UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                          to                                         .

000-50641
(Commission File Number)

PROCENTURY CORPORATION

(Exact name of Registrant as specified in its charter)

Ohio		31-1718622
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)
465 Cleveland Avenue		43082
Westerville, Ohio		(Zip Code)
(Address of principal executive offices)

(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 þ NO o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o          Accelerated filer þ          Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

o Yes þ No

     As of May 10, 2006, the registrant had 13,211,019 outstanding Common Shares, without par value.

 

 

PROCENTURY CORPORATION

QUARTERLY REPORT ON FORM 10-Q
For the Quarterly Period Ended March 31, 2006

INDEX

		Page
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements			3
Consolidated Condensed Statements of Operations — For the three months ended March 31, 2006 and 2005			3
Consolidated Condensed Balance Sheets – March 31, 2006 and December 31, 2005			4
Consolidated Condensed Statements of Shareholders’ Equity and Comprehensive Income (Loss) — For the three months ended March 31, 2006 and 2005			5
Consolidated Condensed Statements of Cash Flows — For the three months ended March 31, 2006 and 2005			6
Notes to Consolidated Condensed Financial Statements — March 31, 2006			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Item 3. Quantitative and Qualitative Disclosures About Market Risk			27
Item 4. Controls and Procedures			27
PART II: OTHER INFORMATION
Item 1. Legal Proceedings			28
Item 1A. Risk Factors			28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			28
Item 3. Defaults Upon Senior Securities			28
Item 4. Submission of Matters to a Vote of Security Holders			28
Item 5. Other Information			28
Item 6. Exhibits			28
SIGNATURES			30
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

PROCENTURY CORPORATION AND SUBSIDIARIES

Consolidated Condensed Statements of Operations
(Unaudited)
(In thousands, except per share data)

		Three Months Ended March 31,
		2006				2005
Premiums earned		$	49,002				41,520
Net investment income			4,426				3,159
Net realized investment gains (losses)			21				(59	)
Total revenues			53,449				44,620
Losses and loss expenses			30,439				25,727
Amortization of deferred policy acquisition costs			12,066				10,220
Other operating expenses			3,923				3,065
Severance expense			—				793
Interest expense			543				417
Total expenses			46,971				40,222
Income before income tax expense			6,478				4,398
Income tax expense			1,878				1,319
Net income		$	4,600				3,079
Basic net income per share		$	0.35				0.24
Diluted net income per share		$	0.35				0.23
Weighted average of shares outstanding — basic			13,100,705				13,046,339
Weighted average of shares outstanding — diluted			13,200,571				13,129,546

See accompanying notes to the unaudited consolidated condensed financial statements.

PROCENTURY CORPORATION AND SUBSIDIARIES

Consolidated Condensed Balance Sheets
(Unaudited)
(In thousands, except share data)

		March 31,				December 31,
		2006				2005
Assets
Investments
Fixed maturities:
Available-for-sale, at fair value (amortized cost 2006, $325,642; 2005, $306,237)		$	318,836				302,632
Held-to-maturity, at amortized cost (fair value 2006, $1,101; 2005, $1,118)			1,125				1,128
Equities (available-for-sale):
Equity securities, at fair value (cost 2006, $28,657; 2005, $27,521)			28,401				26,941
Bond mutual funds, at fair value (cost 2006, $15,732; 2005, $18,516)			15,221				17,852
Short-term investments, at amortized cost			12,499				12,229
Total investments			376,082				360,782
Cash and equivalents			6,189				5,628
Premiums in course of collection, net			13,098				14,849
Deferred policy acquisition costs			21,418				20,649
Prepaid reinsurance premiums			10,691				10,989
Reinsurance recoverable on paid losses, net			7,703				6,422
Reinsurance recoverable on unpaid losses, net			39,179				37,448
Deferred federal income tax asset			10,687				9,151
Other assets			8,292				8,227
Total assets		$	493,339				474,145
Liabilities and Shareholders’ Equity
Loss and loss expense reserves		$	223,780				211,647
Unearned premiums			96,763				95,631
Long term debt			25,000				25,000
Accrued expenses and other liabilities			7,223				6,893
Reinsurance balances payable			3,724				2,572
Collateral held			10,513				11,014
Income taxes payable			2,365				185
Total liabilities			369,368				352,942
Shareholders’ equity:
Common stock, without par value:
Common shares — Issued and outstanding 13,211,019 shares at March 31, 2006 and December 31, 2005			—				—
Additional paid-in capital			99,841				100,202
Retained earnings			29,050				24,846
Unearned compensation			—				(695	)
Accumulated other comprehensive loss, net of taxes			(4,920	)			(3,150	)
Total shareholders’ equity			123,971				121,203
Total liabilities and shareholders’ equity		$	493,339				474,145

See accompanying notes to the unaudited consolidated condensed financial statements.

PROCENTURY CORPORATION AND SUBSIDIARIES

Consolidated Condensed Statements of Shareholders’ Equity
and Comprehensive Income (Loss)
(Unaudited)
(In thousands)

		Three Months Ended March 31,
		2006				2005
Shareholders’ Equity
Capital stock:
Beginning of period		$	—				—
Stock issued			—				—
End of period			—				—
Additional paid-in capital:
Beginning of period			100,202				100,103
Impact of adoption of SFAS 123R			(695	)			—
Shares issued under share compensation plans			302				36
Tax benefit on share compensation plans			32				—
End of period			99,841				100,139
Retained earnings:
Beginning of period			24,846				15,727
Net income			4,600				3,079
Dividend declared (2006, $0.03/share and 2005, $0.02/share)			(396	)			(265	)
End of period			29,050				18,541
Unearned share compensation:
Beginning of period			(695	)			(1,413	)
Impact of adoption of SFAS 123R			695				322
End of period			—				(1,091	)
Accumulated other comprehensive loss, net of taxes:
Beginning of period			(3,150	)			820
Unrealized holding losses arising during the period, net of reclassification adjustment			(1,770	)			(3,135	)
End of period			(4,920	)			(2,315	)
Total shareholders’ equity		$	123,971				115,274
Comprehensive Income (Loss)
Net income		$	4,600				3,079
Other comprehensive loss:
Unrealized losses on securities:
Unrealized holding losses arising during the period:
Gross			(2,703	)			(4,881	)
Related federal income tax benefit			947				1,708
Net unrealized losses			(1,756	)			(3,173	)
Reclassification adjustment for gains (losses) included in net income
Gross			21				(59	)
Related federal income tax (expense) benefit			(7	)			21
Net reclassification adjustment			14				(38	)
Other comprehensive loss			(1,770	)			(3,135	)
Total comprehensive income (loss)		$	2,830				(56	)

See accompanying notes to the unaudited consolidated condensed financial statements.

PROCENTURY CORPORATION AND SUBSIDIARIES

Consolidated Condensed Statements of Cash Flows
(Unaudited)
(In thousands)

		Three Months Ended March 31,
		2006				2005
Cash flows provided by operating activities:
Net income		$	4,600				3,079
Adjustments:
Net realized investment (gains) losses			(21	)			59
Deferred federal income tax benefit			(583	)			(572	)
Share-based compensation expense			302				358
Changes in assets and liabilities:
Premiums in course of collection, net			1,751				(3,610	)
Deferred policy acquisition costs			(769	)			(95	)
Prepaid reinsurance premiums			298				312
Reinsurance recoverable on paid and unpaid losses, net			(3,012	)			(2,393	)
Income taxes payable			2,180				(1,390	)
Losses and loss expense reserves			12,133				12,500
Unearned premiums			1,132				454
Other, net			807				3,009
Net cash provided by operating activities			18,818				11,711
Cash flows used in investing activities:
Purchases of equity securities			(3,178	)			(31,159	)
Purchases of fixed maturity securities available-for-sale			(29,175	)			(35,034	)
Proceeds from sales of equity securities			4,627				18,935
Proceeds from sales and maturities of fixed maturities available-for-sale			9,481				31,673
Change in receivable/payable for securities			622				2,043
Net proceeds from sale of short-term investments			(270	)			(1,017	)
Net cash used in investing activities			(17,893	)			(14,559	)
Cash flows used in financing activities:
Dividend paid to shareholders			(396	)			(265	)
Tax benefit on share compensation plans			32				—
Net cash used in financing activities			(364	)			(265	)
Decrease in cash and equivalents			561				(3,113	)
Cash and equivalents at beginning of year			5,628				6,681
Cash and equivalents at end of period		$	6,189				3,568
Supplemental disclosure of cash flow information:
Interest paid		$	548				417
Federal income taxes paid		$	250				3,281

See accompanying notes to the unaudited consolidated condensed financial statements.

PROCENTURY CORPORATION AND SUBSIDIARIES

Notes to Consolidated Condensed Financial Statements

March 31, 2006

(Unaudited)

(1)		Basis of Presentation
		The accompanying interim unaudited consolidated condensed financial statements and notes include the accounts of ProCentury Corporation, (the “Company” or “ProCentury”) and its wholly owned insurance subsidiary, Century Surety Company (“Century”). The interim unaudited consolidated condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, the interim unaudited consolidated condensed financial statements do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of results for the interim periods have been included. These interim unaudited consolidated condensed financial statements and related notes should be read in conjunction with the consolidated financial statements and related notes in the Company’s audited consolidated financial statements, included in the Company’s annual report on Form 10-K for the year ended December 31, 2005. The Company’s results of operations for interim periods are not necessarily indicative of the results to be expected for the entire year.
		In preparing the interim unaudited consolidated condensed financial statements, management was required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the interim unaudited consolidated condensed financial statements, and the reported amounts of revenue and expenses for the reporting period. Actual results could differ significantly from those estimates.
		Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of loss and loss expense reserves, the recoverability of deferred policy acquisition costs, the determination of federal income taxes, the net realizable value of reinsurance recoverables and the determination of other-than-temporary declines in the fair value of investments. Although considerable variability is inherent in these estimates, management believes that the amounts provided are reasonable. These estimates are continually reviewed and adjusted as necessary. Such adjustments are reflected in current operations.
		All significant intercompany balances and transactions have been eliminated.
		Share Option Accounting
		Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS No. 123R”), using the modified prospective application transition method. SFAS No. 123R revises SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). The Company previously followed the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), the Financial Accounting Standards Board (“FASB”) Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation (an interpretation of APB Opinion No. 25), and other related accounting interpretations for the Company’s share option and restricted common share plans utilizing the “intrinsic value method.” The Company also followed the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, for the Company’s share option grants, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure; an amendment of FASB Statement No. 123.
		Under the modified prospective method, all unvested employee share options and restricted stock are being expensed over the remaining vesting period based on the fair value at the date the options were granted. In addition, SFAS No. 123R requires us to estimate forfeitures in calculating the expense relating to stock-based compensation as opposed to recognizing these forfeitures and the corresponding reduction in expense as they occur. In addition, SFAS No. 123R requires the Company to reflect the tax savings resulting from tax deductions in excess of compensation expense reflected in its financial statements as a cash inflow from financing activities in its statement of cash flows rather than as an operating cash flow as in prior periods.
		If the Company recorded compensation expense for it share grants based on the intrinsic value method as previously required by APB Opinion No. 25, the Company’s following financial information for the three months ended March 31, 2006 would have been adjusted to the pro forma amounts as indicated in the following table:

		Three Months Ended March
		31, 2006
		(In thousands, except per share
		data)
		As reported				ProForma
Income before income tax		$	6,478				6,518
Net income			4,600				4,626
Net cash provided by operating activities			18,818				18,786
Net cash used in financing activities			(364	)			(396	)
Basic net income per share		$	0.35				0.35
Diluted net income per share		$	0.35				0.35

If the Company recorded compensation expense for its share option grants based on the “fair value method” as previously required by SFAS No. 123, the Company’s net income and earnings per share for the three months ended March 31, 2005 would have been adjusted to the pro forma amounts as indicated in the following table:

		Three
		Months
		Ended March
		31,
		2005
		(In thousands,
		except per
		share data)
Net income:
As reported		$	3,079
Add: Share-based employee compensation expense included in reported net income, net of related tax effects			232
Less: Additional share-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects			(592	)
Pro forma		$	2,719
Basic income per common share:
As reported		$	0.24
Pro forma		$	0.21
Diluted income per common share:
As reported		$	0.23
Pro forma		$	0.21

The fair values of the share options are estimated on the dates of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

		Three Months Ended
		March 31, 2005
Risk free interest rate			3.69	%
Dividend yield			0.76	%
Volatility factor			0.231
Weighted average expected option life			6.1	Years

(2)

Income per Common Share

		Basic income per share (“EPS”) excludes dilution and is calculated by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common shares (common share equivalents) were exercised. When inclusion of common share equivalents increases the EPS or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances, diluted net income or net loss per share is computed excluding the common share equivalents.
		Based on the above and pursuant to disclosure requirements contained in SFAS No. 128, Earnings Per Share, the following information represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the Company’s interim unaudited consolidated condensed financial statements.

		Three Months Ended March 31, 2006
		(In thousands, except per share data)
		Income				Shares				Per Share
		(Numerator)				(Denominator)				Amount
Basic Net Income Per Share
Net income		$	4,600				13,100,705			$	0.35
Effect of Dilutive Securities
Restricted common shares and share options			—				99,866				—
Diluted EPS
Net income		$	4,600				13,200,571			$	0.35

		Three Months Ended March 31, 2005
		(In thousands, except per share data)
		Income				Shares				Per Share
		(Numerator)				(Denominator)				Amount
Basic Net Income Per Share
Net income		$	3,079				13,046,339			$	0.24
Effect of Dilutive Securities
Restricted common shares and share options			—				83,207				0.01
Diluted EPS
Net income		$	3,079				13,129,546			$	0.23

(3)		Investments
		The Company invests primarily in investment-grade fixed maturities. The amortized cost, gross unrealized gains and losses and estimated fair value of fixed maturities classified as held-to-maturity were as follows:

		March 31, 2006
		(In thousands)
						Gross				Gross				Estimated
		Amortized				unrealized				unrealized				fair
		cost				gains				losses				value
U.S. Treasury securities		$	89				9				—				97
Agencies not backed by the full faith and credit of the U.S. Government			1,036				—				(32	)			1,004
Total		$	1,125				9				(32	)			1,101

		December 31, 2005
		(In thousands)
						Gross				Gross				Estimated
		Amortized				unrealized				unrealized				fair
		cost				gains				losses				value
U.S. Treasury securities		$	89				13				—				102
Agencies not backed by the full faith and credit of the U.S. Government			1,039				—				(23	)			1,016
Total		$	1,128				13				(23	)			1,118

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:

		March 31, 2006
		(In thousands)
						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
		Cost				Gains				Losses				Fair Value
Fixed maturities:
U.S. Treasury securities		$	3,673				—				(80	)			3,593
Agencies not backed by the full faith and credit of the U.S. Government			14,532				—				(450	)			14,082
Obligations of states and political subdivisions			153,876				100				(2,490	)			151,486
Corporate securities			35,642				32				(1,115	)			34,559
Mortgage-backed securities			39,439				26				(1,420	)			38,045
Collateralized mortgage obligations			34,203				55				(944	)			33,314
Asset-backed securities			44,277				269				(789	)			43,757
Total fixed maturities			325,642				482				(7,288	)			318,836
Equities:
Equity securities			28,657				353				(609	)			28,401
Bond mutual funds			15,732				30				(541	)			15,221
Total equities			44,389				383				(1,150	)			43,622
Total		$	370,031				865				(8,438	)			362,458

		December 31, 2005
		(In thousands)
						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
		Cost				Gains				Losses				Fair Value
Fixed maturities:
U.S. Treasury securities		$	3,688				1				(53	)			3,636
Agencies not backed by the full faith and credit of the U.S. Government			14,526				—				(230	)			14,296
Obligations of states and political subdivisions			142,932				387				(1,037	)			142,282
Corporate securities			36,689				40				(876	)			35,853
Mortgage-backed securities			40,910				31				(880	)			40,061
Collateralized mortgage obligations			27,943				15				(606	)			27,352
Asset-backed securities			39,549				238				(635	)			39,152
Total fixed maturities			306,237				712				(4,317	)			302,632
Equities:
Equity securities			27,521				215				(795	)			26,941
Bond mutual funds			18,516				15				(679	)			17,852
Total equities			46,037				230				(1,474	)			44,793
Total		$	352,274				942				(5,791	)			347,425

		Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment and are recorded as a realized loss in the interim unaudited consolidated condensed statements of operations. No other-than-temporary declines were realized during the three months ended March 31, 2006 or 2005.
		The fair values and gross unrealized losses for securities held by the Company and assessed as temporarily impaired by management, categorized by the length of time that the individual securities have been in a continuous unrealized loss position, as of March 31, 2006 and 2005 are as follows:

		March 31, 2006
		Less than 12 months								12 months or longer								Total
		Estimated				Gross				Estimated				Gross				Estimated				Gross
		fair				unrealized				fair				unrealized				fair				unrealized
		value				loss				value				loss				value				loss
		(In thousands)
Fixed Maturity Securities:
U.S. Treasury Securities		$	—				—				1,004				(32	)			1,004				(32	)
Total		$	—				—				1,004				(32	)			1,004				(32	)

The estimated fair value, related gross unrealized losses, and the length of time that the securities have been impaired for available-for-sale securities that are considered temporarily impaired are as follows:

		March 31, 2006
		Less Than 12 Months								12 Months or Longer								Total
		Estimated				Gross				Estimated				Gross				Estimated				Gross
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Loss				Value				Loss				Value				Loss
		(In thousands)
Fixed maturity securities:
U.S. Treasury securities		$	2,276				(37	)			1,317				(43	)			3,593				(80	)
Obligations of U.S. government corporations and agencies			8,456				(225	)			5,626				(225	)			14,082				(450	)
Obligations of states and political subdivisions			116,937				(1,842	)			22,205				(648	)			139,142				(2,490	)
Corporate securities			11,286				(307	)			20,089				(808	)			31,375				(1,115	)
Mortgage-backed securities			21,615				(754	)			15,927				(666	)			37,542				(1,420	)
Collateralized mortgage obligations			18,603				(507	)			12,882				(437	)			31,485				(944	)
Asset-backed securities			22,097				(521	)			7,143				(268	)			29,240				(789	)
Total			201,270				(4,193	)			85,189				(3,095	)			286,459				(7,288	)
Equities:
Equity securities			12,284				(331	)			4,286				(278	)			16,570				(609	)
Bond mutual funds			8,564				(275	)			6,189				(266	)			14,753				(541	)
Total			20,848				(606	)			10,475				(544	)			31,323				(1,150	)
Grand Total		$	222,118				(4,799	)			95,664				(3,639	)			317,782				(8,438	)

		At March 31, 2006, the Company had 109 fixed income securities and 12 equity securities that have been in an unrealized loss position for one year or longer. Of the fixed income securities, 108 are investment grade, of which 104 of these securities are rated A1/A or better (including 69 securities which are rated AAA). The one remaining non-investment grade fixed income security is rated BB+ and has a fair value equal to 98.3% of its book value as of March 31, 2006. One of the equity securities that has been in an unrealized loss position for one year or longer relates to a closed end preferred stock fund which continues to pay its regular dividend on a monthly basis and also has an underlying net asset value per share that exceeds its price per share as of March 31, 2006. One of the equity securities relates to an investment in an open end high quality short duration bond fund, of which the underlying assets are all rated AAA. Finally, the ten remaining equity securities that have been in an unrealized loss position for one year or longer relate to preferred share investments in issuers each of which has shown an improved financial performance during the past twelve months. In addition, these ten equity securities have an aggregate fair market value equal to 95.4% of their book value as of March 31, 2006. All 109 of the fixed income securities are current on interest and principal and all 12 of the equity securities continue to pay dividends at a level consistent with the prior year. Management believes the declines are temporary and are not indicative of other-than-temporary impairments.
(4)		Loss and Loss Expense Reserves
		Liability for losses and loss expenses represents the Company’s best estimate of the ultimate amounts needed to pay both reported and unreported claims. These estimates are based on quarterly internal actuarial studies and certified on an annual basis by an independent actuary. The Company continually reviews these estimates and, based on new developments and information, the Company includes adjustments of the probable ultimate liability in the operating results for the periods in which the adjustments are made.
		Net loss and loss expenses incurred were $30.4 million for the quarter ended March 31, 2006, compared to $25.7 million for the quarter ended March 31, 2005. In the first quarter of 2006, the Company recorded $29.7 million of incurred losses and loss expenses attributable to the 2006 accident year and $702,000 attributable to events of prior years. In the first quarter of 2005, the Company recorded $23.8 million of incurred losses and loss expenses attributable to the 2005 accident year and $1.9 million attributable to events of prior years.
		The increases for the first quarter of 2006 related to prior years were due to incurred amounts above our expectations in our casualty business included in our property and casualty segment. The increases were primarily due to reported incurred amounts above our expectations for the 2004 and 2003 accident year, an increase in our legal reserves related to expected arbitration with our reinsurers over a disputed claim and an increase in reserves for accident years 1996 and 1997 as a result of higher than anticipated loss, legal and settlement costs. The increase in casualty reserves was partially offset by favorable development in our 2004 and 2005 property line included in our property and casualty segment.

		The increases for the first quarter of 2005 related to prior year resulted principally from construction defect claims within the casualty line of business included in our property and casualty segment. During the first three months of 2005, the Company established reserves for two contribution action settlements that were anticipated to be paid within the year. This development was slightly offset by favorable claim count development, while claim severities continued to be within the Company’s expectations. Prior year development for construction defect claims was $1.4 million for the three months ended March 31, 2005.
		Management believes the loss and loss expense reserves make a reasonable provision for expected losses, however, ultimate settlement of this amount could vary significantly from that recorded.
(5)		Reinsurance
		In the ordinary course of business, Century assumes and cedes reinsurance with other insurers and reinsurers. These arrangements provide greater diversification of business and limit the maximum net loss potential on large risks. There have been no significant changes in the Company’s reinsurance program. The amounts of ceded loss and loss expense reserves and ceded unearned premiums would represent a liability of the Company in the event that its reinsurers would be unable to meet existing obligations under reinsurance agreements.
		The effects of assumed and ceded reinsurance on premiums written, premiums earned and loss and loss expenses incurred were as follows:

		For the Three Months
		Ended March 31,
		2006				2005
Premiums written:
Direct		$	57,275				47,318
Assumed			754				314
Ceded			(7,597	)			(5,346	)
Net premiums written		$	50,432				42,286
Premiums earned:
Direct			56,085				46,963
Assumed			812				215
Ceded			(7,895	)			(5,658	)
Net premiums earned		$	49,002				41,520
Losses and loss expenses incurred:
Direct		$	34,294				31,894
Assumed			104				(270	)
Ceded			(3,959	)			(5,897	)
Net losses and loss expenses incurred		$	30,439				25,727

		In 1998 and 1999, the Company had its quota share and excess of loss reinsurance agreements with three reinsurance companies for its the workers’ compensation line of business. These agreements were entered into through an intermediary, which was ordered into liquidation in 2000. Since that time, the Company attempted to collect the losses directly from one of the reinsurers. On March 22, 2006, the Company’s effort to vacate an adverse award received in arbitration related to this reinsurer proved unsuccessful. As such, the Company is currently in the process of turning the claims over to the liquidator of the intermediary and increased the Company’s reserve to $1.5 million from $1.3 million in the event the Company is unable to fully collect the amounts due. As of March 31, 2006, the Company had approximately $2.9 million of recoverables related to these reinsurance agreements, of which $1.1 million related to the quota share agreements and $1.8 million related to the excess of loss agreements.
		In addition, in 2005, the Company notified its reinsurers of a claim in the amount of $4.0 million for which coverage is now being disputed by certain reinsurers. The Company has filed a notice of arbitration against one of its reinsurers on this claim and may file for arbitration against the others if current negotiations are not successful. On March 31, 2006, the Company established a $250,000 reserve related to the potential arbitrations.
(6)		Deferred Policy Acquisition Costs
		The following reflects the amounts of policy acquisition costs deferred and amortized:

		For the Three Months
		Ended March 31,
		2006				2005
Balance at beginning of year		$	20,649				17,411
Policy acquisition costs deferred			12,835				10,315
Amortization of deferred policy acquisition costs			(12,066	)			(10,220	)
Balance at end of quarter		$	21,418				17,506

(7)		Federal Income Taxes
		The income tax provision for the three months ended March 31, 2006 and 2005 has been computed based on our estimated annual effective tax rate of 29.0% and 30.0%, respectively, which differs from the federal income tax rate of 35% principally because of tax-exempt investment income.
(8)		Commitments and Contingencies
		The Company is a defendant in various lawsuits in the ordinary course of its business. In the opinion of management, the effects, if any, of such lawsuits are not expected to be material to the Company’s consolidated financial position or results from operations.
(9)		Employee Benefits
		During 2004, the Company adopted and the shareholders approved a stock option plan that provided tax-favored incentive stock options (qualified options), non-qualified share options to employees and qualified board members that do not qualify as tax-favored incentive share options (non-qualified options), time-based restricted shares that vest solely on service provided and restricted shares that vest based on achieved performance metrics. Any compensation cost is recorded in the same captions as the salary expense of the employee (i.e. the compensation cost for the Chief Investment Officer is recorded in net investment income).
		With respect to qualified options, an employee may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of four years.
		With respect to non-qualified options, an employee or a board member may be granted an option to purchase shares at the grant date fair market value, payable as determined by the Company’s board of directors. An optionee must exercise an option within 10 years from the grant date. Full vesting of options granted occurs at the end of three years.
		For both non-qualified and qualified options, the option exercise price equals the stock’s fair market value on the date of the grant. In accordance with SFAS No. 123R, compensation expense is recorded over the service period based on the grant date fair market value of the options. The fair market value is determined by the Company using the Black-Scholes option pricing model. Prior to the adoption of SFAS 123R, in accordance with APB No. 25, no compensation was recorded for the qualified and non-qualified share options as the market value on the grant dates equaled the exercise price.
		The time-based restricted shares are granted to key executives and vest in equal installments upon the lapse of a period of time, typically over, four and five year periods and include both monthly and annual vesting periods. Compensation expense for time-based restricted shares is measured on the grant date at the current market value and then recognized over the respective service period, which typically matches the vesting period.
		The performance-based restricted shares are granted to key executives and vest annually over a four year period based on achieved specified performance metrics. In accordance with SFAS 123R, compensation cost is measured on the grant date at the grant date market value and recorded over the service period. Prior to the adoption of SFAS 123R, compensation expense for performance-based restricted share awards was recognized based on the fair value of the awards at the end of the period.
		The Company may grant options for up to 1.2 million shares under the plan. Through December 31, 2005, the Company had granted 287,000 non-qualified options, 95,000 qualified options, 156,000 time-based restricted shares and 55,024 performance-based restricted shares under the share plan. On January 3, 2006, the Company granted an additional 112,500 qualified options.

A summary of the status of the option plan for the three months ended March 31, 2006 and for the year ended December 31, 2005 are presented in the following table:

		March 31, 2006								December 31, 2005
						Weighted-								Weighted-
		Number of				Average				Number of				Average
		Shares				Exercise Price				Shares				Exercise Price
Outstanding at beginning of year			382,000			$	10.49				364,000			$	10.50
Granted			112,500				10.64				18,000				10.30
Exercised			—				—				—				—
Forfeited			—				—				—				—
Outstanding at end of period			494,500			$	10.52				382,000			$	10.49
Exercisable at end of period			253,684			$	10.50				217,393			$	10.50
Weighted-average fair value of options granted during year						$	3.07							$	2.99

The fair market value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2006 and 2005:

		Three Months
		Ended				Year Ended
		March 31,				December 31
		2006				2005
Risk free interest rate			4.06	%			4.03	%
Dividend yield			0.95	%			0.76	%
Volatility factor			23.1	%			23.14	%
Weighted average expected option life			7	Years			7	Years

Information on the range of exercise prices for options outstanding as of March 31, 2006, is as follows:

		Options Outstanding												Options Excercisable
						Weighted
						Average				Weighted								Weighted
						Remaining				Average				Exercisable				Average
		Outstanding				Contract				Exercise				as of				Exercise
Price Range		Options				Life				Price				March 31, 2006				Price
$10.20			12,000				9.2			$	10.20				3,330			$	10.20
$10.50			370,000				8.1			$	10.50				242,714			$	10.50
$10.64			112,500				9.8			$	10.64				7,634			$	10.64

A summary of all employee time-based restricted share activity during the three months ended March 31, 2006 and the year ended December 31, 2005 are as follows:

		2006								2005
						Weighted								Weighted
		Number of				Average				Number of				Average
		Shares				Grant Price				Shares				Grant Price
Beginning of year			68,033			$	10.22				137,049			$	10.31
Add (deduct):
Granted			—				—				—				—
Vested			(2,742	)			10.58				(31,593	)			10.28
Cancelled			—				—				(37,423	)			10.50
End of year			65,291			$	10.20				68,033			$	10.22

		In January 2005 and September 2005, the Company modified two executives’ time-based restricted share awards in connection with the termination of their employment to accelerate the vesting period. As such, the Company accounted for the modifications as cancellations of a fixed award and a grant of a variable award, which are valued at the fair market value on the monthly vesting date. During 2005, the Company recorded $231,924 of compensation expense related to the January modification and $42,617 related to the September modification. During the first three months of 2006, the Company recorded no compensation expense related the January modification and $50,722 related to the September modification. All shares related to the January modification have vested as of December 31, 2005 and 8,170 shares related to the September modification remain unvested at March 31, 2006.
		A summary of all employee performance-based restricted share activity during the quarters ended March 31, 2006 and 2005 are as follows:

		2006								2005
						Weighted								Weighted
		Number of				Average				Number of				Average
		Shares				Grant Price				Shares				Grant Price
Beginning of year			37,365			$	10.50				—			$	—
Add (deduct):
Granted			—				—				55,024				10.50
Vested			(9,341	)			10.50				—				—
Cancelled			—				—				(17,659	)			10.50
End of year			28,024			$	10.50				37,365			$	10.50

		Of the performance-based restricted share awards granted in March of 2005, an award for 17,659 shares was modified in accordance with the agreement entered into in connection with the termination of an executive officer’s employment in September 2005. As such, the award was treated as cancelled on September 30, 2005 due to a modification of the award to accelerate the vesting of the shares, change the vesting from annual vesting to monthly vesting and remove the performance based restrictions. As such, the award is treated as a variable award which is valued at the fair market value on the monthly vesting date. During 2005, the Company recorded $46,058 compensation expense related to the restricted shares. During the first three months of 2006, the Company recorded $54,818 compensation expense related to the restricted shares and 8,829 shares remain unvested at March 31, 2006.
(10)		Segment Reporting Disclosures
		The Company operates in the Property and Casualty Lines (“P/C”) (including general liability, multi-peril, commercial property and garage liability).
		The Company’s other (including exited lines) include the surety business and the Company’s exited lines, such as workers’ compensation and commercial auto/trucking. A limited amount of surety business is written in order to maintain Century’s U.S. Treasury listing.
		All investment activities are included in the investing operating segment.

		The Company considers many factors, including economic similarity, the nature of the underwriting units’ insurance products, production sources, distribution strategies and regulatory environment in determining how to aggregate operating segments.
		Segment profit or loss for each of the Company’s segments is measured by underwriting profit or loss. The property and casualty insurance industry commonly defines underwriting profit or loss as earned premium net of loss and loss expenses and underwriting, acquisition and insurance expenses. Underwriting profit or loss does not replace operating income or net income computed in accordance with GAAP as a measure of profitability. Segment profit for the Investing operating segment is measured by net investment income and net realized gains or losses. The Company does not allocate assets, including goodwill, to the P/C and Other operating segments for management reporting purposes. The total investment portfolio and cash are allocated to the Investing operating segment.
		Following is a summary of segment disclosures:

		For the Three Months
		Ended March 31,
		2006				2005
		(In thousands)
Segment revenue:
P/C		$	48,343				41,513
Investing			4,447				3,100
Other (including exited lines)			659				7
Segment revenue		$	53,449				44,620
Segment profit (loss):
P/C		$	2,288				2,938
Investing			4,447				3,100
Other (including exited lines)			377				(561	)
Segment profit		$	7,113				5,477
Segment assets:
Investing		$	376,082				318,436
Assets not allocated			117,257				90,981
Total consolidated assets		$	493,339				409,417

The following summary reconciles significant segment items to the Company’s interim unaudited consolidated condensed financial statements:

		For the Three Months
		Ended March 31,
		2006				2005
		(In thousands)
Income before income taxes:
Segment profit		$	7,113				5,477
Unallocated amounts:
Corporate expenses			(92	)			(662	)
Interest expense			(543	)			(417	)
Income before income taxes		$	6,478				4,398

The following is a summary of segment earned premium by group of products:

		Property				Casualty				Other				Consolidated
		(In thousands)
Three Months Ended March 31, 2006
P/C		$	14,433				33,910				—				48,343
Other (including exited lines)			—				—				659				659
Earned premiums		$	14,433				33,910				659				49,002
Three Months Ended March 31, 2005
P/C		$	14,416				27,097				—				41,513
Other (including exited lines)			—				—				7				7
Earned premiums		$	14,416				27,097				7				41,520

		The Company does not manage property and casualty products at this level of detail.
(11)		Dividend to Common Shareholders
		On March 13, 2006, the Board of Directors declared a dividend of $0.03 per common share that was paid on April 17, 2006 to shareholders of record as of March 27, 2006. The dividends were accrued in the accompanying March 31, 2006 interm unaudited consolidated condensed balance sheet in the caption accrued expenses and other liabilities.

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 interim unaudited consolidated condensed financial statements and the notes to those statements included in this Form 10-Q. Some of the statements in this report, including those set forth in the discussion and analysis below, are “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are derived from information that we currently have and assumptions that we make and may be identified by words such as “believes,” “anticipates,” “expects,” “plans,” “should,” “estimates” and similar expressions. We cannot assure you that anticipated results will be achieved, since actual results may differ materially because of both known and unknown risks and uncertainties we face. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Factors that could cause actual results to differ materially from our forward-looking statements are described under the heading “Risks Related to Our Business and Industry” in our Annual Report on Form 10-K for the year ended December 31, 2005, and elsewhere in this report, and include, but are not limited to, the following factors:

	•		our actual incurred losses may be greater than our loss and loss expense reserves, which could cause our future earnings, liquidity and financial rating to decline.
	•		a decline in our financial rating assigned by A.M. Best may result in a reduction of new or renewal business;
	•		we are subject to extensive regulation and judicial decisions affecting insurance and tort law, which may adversely affect our ability to achieve our business objectives. In addition, if we fail to comply with certain regulations, we may be subject to penalties, including fines and suspensions, which may adversely affect our financial condition and results of operations;
	•		our general agents may exceed their authority and bind us to policies outside our underwriting guidelines, and until we effect a cancellation, we may incur loss and loss expenses related to those policies;
	•		if we lose key personnel or are unable to recruit qualified personnel, our ability to implement our business strategies could be delayed or hindered;
	•		our investment results and, therefore, our financial condition may be impacted by changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in government monetary policies, general economic conditions and overall market conditions, all of which impact interest rates;
	•		we distribute our products through a select group of general agents, five of which account for a significant part of our business, and such relationships could be discontinued or cease to be profitable;
	•		our reinsurers may not pay claims made by us on losses in a timely fashion or may not pay some or all of these claims, in each case causing our costs to increase and our revenues to decline;

	•		if we are not able to renew our existing reinsurance or obtain new reinsurance, either our net exposure would increase or we would have to reduce the level of our underwriting commitment;
	•		our business is cyclical in nature, which will affect our financial performance and may affect the price of our common shares;
	•		if we are unable to compete effectively with the large number of companies in the insurance industry for underwriting revenues, we may incur increased costs and our underwriting revenues and net income may decline;
	•		severe weather conditions and other catastrophes may result in an increase in the number and amount of claims experienced by our insureds; and
	•		as a holding company, we are dependent on the results of operations of our insurance subsidiary and the regulatory and contractual capacity of our subsidiary to pay dividends to us. Some states limit the aggregate amount of dividends our subsidiary may pay to us in any twelve-month period, thereby limiting our funds to pay expenses and dividends.

     You are cautioned not to place undue reliance on forward-looking statements, which speak only as of their respective dates.

Overview

     ProCentury is a holding company that underwrites selected property and casualty and surety insurance through its subsidiaries collectively known as the Century Insurance Group^®. 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 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 are 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 are 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.

     Earned Premiums. Earned premiums are the portion of a premium paid by an insured that has been allocated to our revenue, loss experience, expenses, and year to date profit.

     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, which is net of ceded reinsurance, is meaningful in evaluating our financial results, as reflected in our consolidated 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 our consolidated financial statements, we believe 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 combined ratio in evaluating our overall underwriting profitability and as a measure for comparing our profitability relative to the profitability of our competitors.

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), reinsurance recoverables, the impairment of investments, deferred policy acquisition costs and federal income 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, the effect of changes in the law or unexpected judicial 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 4 to our interim 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 5 to our interim unaudited consolidated condensed financial statements included in this Form 10-Q.

     Impairment of Investments. Impairment of investment securities results in a charge to operations when a market decline below cost is deemed to be other-than-temporary. Under the Company’s accounting policy for equity securities and fixed-maturity securities, an impairment is deemed to be other-than-temporary unless the Company has both the ability and intent to hold the investment for a reasonable period until the security’s forecasted recovery and evidence exists indicating that recovery will occur in a reasonable period of time.

     For other fixed-maturity and equity securities, an other-than-temporary impairment charge is taken when the Company does not have the ability and intent to hold the security until the forecasted recovery or if it is no longer probable that the Company will recover all amounts due under the contractual terms of the security. Many 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 amount and length of time a security’s fair value has been below amortized cost or cost; specific credit issues and financial prospects related to the issuer; the Company’s ability and intent to hold or dispose of the security; and current economic conditions. Other-than-temporary impairment losses result in a permanent reduction to the cost basis of the underlying investment.

     Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), FASB Emerging Task Force (EITF) 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”, requires us to periodically update our best estimate of cash flows over the life of the security. If management determines that the fair value of a securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other –than-temporary impairment is recognized.

     For additional detail regarding our investment portfolio at March 31, 2006 and December 31, 2005, including disclosures regarding other-than-temporary declines in investment value, see Note 3 to our interim unaudited consolidated condensed financial statements included 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 6 to our interim unaudited consolidated condensed financial statements included in this Form 10-Q.

     Federal Income Taxes. The Company provides for federal income taxes based on amounts the Company believes it ultimately will owe. Inherent in the provision for federal income taxes are estimates regarding the deductibility of certain items and the realization of certain tax credits. In the event the ultimate deductibility of certain items or the realization of certain tax credits differs from estimates, the Company may be required to significantly change the provision for federal income taxes recorded in the consolidated financial statements. Any such change could significantly affect the amounts reported in the consolidated statements of income.

     We utilize the asset and liability method of accounting for income taxes. 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. See Note 7 to our interim unaudited consolidated condensed financial statements included in this Form 10-Q.

Results of Operations

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

		For the Three Months
		Ended March 31,
		2006				2005
		(In thousands)
Selected Financial Data:
Gross written premiums		$	58,029				47,632
Premiums earned			49,002				41,520
Net investment income			4,426				3,159
Net realized investment gains (losses)			21				(59	)
Total revenues			53,449				44,620
Total expenses			46,971				40,222
Net income			4,600				3,079
Key Financial Ratios:
Loss and loss expense ratio			62.1	%			62.0	%
Expense ratio			32.6	%			33.9	%
Combined ratio			94.7	%			95.9	%