included in this Form 10-Q.

     Deferred Taxes. We utilize the asset and liability method of accounting for income tax. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts more likely than not to be realized.

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Results of Operations

     The table below summarizes certain operating results and key measures we use in monitoring and evaluating our operations. The information is intended to summarize and supplement information contained in our unaudited consolidated condensed financial statements and to assist the reader in gaining a better understanding of our results of operations.

Overview of Operating Results

     Net income increased to $2.8 million for the three months ended March 31, 2004, compared to net income of $848,000 for the same period in 2003. The increase in net income was primarily attributable to improved underwriting results from decreasing current accident year loss and expense ratios, an increase in premium volume that provided additional underwriting margins, and an increase in net investment income, including $79,000 increase in net realized investment gains.

Revenues

       Premiums

     Premiums include insurance premiums underwritten by our insurance subsidiaries (which we refer to as direct premiums) and insurance premiums assumed from other insurers generally in states where we do not currently have a licensed insurance subsidiary (which we refer to as assumed premiums). We refer to direct and assumed premiums together as gross premiums.

     Written premiums refers to the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a given period. Written premiums become premiums earned as the policy ages. Barring premium changes, if an insurance company writes the same mix of business each year, written premiums and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than written premiums. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than written premiums.

     We have historically relied on quota share, excess of loss, and catastrophe reinsurance primarily to manage our regulatory capital requirements and also to limit our exposure to loss.

     Our underwriting business can be divided into three primary segments:

     Our property/casualty segment primarily includes general liability, commercial property and multi-peril insurance for small and mid-sized businesses. Our surety segment includes landfill, specialty surety and bail bonds. The other (including exited lines) segment includes workers’ compensation, which we exited in January 2002, and commercial auto, which was exited in May 2000.

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     The following table presents our gross written premiums in our primary segments and provides a summary of gross, ceded and net written premiums and net premiums earned for the periods indicated.

     Gross Written Premiums

     Gross written premiums increased $9.4 million or 23.6% for the three months ended March 31, 2004 compared to the same period in 2003. This increase was due primarily to increased market penetration in our property/casualty and surety segments, which was slightly offset by amounts representing returned premiums for our other (including exited lines) segment. During the three months ended March 31, 2004, gross written premiums for our property/casualty segment increased $9.4 million or 28.3% due to continued favorable market conditions that have allowed us to increase our premium volume and prices in the casualty market for the fourth consecutive year. During the same period, gross written premiums for our surety segment increased $2.0 million or 32.3% due primarily to favorable market conditions that allowed us to increase our volume. The growth in our property/casualty and surety segments was offset by decrease in written premiums for the other (including exited lines) segment.

     Net Written and Earned Premiums

     Net written premiums for the three months ended March 31, 2004 were $38.0 million, representing an increase of 25.3% compared to the same period in 2003. Net written premiums were consistent with the same period in 2003 of 77.0% of gross written premiums for the three months ended March 31, 2004. Net premiums earned, a function of net written premiums, amounted to $34.5 million for the three months ended March 31, 2004 and were 90.7% of net written premiums. This is higher than the relationship of net premiums earned to net written premiums during the same period in 2003, reflecting a change in the 2003 reinsurance agreements that resulted in a lower percentage of business ceded during 2003 that is earning in 2004.

     Net Investment Income

     Our investment portfolio is generally highly liquid and consists substantially of readily marketable, investment-grade fixed-income securities. Net investment income is primarily comprised of interest earned on these securities, net of related investment expenses.

     Net investment income increased to $2.3 million for the three months ended March 31, 2004, compared to $1.6 million for the same period in 2003. The increase was due primarily to an increase in invested assets, including cash. Invested assets, including cash, increased 41.0% to $248.7 million as of March 31, 2004 from $176.4 million as of March 31, 2003. Our average investment yield for the first three months of 2004 was 4.3%, which is consistent with the yield for the same period in 2003. In the first three months of 2004, we decreased the amount of cash and short-term investments from 14.3% of invested assets, including cash at December 31, 2003 to 4.3% at March 31, 2004. This decrease in cash and short-term investments was part of an effort to increase our investment yield throughout 2004 by investing in higher yielding investment grade fixed-maturity securities while maintaining the targeted duration and credit quality of our portfolio.

     Realized Gains (Losses) on Securities

     Realized gains and losses on securities are principally affected by changes in interest rates, the timing of sales of investments and changes in credit quality of the securities we hold as investments.

     We realized net investment gains of $161,000 on the sale of securities for the three months ended March 31, 2004 and $82,000 for the same period in 2003. These gains did not include any adjustments for other-than-temporary impairment of securities.

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Expenses

     Losses and Loss Expenses

     Losses and loss expenses represent our largest expense item and include (1) payments made to settle claims, (2) estimates for future claim payments and changes in those estimates for current and prior periods, and (3) costs associated with settling claims. The items that influence the incurred losses and loss expenses for a given period include, but are not limited to, the following:

     We continue to perform an internal quarterly actuarial analysis and establish or adjust (for prior accident quarters) our best estimate of the ultimate incurred losses and loss expenses to reflect loss development information and trends that have been updated for the most recent quarter’s activity. As of December 31 of each year, we have an independent actuarial analysis performed of the adequacy of our reserves. Our estimate of ultimate loss and loss expenses is evaluated and re-evaluated by accident year and by major coverage grouping and changes in estimates are reflected in the period the additional information becomes known.

     Our reinsurance program significantly influences our net retained losses. In exchange for premiums ceded to reinsurers under quota share and excess of loss reinsurance agreements, our reinsurers assume a portion of the losses and loss expenses incurred.

     Net loss and loss expenses increased to $18.7 million for the three months ended March 31, 2004 from $13.9 million for the same period in 2003. Net loss and loss expense ratios for the three months ended March 31, 2004 and 2003 were 54.1% and 56.5%, respectively.

     Our reserve for losses and loss expenses as of March 31, 2004 was $144.8 million (before the effects of reinsurance) and $102.1 million (after the effects of reinsurance), as estimated through our internal actuarial analysis. During 2004, we concluded, through our actuarial analysis, that the December 31, 2003 reserve for losses and loss expenses of $95.2 million (after the effects of reinsurance) was deficient by $2.2 million primarily on our construction defect and commercial auto reserves. Excluding construction defect, we had no prior year development in our property and casualty segment on accident years 2003, 2002, or 2001.

     Our reserve for losses and loss expenses (net of the effects of reinsurance) at March 31, 2004 and December 31, 2003 by line was as follows:

     Based on a first quarter internal actuarial review, we recorded $16.4 million of incurred losses and loss expense attributable to the 2004 accident year and $2.2 million attributable to events of prior years. The accident year loss and loss expense ratios for the property and casualty segment for accident years 2004, 2003, and 2002 were 52.2%, 48.9% and 53.2%, respectively. The property and casualty segment combined accident year loss and loss expense ratio for the 2004, 2003, and 2002 year was 50.7%.

     A significant portion of the 2004 increase for events of prior years resulted principally from construction defect claims in the

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other liability line in the property and casualty segment. During the first quarter of 2004, new construction defect claim counts exceeded expectations. As a result, the Company’s actuaries revised the factors used in the estimation of ultimate construction defect claim counts. This re-estimation of claim count projection factors produced an increase in the estimated ultimate cost of construction defect claims. The prior year development recognized during the quarter for construction defect is substantially due to adverse claim count experience. The claim severities for the quarter were in line with the Company’s recent experience and expectations. Additionally, during the quarter, development on pending claims was favorable and the amount of claims closed continued to exceed the amount of new claims reported. As of March 31, 2004, we had 572 open claims relating to construction defects compared to 597 open claims as of December 31, 2003. During the first three months of 2004, 262 new claims were reported and 287 existing claims were settled or dismissed. Our net loss and loss expense reserves for construction defect claims as of March 31, 2004 were $17.9 million. The re-estimation of construction defect reserves primarily affected the 1996 and 1997 accident years and the 1999 to 2001 accident years.

     During the first quarter of 2004, we observed increases in paid and incurred losses and loss expenses on seven commercial auto liability claims. The increase in net incurred losses and loss expenses on these claims totaled $778,000. The increases were related to one significant, unanticipated new claim ($155,000), reserve increases related to coverage disputes on three claims ($297,000), and unfavorable changes in conditions relating to three other claims ($326,000).

     Due to the development during the quarter, we are conducting further analysis of the nature and impact of the commercial automobile activity. In addition to its current methods for assessing the overall reserve needs on this run-off business, the Company’s actuaries have undertaken a project with claims management to assess the range of potential costs on the 51 remaining pending claims.

     As of March 31, 2004, we had 51 open claims relating to commercial automobile compared to 63 open claims as of December 31, 2003. During the first three months of 2004, four new claims were reported and 16 existing claims were settled or dismissed. Our net loss and loss expense reserves for commercial automobile as of March 31, 2004 were $3.8 million.

     In the first quarter of 2003, the Company recorded $2.8 million of incurred losses and loss expenses attributable to events of prior years. During this period, the Company experienced increases in claims and claim severity above expectations in the property line that caused changes to the selected development patterns primarily for the 2002 accident year that caused a reestimation of reserves on the property line of $2.2 million.

       Operating Expenses

     Operating expenses include the costs to acquire a policy (included in amortization of deferred policy acquisition costs), other operating expenses (including corporate expenses) and interest expense. The following table presents our amortization of deferred policy acquisition costs, other operating expenses and related ratios and interest expense for the periods indicated:

     Operating expenses increased $3.0 million, or 28.0%, to $13.3 million for the first three months of 2004 from $10.4 million for the same period in 2003. The increase was primarily attributable to a $3.0 million increase in amortized deferred policy acquisition costs, including commission expenses, associated with the increase in the volume of insurance written and other increases to support future growth. Additionally, other operating expenses include a $250,000 non-recurring severance agreement and $100,000 of expenses related to the IPO that could not be capitalized. In addition, interest expense increased $97,000 due to interest on the $10.0 million trust preferred security that was issued in May 2003. The overall decline in the expense ratio was due to an increase in premiums without a corresponding increase in our fixed expenditures.

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Income Taxes

     The income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 35% to income before minority interest and income taxes as a result of the following:

Pro Forma Information

     In connection with our IPO completed on April 26, 2004, we exited the specialty surety lines of business written by Evergreen and Continental. To effect our disposition of these lines of business, Evergreen purchased the common shares of Continental owned by Century effective January 1, 2004 for $6.3 million, representing its GAAP book value as of December 31, 2003. Immediately prior to the completion of the IPO, Century distributed to ProCentury all of the Class A and B common shares of Evergreen owned by Century. ProCentury then distributed these shares on a pro rata basis to the pre-offering Class A shareholders of ProCentury in the form of a stock dividend that was approved by the Ohio Department of Insurance.

     As a result of these transactions following the IPO, which we refer to as the Evergreen and Continental transactions, Century is ProCentury’s only operating insurance subsidiary, and Evergreen and Continental and the related specialty surety business are no longer a part of ProCentury.

     The following unaudited pro forma condensed consolidated statement of operations for the three months ended March 31, 2004 give effect to the Evergreen and Continental transactions as if they occurred as of January 1, 2004.

     The transactions are presented in a columnar format beginning with ProCentury’s unaudited condensed consolidated historical information.

     The Evergreen and Continental Pro Forma column presents historical information, adjusted on a pro forma basis, to give effect to the termination of the intercompany pooling agreement that had existed among Century, Evergreen and Continental and the implementation of reinsurance agreements, transitional administrative agreements and fronting agreements. In other words, the Evergreen and Continental Pro Forma column represents the statement of operations of Evergreen and Continental and their related landfill, specialty surety and bail bond business that would have been distributed to the shareholders of ProCentury if the distribution had occurred as of January 1, 2004.

     The Other column represents adjustments related to the transfer of proceeds from the sale of Continental and adjustments to remove the effects of the minority interest ownership of Evergreen.

     The result of the adjustments, as presented in the ProCentury Pro Forma column, presents the financial position of ProCentury after giving effect to the Evergreen and Continental transactions. This column presents financial information for ProCentury as an excess and surplus lines organization and includes activity related to the exited lines.

     The Evergreen and Continental transactions have been accounted for as a sale and dividend distribution of shares and will not change the historical accounting basis of ProCentury’s unaudited consolidated condensed financial statements.

     The unaudited pro forma condensed financial information does not purport to represent the consolidated financial position or results of operations that we would have experienced if the Evergreen and Continental transactions had occurred as of the dates indicated. This information is not intended to project our consolidated financial position or results of operations for any future date or period. The pro forma adjustments are based on available information and assumptions that we believe are factually supportable and reasonable under the circumstances. The unaudited pro forma condensed consolidated financial information should be read in conjunction with the accompanying notes and the other consolidated financial information pertaining to ProCentury included elsewhere in this report.

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Unaudited Pro Forma Condensed Consolidated Statement of Operations
For the Three Months Ended March 31, 2004