10-Q 1 edgar092003.txt 10-Q 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 -------------------------------------------------------------------------- FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2003 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------------------------------- Commission File Number 33-94670-01 ------------------------------------- FARMERS GROUP, INC. (Exact name of registrant as specified in its charter) NEVADA (State or other jurisdiction of incorporation or organization) 95-0725935 (IRS Employer Identification No.) 4680 WILSHIRE BOULEVARD, LOS ANGELES, CALIFORNIA 90010 (Address of principal executive offices)(Zip Code) (323) 932-3200 (Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act 12b-2). Yes /X/ No / / Registrant's Common Stock outstanding on September 30, 2003 was 1,000 shares. 2 [THIS PAGE INTENTIONALLY LEFT BLANK] 3 FARMERS GROUP, INC. AND SUBSIDIARIES TABLE OF CONTENTS FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 2003 PART I. FINANCIAL INFORMATION PAGE ---- ITEM 1. Financial Statements (Unaudited) Consolidated Balance Sheets - Assets September 30, 2003 (Unaudited) and December 31, 2002 (Audited) 4 Consolidated Balance Sheets - Liabilities and Stockholders' Equity September 30, 2003 (Unaudited) and December 31, 2002 (Audited) 5 Unaudited Consolidated Statements of Income Nine Month Periods ended September 30, 2003 and September 30, 2002 6 Unaudited Consolidated Statements of Comprehensive Income Nine Month Periods ended September 30, 2003 and September 30, 2002 7 Unaudited Consolidated Statements of Income Three Month Periods ended September 30, 2003 and September 30, 2002 8 Unaudited Consolidated Statements of Comprehensive Income Three Month Periods ended September 30, 2003 and September 30, 2002 9 Unaudited Consolidated Statement of Stockholders' Equity Nine Month Period ended September 30, 2003 10 Unaudited Consolidated Statements of Cash Flows Nine Month Periods ended September 30, 2003 and September 30, 2002 11 Notes to Unaudited Interim Financial Statements 12 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 23 ITEM 3. Quantitative and Qualitative Disclosures about Market Risks 39 ITEM 4. Controls and Procedures 39 PART II. OTHER INFORMATION 40 SIGNATURES 41 4 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except for per share data) ASSETS

5 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except for per share data) LIABILITIES AND STOCKHOLDERS' EQUITY

6 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands) (Unaudited)

7 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands) (Unaudited)

8 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands) (Unaudited)

9 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in thousands) (Unaudited)

10 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY For the nine month period ended September 30, 2003 (Amounts in thousands) (Unaudited)

11 FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands) (Unaudited)

12 FARMERS GROUP, INC. AND SUBSIDIARIES NOTES TO INTERIM FINANCIAL STATEMENTS (Unaudited) 1. Basis of presentation and summary of significant accounting policies The accompanying consolidated balance sheet and statement of stockholders' equity of Farmers Group, Inc. ("FGI") and its subsidiaries (together, the "Company"; references to attorney-in-fact ("AIF"), as applicable in context, are to FGI, dba Farmers Underwriters Association, attorney-in-fact of Farmers Insurance Exchange; or Fire Underwriters Association, attorney-in-fact of Fire Insurance Exchange; or Truck Underwriters Association, attorney-in-fact of Truck Insurance Exchange) as of September 30, 2003, the related consolidated statements of income and comprehensive income for the three and nine month periods ended September 30, 2003 and September 30, 2002 and consolidated statements of cash flows for the nine month periods ended September 30, 2003 and September 30, 2002, have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim periods and are unaudited. However, in management's opinion, the consolidated financial statements include all adjustments (consisting of only normal recurring adjustments) necessary for a fair presentation of results for such interim periods. These statements do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the consolidated balance sheets of the Company as of December 31, 2002 and 2001, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years reported in the SEC Form 10-K for the period ended December 31, 2002. Interim results are not necessarily indicative of results for the full year. All material inter-company transactions have been eliminated. Certain amounts applicable to prior years have been reclassified to conform to the 2003 presentation. The preparation of the Company's financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. In December 1988, B.A.T Industries p.l.c. ("B.A.T") acquired 100% ownership of the Company for $5.2 billion through its wholly owned subsidiary BATUS Financial Services. Immediately thereafter, BATUS Financial Services was merged into FGI. The acquisition was accounted for as a purchase and, accordingly, the acquired assets and liabilities were recorded in the Company's consolidated balance sheets based on their estimated fair values at December 31, 1988. In September 1998, the financial businesses of B.A.T, which included the Company, were merged with Zurich Insurance Company ("ZIC"). The businesses of ZIC and the financial services businesses of B.A.T were transferred to Zurich Group Holding ("ZGH"), formerly known as Zurich Financial Services, a Swiss holding company with headquarters in Zurich, Switzerland. This merger was accounted for by ZGH as a pooling of interests under International Financial Reporting Standards ("IFRS"), formerly International Accounting Standards ("IAS"). As a result of a unification of the holding structure of the Zurich Financial Services Group in October 2000, Zurich Financial Services was renamed Zurich Group Holding, as noted above, and a new group holding company, Zurich Financial Services, was formed. As such, references to "Zurich" are to the group holding company, Zurich Financial Services ("ZFS"). The Company has AIF relationships with three inter-insurance exchanges: Farmers Insurance Exchange, Fire Insurance Exchange and Truck Insurance Exchange (collectively the "Exchanges"), which operate in the property and casualty insurance industry. Each policyholder of each Exchange appoints the AIF to provide non-claims related management services to each Exchange. For such services, the Company earns management fees based primarily on a 13 percentage of gross premiums earned by the Exchanges, their respective subsidiaries, Farmers Texas County Mutual Insurance Company, Foremost County Mutual Insurance Company and Foremost Lloyds of Texas (collectively the "P&C Group Companies"). The P&C Group Companies are owned by the respective policyholders of the Exchanges, Farmers Texas County Mutual Insurance Company and Foremost County Mutual Insurance Company as well as the underwriters of Foremost Lloyds of Texas. Accordingly, the Company has no ownership interest in the P&C Group Companies. Farmers New World Life Insurance Company ("Farmers Life"), a Washington domiciled insurance company, is a wholly owned subsidiary of FGI. Farmers Life markets a broad line of individual life insurance products, including universal life, term life and whole life insurance and fixed annuity products, predominately flexible premium deferred annuities, as well as variable universal life insurance and variable annuity products. These products are sold directly by the Farmers Agency Force. Farmers Life also marketed structured settlement annuities sold by independent brokers. As of December 2002, Farmers Life exited the business of writing structured settlements. The 5,200 structured settlement cases in force as of September 30, 2003 will continue to be serviced by Farmers Life. For the nine months ended September 30, 2003 and September 30, 2002, the structured settlement business represented 1.1% and 2.2% of Farmers Life's income before provision for taxes, respectively. For the three months ended September 30, 2003 and September 30, 2002, the structured settlement business represented 1.0% and 1.2% of Farmers Life's income before provision for taxes, respectively. Farmers Reinsurance Company ("Farmers Re"), a wholly owned subsidiary of FGI which was formed and licensed to conduct business in December 1997, provides reinsurance coverage to the P&C Group Companies. As of September 30, 2003, Farmers Re participates in three reinsurance treaties: 1) an Auto Physical Damage ("APD") reinsurance agreement, 2) a 10% All Lines Quota Share reinsurance treaty and 3) a 20% Personal Lines Auto Quota Share reinsurance treaty (see Note 5 to Consolidated Financial Statements, "Note 5"). References to the "Insurance Subsidiaries" within the consolidated financial statements are to Farmers Life and Farmers Re. References to "Farmers Management Services" are to the Company excluding the Insurance Subsidiaries. 2. Recent accounting pronouncements In November 2002, the Financial Accounting Standards Board ("FASB") issued Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This Interpretation identifies characteristics of certain guarantee contracts and requires that a liability be recognized at fair value at the inception of such guarantees for the obligations undertaken by the guarantor. Additional disclosures also are prescribed for certain guarantee contracts. The initial recognition and initial measurement provisions of this Interpretation are effective for these guarantees issued or modified after December 31, 2002. The disclosure requirements of this Interpretation are effective for the Company as of December 31, 2002. The adoption of this Interpretation did not have a material impact on the Company's consolidated financial statements. In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities". This Interpretation provides guidance on the identification of entities for which control is achieved through means other than through voting rights, variable interest entities ("VIEs"), and how to determine when and which business enterprises should consolidate VIEs. This Interpretation applies immediately to VIEs created after January 31, 2003. For a VIE created before February 1, 2003, the provisions of FIN 46 were to be applied at the beginning of the first interim or annual period beginning after June 15, 2003. However, the FASB, at its meeting on October 8, 2003, issued FASB staff position 46-6, "Effective Date of FASB Interpretation No. 46, Consolidation of VIEs" ("FSP 46-6"). FSP 46-6 delayed implementation of provisions of FIN 46 for entities created before February 1, 2003 to the first interim or annual period ending after December 15, 2003. Based on the current Interpretation, the Company does not believe they have VIEs. In April 2003, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". This Statement amends and 14 clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities". This Statement is effective for contracts entered into or modified after June 30, 2003. The adoption of this Statement did not have a material impact on the Company's consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting of Certain Financial Instruments with Characteristics of both Liabilities and Equity". This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Under this Statement, a financial instrument issued in the form of shares that are mandatorily redeemable that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date or upon an event that is certain to occur shall be classified as a liability at the amount of cash that would be paid under the conditions specified in the contract. The provisions of this Statement are effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement had an impact on presentation of the Company's consolidated balance sheet as the "Company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures" line of the balance sheet was reclassified to the liability section for the period ended September 30, 2003. 3. Intangible assets As of September 30, the Company held the following intangible assets: assets:

15 For the three and nine months ended September 30, 2003, amortization expense, net of accrued interest, related to the VOLBA asset totaled $4.0 million and $15.8 million, respectively. Estimated amortization, net of accrued interest, related to the VOLBA asset for each of the years in the five-year period ended December 31, 2007 follows:

4. Management fees FGI and its subsidiaries, through their AIF relationships with the Exchanges, provide non-claims related management services to the P&C Group Companies and receive management fees for the services rendered. As a result, the Company received management fees from the P&C Group Companies of $1,310.1 million and $1,256.3 million for the nine month periods ended September 30, 2003 and September 30, 2002, respectively. For the three month periods ended September 30, 2003 and September 30, 2002, the Company received management fees from the P&C Group Companies of $441.3 million and $428.7 million, respectively. Management fees earned for the nine month periods ended September 30 are as follows:

16 Management fees earned for the three month periods ended September 30 are as follows:

5. Non-life reinsurance Farmers Re, a wholly owned subsidiary of FGI, reinsures a percentage of the business written by the P&C Group Companies through three quota share reinsurance agreements. Under an APD Quota Share agreement, Farmers Re assumes $200.0 million annually of the APD premiums written by the P&C Group Companies. An additional $1.8 billion is assumed by the Zurich affiliates and outside reinsurance companies identified in the agreement. As a result of this APD agreement, on a monthly basis, Farmers Re assumes $16.7 million of premiums written. Farmers Re assumes a quota share percentage of ultimate net losses sustained by the P&C Group Companies in their APD lines of business. The agreement, which can be terminated after 30 days notice by any of the parties, also provides for the P&C Group Companies to receive a ceding commission of 18% of premiums, with additional experience commissions that depend on loss experience. This experience commission arrangement limits Farmers Re's potential underwriting gain on the assumed business to 2.5% of premiums assumed. As a result of this APD reinsurance agreement, Farmers Re assumes an underwriting risk. In December 2002, Farmers Re paid the P&C Group Companies a total of $45.2 million in full settlement of 2002 accident year related activities. This amount consisted of $25.8 million of net balances due on 4th quarter 2002 transactions, $19.0 million of advance settlement of losses and loss adjustment expense reserves, and $0.4 million of accrued interest. In May 2003, a final commutation of the 2002 accident year loss and loss adjustment expense reserves was made. Under this commutation, Farmers Re and the P&C Group Companies ultimately commuted $19.0 million of loss and loss adjustment expense reserves related to the 2002 accident year. Reinsurance recoverables relating to the 2003 accident year losses and loss adjustment expenses will be settled in December 2003 per terms of the APD agreement. Effective December 31, 2002, Farmers Re and a Zurich affiliate entered into a 10% All Lines Quota Share reinsurance treaty under which they assume a percentage of all lines of business written by the P&C Group of Companies, prospectively. Under this treaty, Farmers Re assumes a 2% quota share of the premiums written and the ultimate net losses sustained in all lines of business written by the P&C Group Companies after the APD reinsurance agreement is applied. Underwriting results assumed are subject to a maximum combined ratio of 112.5% and a minimum combined ratio of 93.5%. In addition, catastrophe losses subject to this reinsurance treaty are limited to a pro-rata share of $800.0 million annually. The reinsurance agreement, which can be terminated after 60 days notice by any of the parties beginning with the quarter ending December 31, 2003, also provides for the P&C Group Companies to receive a provisional ceding commission of 22% of premiums for acquisition expenses and 14.1% of premiums for other expenses with additional experience commissions that depend on loss experience. As a result of this quota share reinsurance treaty, Farmers Re assumes an underwriting risk. In addition, effective December 31, 2002, Farmers Re and a Zurich affiliate entered into a 20% Personal Lines Auto Quota Share reinsurance treaty under which they assume a percentage of the personal lines auto business written 17 by the P&C Group of Companies, prospectively. Under this treaty, Farmers Re assumes a 4% quota share of the premiums written and the ultimate net losses sustained in the personal lines auto business written by the P&C Group Companies after all other reinsurance treaties are applied. Underwriting results assumed are subject to a maximum and minimum combined ratio of 112.5% and 97.0%, respectively. In addition, catastrophe losses subject to this reinsurance treaty are limited to a pro-rata share of $150.0 million. The reinsurance agreement, which can be terminated after 60 days notice by any of the parties beginning with the quarter ending December 31, 2003, also provides for the P&C Group Companies to receive a provisional ceding commission of 20% of premiums for acquisition expenses and 17.2% of premiums for other expenses with additional experience commissions that depend on loss experience. As a result of this quota share reinsurance treaty, Farmers Re assumes an underwriting risk. 6. Material contingencies Due to its AIF relationships, the Company is a party to lawsuits in which the Exchanges are the primary defendants. The Company is also party to lawsuits arising from its other normal business activities. In addition, the Company is, from time to time, involved as a party in various governmental and administrative proceedings. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. On August 5, 2002, the Texas Attorney General and Texas Department of Insurance ("TDI") initiated a legal action against Farmers Insurance Exchange, Fire Insurance Exchange and certain of their affiliates which alleged certain improprieties in the pricing of a portion of their homeowners insurance policies written in the state of Texas. FGI and certain of its subsidiaries were also named as parties in that action. On December 18, 2002, the parties executed a Settlement Agreement respecting this litigation, which, when approved by the court, will provide for certain rate reductions and refunds to Texas policyholders. No fines or penalties are included, and there is no admission of wrongdoing. The settlement also allows Farmers Insurance Exchange and Fire Insurance Exchange, which had previously sent notices terminating all of their homeowner policies, to continue operating in the homeowners insurance market in Texas. Although it was a defendant in the initial lawsuit, the settlement imposes no direct financial burdens on FGI. There is a possible indirect financial impact on FGI because of lower renewal rates. The timetable for final court approval of the settlement is unclear. Certain additional parties have intervened in the approval process, objecting to the settlement. Although the settlement did receive preliminary approval from the trial court, the intervenors sought and obtained an order from the Court of Appeals staying further actions in the trial court until the appeal of the intervenors can be heard. Oral argument of the intervenors' appeal has been scheduled for December 2003. In addition to the rate reductions agreed upon in the settlement, on August 8, 2003, the TDI, pursuant to recent insurance legislation affecting all major homeowners insurers in the state, determined that Farmers Insurance Exchange and Fire Insurance Exchange homeowners insurance rates should be further reduced by 17.5%. Farmers Insurance Exchange and Fire Insurance Exchange requested a public hearing before the Commissioner of Insurance appealing the TDI's determination. On September 12, 2003, the Commissioner issued an order that the base rates for Farmers Insurance Exchange shall be reduced by 17.5% for homeowners coverage for all new and renewed business issued effective on or after September 7, 2003, and the base rates for Fire Insurance Exchange shall be reduced by 17.5% for homeowners coverage and 5% for residential fire and allied lines coverage for all new and renewed business issued effective on or after September 7, 2003. Farmers Insurance Exchange and Fire Insurance Exchange subsequently filed an appeal with the District Court in Texas, which is currently pending. 7. Related parties As of September 30, 2003, the Company held a $160.0 million note receivable from ZGA US Limited ("ZGAUS"), a subsidiary of Zurich, formerly known as Orange Stone (Delaware) Holdings Limited. The Company loaned $250.0 million to ZGAUS on December 15, 1999 and, in return, received a medium-term note with a 7.50% 18 fixed interest rate that matures on December 15, 2004. Subsequently, on April 9, 2002, $30.0 million of the note receivable was redeemed. Also on March 17, 2003 and June 16, 2003, $25.0 million and $35.0 million of the note receivable were redeemed, respectively. Interest on this note is paid semi-annually. Interest income totaled $10.6 million and $13.0 million for each of the nine months periods ended September 30, 2003 and September 30, 2002, respectively. For each of the three months periods ended September 30, 2003 and September 30, 2002, interest income totaled $3.0 million and $4.1 million, respectively. Subsequently, on October 2, 2003, the Company assigned the remaining balance of the $160.0 million note receivable to ZIC for its principal value plus accrued interest in exchange for cash. On September 3, 2002, $95.0 million of notes receivable, $25.0 million of which had a fixed coupon rate of 6.80% and $70.0 million of which had a coupon rate of 5.67%, from Zurich Financial Services (UKISA) Limited ("UKISA"), a subsidiary of Zurich, matured. These notes were renewed for two short-term notes receivables of $12.5 million each and a $70.0 million note receivable, each of which had a 2.75% fixed coupon rate and matured on September 2, 2003. Interest on the notes was paid semi-annually. Interest income totaled $1.8 million and $4.0 million for each of the nine months periods ended September 30, 2003 and September 30, 2002, respectively. For each of the three months periods ended September 30, 2003 and September 30, 2002, interest income totaled $0.5 million and $1.2 million, respectively. On September 2, 2003, the $95.0 million principal repayment of the UKISA notes was loaned to ZIC. In return, the Company received a short-term note with a 1.40% fixed interest rate that matures on October 29, 2003. For the nine and three month periods ended September 30, 2003, interest income totaled $0.1 million. Subsequently, on October 2, 2003, ZIC redeemed the $95.0 million note, and the full $95.0 million of principal and $0.1 million of interest were paid to the Company. In addition, on December 27, 2002, the Company loaned $100.0 million to ZIC and, in return, received a short-term note with a 1.50% fixed interest rate that matured on February 14, 2003. On February 14, 2003, the full $100.0 million of principal and $0.2 million of interest were paid to the Company. On March 24, 2003, the Company loaned $100.0 million to ZCM Matched Funding Corp ("ZCM"), a subsidiary of Zurich and, in return, received a short-term note with a 1.95% fixed interest rate that matured on May 30, 2003. On May 30, 2003, $100.0 million of principal and $0.3 million of interest were paid to the Company. 8. Certificates of contribution and surplus note of the P&C Group Companies From time to time, the Company has purchased certificates of contribution or surplus notes of the P&C Group Companies in order to supplement the policyholders' surplus of the P&C Group Companies. As of September 30, 2003 and December 31, 2002, the Company held the following certificates of contribution and surplus note of the P&C Group Companies: - An $87.5 million surplus note, issued in March 2000, bearing interest at 8.50% annually and maturing in February 2005. - $370.0 million of certificates of contribution, issued in March 2000, bearing interest at 7.85% annually and maturing in March 2010. - $350.0 million of certificates of contribution, issued in November 2001, bearing interest at 6.00% annually and maturing in September 2006. 19 - $206.5 million of certificates of contribution, issued in December 2001, bearing interest at 6.00% annually and maturing in September 2006. - Other certificates of contribution totaling $23.3 million which bear interest at various rates. Interest income related to the certificates of contribution and surplus note of the P&C Group Companies totaled $53.2 million and $53.3 million for each of the nine month periods ended September 30, 2003 and September 30, 2002, respectively. For each of the three months ended September 30, 2003 and September 30, 2002, interest income related to the certificates of contribution and surplus note of the P&C Group Companies totaled $17.7 million. Conditions governing payment of interest and repayment of principal are outlined in the certificates of contribution and the surplus note. Generally, repayment of principal may be made only when the issuer has an appropriate amount of surplus and then only after approval is granted by the issuer's governing board and the appropriate state insurance regulatory department. In addition, payment of interest may generally be made only when the issuer has an appropriate amount of surplus and then only after approval is granted by the appropriate state insurance regulatory department. 9. Operating segments The Company provides management services to the P&C Group Companies and owns and operates the life and reinsurance subsidiaries. These activities are managed separately as each offers a unique set of services. As a result, the Company is comprised of the following three reportable operating segments as defined in SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information": the management services segment, the life insurance segment and the reinsurance segment. Through its AIF relationships with the Exchanges, the Company's management services segment (Farmers Management Services) is primarily responsible for providing non-claims management services to the P&C Group Companies. The P&C Group Companies collectively represent the Company's largest customer. Management fees earned from the P&C Group Companies totaled $1,310.1 million and $1,256.3 million for the nine month periods ended September 30, 2003 and September 30, 2002, respectively, which represented 53.2% and 60.8% of the Company's consolidated operating revenues for the same periods. For the three month periods ended September 30, 2003 and September 30, 2002, the Company received management fees from the P&C Group Companies of $441.3 million and $428.7 million, respectively, which represented 53.3% and 61.6% of the Company's consolidated operating revenue for the same periods. The Company has no ownership interest in the P&C Group Companies and, therefore, excluding the impact of the three quota share reinsurance treaties, is not directly affected by the underwriting results of the P&C Group Companies. However, as management fees comprise a significant part of the Company's revenues, the ongoing financial performance of the Company depends on the volume of business written by and the operating performance and financial strength of the P&C Group Companies. In addition, a lack of appropriate surplus could impact the P&C Group Companies' ability to make interest payments and repay the principal on the certificates of contribution or the surplus note purchased by the Company. The life insurance segment provides individual life insurance products, including universal life, term life and whole life insurance and annuity products, as well as variable universal life and annuity products. The reinsurance segment provides reinsurance coverage to a percentage of the business written by the P&C Group Companies. The Company's management uses an IFRS basis of accounting for evaluating segment performance and determining how resources should be allocated, as this is the basis upon which ZFS, the Company's parent company, measures its performance. This differs from the basis used in preparing the Company's financial statements included in the SEC Form 10-K and 10-Q reports, which is based on GAAP and therefore excludes the effects of all IFRS adjustments. 20 The Company accounts for intersegment transactions as if they were to third parties and, as such, records the transactions at current market prices. There were no intersegment revenues among the Company's three reportable operating segments for the nine month and three month periods ended September 30, 2003 and September 30, 2002. The Company operates throughout the U.S. and does not earn revenues or hold assets in any foreign countries. Information regarding the Company's reportable operating segments follows:

(a) Revenues for the insurance operating segments include net investment income, net realized losses and impairment losses on investments. (b) Amount includes adjustment associated with the amortization of the AIF relationships ($10.7 million). (c) Amounts include impairment losses on investments. 10. Impairment losses on investments The Company regularly reviews its investment portfolio to determine whether declines in the value of investments are other than temporary as defined by SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The Company's review for declines in value includes reviewing historical and forecasted financial information as well as analyzing the market performance of similar types of investments. As a result of the Company's review, the Company determined that some of its investments had declines in value that were other than temporary as of September 30, 2003 and September 30, 2002 due to unfavorable market and economic conditions. 22 Impairment losses on investments for the nine months ended September 30 are as follows:

Impairment losses on investments for the three months ended September 30 are as follows:

11. Merger of the AIF On October 31, 2002, the Board of Directors approved the merger into FGI of certain FGI subsidiaries (Fire Underwriters Association and Truck Underwriters Association) that act as AIF to the Exchanges. However, for the merger to become effective, it first needs to be approved by the California Department of Insurance ("DOI") and then must be filed with the appropriate Secretaries of State. The Company filed the AIF merger request with the DOI on December 30, 2002 and is currently awaiting the DOI's approval. 12. Revolving credit agreement On September 23, 2003, the Company's existing $250.0 million revolving credit agreement that was scheduled to expire on September 25, 2003 was cancelled. At the same time, the Company entered into a new 364 day senior revolving credit agreement with certain financial institutions. Under this agreement, the Company has an aggregate borrowing facility of $250.0 million. The proceeds of the facility are available to the Company for general corporate purposes, including loans to the P&C Group Companies. Facility fees are payable on the aggregate 23 borrowing facility in the amount of 6 basis points per annum. In the case of a draw on the facility, the Company has the option to borrow at an annual rate equal to (i) London Interbank Offered Rate ("LIBOR") plus an Applicable Margin of 19 basis points or (ii) the Alternate Base Rate (to be defined as the higher of (a) the Bank of America prime rate or (b) the Federal Funds rate plus 50 basis points). As of September 30, 2003, the Company did not have any outstanding borrowings under the revolving credit agreement. Facility fees paid under the two agreements for the period ended September 30, 2003 were $0.3 million, of which $0.2 million were reimbursed by the P&C Group Companies. 13. Subsequent Event On October 22, 2003, FGI announced that it will redeem all of its outstanding 8.45% Junior Subordinated Debentures, Series A and 8.25% Junior Subordinated Debentures, Series B. The proceeds will be applied by Farmers Group Capital and Farmers Group Capital II (the "Subsidiary Trusts"), consolidated wholly owned subsidiaries of FGI, to simultaneously redeem all outstanding 8.45% Cumulative Quarterly Income Preferred Securities ("QUIPS"), Series A and all outstanding 8.25% QUIPS, Series B at a price of $25 per share plus accrued unpaid dividends. The redemption date will be November 25, 2003. Following the anticipated redemption, the Company, including the Subsidiary Trusts, would have no publicly traded securities, would no longer be an SEC registrant and would not file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. On October 2, 2003, the Company assigned the remaining balance of the $160.0 million ZGAUS note receivable to ZIC. In addition, on October 2, 2003, ZIC redeemed the $95.0 million note receivable (see Note 7). ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations General The Company provides non-claims related management services to the P&C Group Companies and owns and operates the Insurance Subsidiaries. Revenues and expenses relating to these principal business activities are reflected in the Company's Consolidated Financial Statements prepared in accordance with GAAP, which differs from statutory accounting practices ("SAP"), which the Insurance Subsidiaries are required to use for regulatory reporting purposes. Unless otherwise indicated, financial information, operating statistics and ratios applicable to the P&C Group Companies set forth in this document are also based on SAP. Under SAP, the financial results of the P&C Group Companies are combined with the results of Farmers Re. This is known as a "Statutory Combined Basis". Unless otherwise specified, the financial information of the P&C Group Companies is on a Statutory Combined Basis. Farmers Life, a Washington domiciled insurance company, is a wholly owned subsidiary of FGI. Farmers Life markets a broad line of individual life insurance products, including universal life, term life and whole life insurance and fixed annuity products, predominantly flexible premium deferred annuities, as well as variable universal life and variable annuity products. Revenues attributable to traditional life insurance products, such as whole life or term life contracts, as well as structured settlements with life contingencies are classified as premiums as they become due. Future benefits are associated with such premiums (through increases in liabilities for future policy benefits) and prior period capitalized costs are amortized (through amortization of Deferred Policy Acquisition Costs ("DAC")) so that profits are generally recognized over the same period as revenue income. Revenues attributable to universal life, variable life and variable annuity products consist of policy charges for the cost of insurance, policy administration charges, surrender charges and investment income on assets allocated to support policyholder account balances on deposit. Revenues for deferred annuity products consist of surrender charges and investment income on assets allocated to support policyholder account balances. Expenses on universal life and annuity policies as well as on variable products include interest credited to policyholder on policy balances as well as benefit claims incurred in excess of policy account balances. Revenues attributable to structured settlements without life contingencies consist of investment income on assets allocated to support the policyholder benefits schedule and expenses consist of interest credited to policyholders on policy balances. 24 As of December 2002, Farmers Life exited the business of writing structured settlements. The 5,200 structured settlement cases in force as of September 30, 2003 continue to be serviced by Farmers Life. For the three months ended September 30, 2003 and September 30, 2002, the structured settlement business represented 1.0% and 1.2% of Farmers Life's income before provision for taxes, respectively. For the nine months ended September 30, 2003 and September 30, 2002, the structured settlement business represented 1.1% and 2.2% of Farmers Life's income before provision for taxes, respectively. Farmers Re, a wholly owned subsidiary of FGI which was formed and licensed to conduct business in December 1997, provides reinsurance coverage to the P&C Group Companies. As of September 30, 2003, Farmers Re participates in three reinsurance treaties: 1) an APD reinsurance agreement, 2) a 10% All Lines Quota Share reinsurance treaty and 3) a 20% Personal Lines Auto Quota Share reinsurance treaty (see Note 5). Major Customer and Related Matters The P&C Group Companies collectively represent the Company's largest customer. Management fees earned by the Company as AIF for the Exchanges totaled $1,310.1 million and $1,256.3 million for the nine months ended September 30, 2003 and September 30, 2002, respectively, which represented 53.2% and 60.8%, respectively, of the Company's consolidated operating revenues for the same periods. Management fees earned by the Company as AIF for the Exchanges totaled $441.3 million and $428.7 million, respectively, for the three months ended September 30, 2003 and September 30, 2002, which represented 53.3% and 61.6%, respectively, of the Company's consolidated operating revenues for the same periods. On a Statutory Combined Basis, as of September 30, 2003, the P&C Group Companies had surplus of $3.6 billion, and for the nine months ended September 30, 2003, had gross premiums earned of $10.2 billion. The Company has no ownership interest in the P&C Group Companies and, therefore, excluding the impact of the three quota share reinsurance treaties, is not directly affected by the underwriting results of the P&C Group Companies. However, as management fees comprise a significant part of the Company's revenues, the ongoing financial performance of the Company depends on the volume of business written by and the operating performance and financial strength of the P&C Group Companies. In 2003, the P&C Group Companies have shown continued improvement in their underwriting results. Their combined ratio, excluding the quota share reinsurance agreements, decreased 6.0 percentage points from 106.8% for the nine months ended September 30, 2002 to 100.8% for the nine months ended September 30, 2003. The 100.8% combined ratio for the nine months ended September 30, 2003 also compares favorably to the 105.6% combined ratio for the year ended December 31, 2002. On December 31, 2002, two new prospective quota share reinsurance treaties were implemented. These treaties not only increased the Statutory Combined Basis surplus as of December 31, 2002, but also provide additional protection for the year 2003. The Statutory Combined Basis surplus increased $140.9 million from December 31, 2002 and amounted to $3.6 billion as of September 30, 2003. In addition, the ratio of Statutory Combined Basis surplus to net premiums written ("surplus ratio") improved from 28.7% as of September 30, 2002 to 32.5% as of December 31, 2002 and to 37.9% as of September 30, 2003 due to the reduced risk profile created by the new reinsurance treaties. Future operating losses suffered by the P&C Group Companies and any corresponding reduction in surplus could impact their ability to grow written premiums which, in turn, would impact the amount of management fees earned by the Company. In addition, a lack of adequate surplus could impact the P&C Group Companies' ability to make interest payments and repay principal on the certificates of contribution or the surplus note purchased by the Company. On August 5, 2002, the Texas Attorney General and TDI initiated a legal action against Farmers Insurance Exchange, Fire Insurance Exchange and certain of their affiliates which alleged certain improprieties in the pricing of a portion of their homeowners insurance policies written in the state of Texas. FGI and certain of its subsidiaries were also named as parties in that action. On December 18, 2002, the parties executed a Settlement Agreement respecting this litigation, which, when approved by the court, will provide for certain rate reductions and refunds to Texas 25 policyholders. No fines or penalties are included, and there is no admission of wrongdoing. The settlement also allows Farmers Insurance Exchange and Fire Insurance Exchange, which had previously sent notices terminating all of their homeowner policies, to continue operating in the homeowners insurance market in Texas. Although it was a defendant in the initial lawsuit, the settlement imposes no direct financial burdens on FGI. There is a possible indirect financial impact on FGI because of lower renewal rates. The timetable for final court approval of the settlement is unclear. Certain additional parties have intervened in the approval process, objecting to the settlement. Although the settlement did receive preliminary approval from the trial court, the intervenors sought and obtained an order from the Court of Appeals staying further actions in the trial court until the appeal of the intervenors can be heard. Oral argument of the intervenors' appeal has been scheduled for December 2003. In addition to the rate reductions agreed upon in the settlement, on August 8, 2003, the TDI, pursuant to recent insurance legislation affecting all major homeowners insurers in the state, determined that Farmers Insurance Exchange and Fire Insurance Exchange homeowners insurance rates should be further reduced by 17.5%. Farmers Insurance Exchange and Fire Insurance Exchange requested a public hearing before the Commissioner of Insurance appealing the TDI's determination. On September 12, 2003, the Commissioner issued an order that the base rates for Farmers Insurance Exchange shall be reduced by 17.5% for homeowners coverage for all new and renewed business issued effective on or after September 7, 2003, and the base rates for Fire Insurance Exchange shall be reduced by 17.5% for homeowners coverage and 5% for residential fire and allied lines coverage for all new and renewed business issued effective on or after September 7, 2003. Farmers Insurance Exchange and Fire Insurance Exchange subsequently filed an appeal with the District Court in Texas, which is currently pending. Effective September 19, 2003, the P&C Group Companies discontinued writing new malpractice business. In addition, effective January 1, 2004, the P&C Group Companies will begin to non-renew existing malpractice policies. This decision is not expected to have a material impact on the revenues received by the Company. The P&C Group Companies have been impacted by the fires which broke out in California in late October. As of November 3, 2003, the P&C Group Companies have received approximately 1,960 homeowners claims in the region, nearly 430 of which are considered large losses. The P&C Group Companies insure 19% of California homes which amounts to approximately 1.5 million policies. The impact on the Company is not expected to be material as the losses incurred by the P&C Group Companies would only affect Farmers Re through its 2% participation in the 10% All Lines Quota Share Reinsurance treaty (see Note 5). Critical Accounting Policies The consolidated financial statements of the Company have been prepared in accordance with GAAP. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The Company's critical accounting policies relate to revenue recognition, valuation of intangible assets, loss and loss adjustment expense reserves, impairment of investments, the fair value of financial instruments and accounting for internally developed software. Revenue Recognition. Through its AIF relationships with the Exchanges, the Company provides non-claims related management services to the P&C Group Companies' business and receives management fees for the services rendered. The Company recognizes management fee revenue according to the revenue recognition criteria established by Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements". The Company, through its AIF relationships with the Exchanges, is contractually permitted to receive an AIF fee based on the gross premiums earned by the P&C Group Companies. The range of fees has varied by line of business over time. During the past five years, aggregate AIF fees have averaged between 12% and 13% of gross premiums earned by the P&C Group Companies. In order to enable the P&C Group Companies to maintain 26 appropriate capital and surplus while offering competitive insurance rates, each AIF has historically charged a lower AIF fee than the contractually permitted fee of 20% (25% in the case of the Fire Insurance Exchange). As the P&C Group Companies earn gross premiums ratably over the life of the underlying insurance policies, the Company receives and recognizes the corresponding AIF fee ratably over the life of the underlying policies for which it is providing services. The risk of uncollectable premiums is borne by the P&C Group Companies and collectability of the premiums does not affect the amount of revenues the Company recognizes in a given period. Premiums for traditional life insurance policies, structured settlement contracts involving life contingencies and other annuity contracts with life contingencies are recognized as revenues when due from policyholders. Accident and health insurance premiums are recognized as revenue pro rata over the terms of the contract. Revenues associated with universal life, variable universal life products and other investment type contracts consist of policy charges for the cost of insurance, policy administration fees, surrender charges, and investment income on assets allocated to support policyholder account balances on deposit. Revenues for deferred fixed and variable annuity products and structured settlement contracts not involving life contingencies ("SSNILC") consist of surrender charges, investment income on assets allocated to support policyholder account balances on deposit, and administrative charges for equity-indexed annuities. Consideration received for interest-sensitive insurance, SSNILC, and annuity products are recorded as a liability when received. Policy withdrawal and other charges are recognized as revenue when assessed. Farmers Re reinsures a percentage of the business written by the P&C Group Companies. Under the APD reinsurance agreement, Farmers Re assumes $200.0 million of annual premiums. Under the 10% All Lines Quota Share reinsurance treaty, Farmers Re assumes a 2% quota share of premiums written in all lines of business written by the P&C Group Companies after the APD contract is applied. Under the 20% Personal Lines Quota Share reinsurance treaty, Farmers Re assumes a 4% quota share of the personal lines auto business written by the P&C Group Companies after all other reinsurance treaties are applied. Premiums assumed by Farmers Re are earned ratably over the life of the underlying insurance policies. Intangible Assets. The Company's critical accounting policies related to the valuation of intangible assets include the AIF relationships, Goodwill, VOLBA and DAC. AIF Relationships. Through its AIF relationships, the Company receives a substantial portion of its revenues and profits through the management services the Company provides to the P&C Group Companies. Therefore, the Company's ongoing financial performance depends on the volume of business written by and operating performance and financial strength of the P&C Group Companies. As a result, a portion of the purchase price ($1.7 billion) associated with B.A.T's acquisition of the Company in 1988 was assigned to these AIF relationships. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets", and identified the AIF relationships as intangible assets with indefinite useful lives. Under SFAS No. 142, intangible assets with indefinite useful lives are no longer amortized, and as such, the Company no longer records $42.8 million of pretax annual amortization relating to the AIF relationships. In addition, SFAS No. 142 requires that intangible assets not subject to amortization be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company performed impairment tests of the AIF relationships balance of $1.2 billion as of January 1, 2002, as part of the implementation of SFAS No. 142, and then as of December 31, 2002, in accordance with the annual impairment test, using discounted future cash flows. Such tests did not indicate any impairment of the recorded AIF relationships. Goodwill. Through December 31, 2001, the excess of the purchase price over the fair value of the net assets ("Goodwill") of the Company at the date of the Company's acquisition by B.A.T ($2.4 billion) was amortized on a straight-line basis over forty years. 27 Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142. Under SFAS No. 142, goodwill is no longer amortized, and as such, the Company no longer records $60.0 million of annual amortization relating to goodwill. In addition, SFAS No. 142 requires goodwill to be tested for impairment on an annual basis and between annual tests in certain circumstances (e.g., a significant adverse change in legal factors or the business climate of the Company, an adverse action by a regulator, a loss of key personnel, etc.) using a two-step process. The first step of the goodwill impairment test identifies a potential impairment by comparing the fair value of a reporting unit with its carrying value, including goodwill. The second step measures the amount of the impairment by comparing the implied fair value of the goodwill with the carrying amount of that goodwill. The Company performed impairment tests of its Goodwill balance of $1.6 billion as of January 1, 2002, as part of the implementation of SFAS No. 142, and then as of December 31, 2002, in accordance with the annual impairment test, using discounted future cash flows. Such tests did not indicate any impairment of recorded goodwill. VOLBA. At the date of B.A.T's acquisition of the Company, a portion of the purchase price ($662.8 million) was assigned to the VOLBA asset, which represented an actuarial determination of the expected profits from the life business in force at that time. The amount so assigned is being amortized over its actuarially determined useful life with the unamortized amount included in the "Value of life business acquired" line in the accompanying consolidated balance sheets, which amounted to $238.5 million and $254.5 million for the period ended September 30, 2003 and the year ended December 31, 2002, respectively. Life DAC. Costs that vary with, and are related primarily to, the production of new business have been deferred to the extent that they are deemed recoverable. Such costs include commissions, certain costs of policy and underwriting, and certain agency expenses. For universal life insurance contracts and investment-type products, such costs are being amortized generally in proportion to the present value of expected gross profits arising principally from surrender charges and investment results, and mortality and expense margins. Interest rates are based on rates in effect during the period. The effects on the amortization of deferred policy acquisition costs of revisions to estimated gross margins and profits are reflected in earnings in the period such estimated gross margins and profits are revised. Management periodically updates these estimates and evaluates the recoverability of deferred policy acquisition costs. When appropriate, management revises its assumptions of the estimated gross margins or profits of these contracts, and the cumulative amortization is re-estimated and adjusted by a cumulative charge or credit to current operations. Deferred policy acquisition costs for non-participating traditional life and annuity policies with life contingencies are amortized in proportion to anticipated premiums. Assumptions as to anticipated premiums are made at the date of policy issuance or acquisition and are consistently applied during the lives of the contracts. Deviations from estimated experience are included in operations when they occur. For these contracts, the amortization period is typically the estimated life of the policy. Deferred policy acquisition costs include amounts associated with the unrealized gains and losses recorded as other comprehensive income, a component of stockholder's equity. Accordingly, deferred policy acquisition costs are increased or decreased for the impact of estimated future gross profits as if net unrealized gains or losses on securities had been realized at the balance sheet date. Net unrealized gains or losses on securities within other comprehensive income also reflect this impact. Non-life DAC. Acquisition costs, consisting primarily of commissions incurred on business related to the two new prospective quota share reinsurance treaties, are deferred and amortized over the period in which the related premiums are earned. Anticipated losses and loss adjustment expenses as well as any estimated remaining costs associated with the treaties are considered in determining acquisition costs to be deferred. Anticipated investment income is not considered in the deferral of acquisition costs. Loss and Loss Adjustment Expense Reserves. Under the three reinsurance treaties, Farmers Re assumes a percentage of the ultimate net losses sustained by the P&C Group Companies. Loss and loss adjustment expense reserves for all claims outstanding of the P&C Group Companies are established as of the reporting date. Reserves 28 include a provision for claims incurred but not yet reported, as well as development of known claims. The Company's actuaries review the reserves on a regular basis and make any necessary changes to the estimates in the current period. Loss and loss adjustment expense reserve estimates are uncertain by their very nature. Although reserves are established on the basis of a reasonable estimate, it is probable that reserves will differ from their related subsequent developments. Underlying causes for this uncertainty include, but are not limited to, changes in judicial interpretation of coverage, statutory and other changes in the regulation of insurance and unanticipated inflationary trends. This uncertainty can result in both adverse as well as favorable development of actual subsequent activity when compared to the reserves established. Impairment of Investments. The Company regularly reviews its investment portfolio to determine whether declines in the value of investments are other than temporary as defined by SFAS No. 115. The Company's review for declines in value includes analyzing historical and forecasted financial information as well as reviewing the market performance of similar types of investments. As a result of the Company's review, the Company determined that some of its investments had declines in value that were other than temporary as of September 30, 2003 and September 30, 2002 due to unfavorable market and economic conditions. Accordingly, for the three month periods ended September 30, 2003 and September 30, 2002, the Company recorded $0.2 million and $28.9 million, respectively, of impairment losses on investments in the equity portfolio and investment real estate. For the nine month periods ended September 30, 2003 and September 30, 2002, the Company recorded $39.9 million and $78.8 million, respectively, of impairment losses on investments in the equity and fixed income portfolios and investment real estate. Fair Value of Financial Instruments. The fair values of financial instruments have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, these estimates may not be indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts. Cash Equivalents. The Company considers all investments with original maturities of 90 days or less as cash equivalents. Accounting for Internally Developed Software. The Company follows the provisions of Statement of Position No. 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use". The Company expenses costs incurred in the preliminary project stage and, thereafter, capitalizes costs incurred in developing or obtaining internal use software. Certain costs, such as maintenance and training, are expensed as incurred. Capitalized costs are amortized on a straight-line basis over the useful life of the software once it is placed into service. The Company regularly reviews its existing capitalized software assets in order to determine if any should be considered impaired or abandoned. Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002 Farmers Management Services Operating Revenues. Operating revenues, which primarily consist of AIF fees paid to Farmers Management Services as a percentage of gross premiums earned by the P&C Group Companies and other fees, increased $14.6 million, or 3.2%, from $459.2 million for the three months ended September 30, 2002 to $473.8 million for the three months ended September 30, 2003. This growth in operating revenues was primarily attributable to an increase in the AIF fee rate which became effective in March 2003 for some of the specialty lines, a slight increase in the gross premiums earned by the P&C Group Companies between periods and a shift in the mix of business. Operating Expenses. Operating expenses decreased from $242.1 million for the three months ended September 30, 2002 to $213.6 million for the three months ended September 30, 2003, a decrease of $28.5 million, or 11.8%. This decrease was due primarily to a $27.5 million write-down of internally developed software in the 29 quarter ended September 30, 2002. Excluding the effects of the software write-down, operating expenses decreased $1.0 million, or 0.4%, between periods. Salaries and Employee Benefits. Salaries and employee benefits expenses increased $1.7 million, or 1.5%, from $112.6 million for the three months ended September 30, 2002 to $114.3 million for the three months ended September 30, 2003 due primarily to an increase in pension expenses. This increase was partially offset by a decrease in outside contractor and salary expenses. Buildings and Equipment Expenses. Buildings and equipment expenses increased from $28.1 million for the three months ended September 30, 2002 to $29.1 million for the three months ended September 30, 2003, an increase of $1.0 million, or 3.6%, due primarily to an increase in the amortization expense related to internally developed software. General and Administrative Expenses. General and administrative expenses decreased from $101.4 million for the three months ended September 30, 2002 to $70.2 million for the three months ended September 30, 2003, a decrease of $31.2 million, or 30.8%, due primarily to a $27.5 million write-down of internally developed software in September 2002. Also contributing to the decrease between periods was the decrease in certain general and administrative expenses resulting from a lower number of policies in-force as well as a continued focus on cost controls and efficiencies. Net Investment Income. Net investment income increased from $14.9 million for the three months ended September 30, 2002 to $20.1 million for the three months ended September 30, 2003, an increase of $5.2 million, or 34.9%. This increase was due to improved equity markets and to growth in higher return invested assets, primarily fixed income securities including mortgage-backed securities. These increases were offset in part by lower interest income on the UKISA notes which were reissued in September 2002 at a lower interest rate as well as lost income resulting from partial redemption of the ZGAUS notes (see Note 7). Net Realized Gains. Net realized gains increased from $0.2 million for the three months ended September 30, 2002 to $0.4 million for the three months ended September 30, 2003, an increase of $0.2 million, or 100.0%, due primarily to favorable market conditions. Impairment Losses on Investments. Impairment losses on investments were $11.0 million for the three months ended September 30, 2002. No impairment losses were recorded for the three months ended September 30, 2003. Dividends on Preferred Securities of Subsidiary Trusts. Dividend expense related to the $500.0 million of QUIPS issued in 1995 was $10.6 million in each of the three months ended September 30, 2003 and September 30, 2002. Provision for Income Taxes. Provision for income taxes increased from $77.2 million for the three months ended September 30, 2002 to $97.7 million for the three months ended September 30, 2003, an increase of $20.5 million, or 26.6%, due mainly to an increase in pretax income between periods. Farmers Management Services Income. As a result of the foregoing, Farmers Management Services income increased from $133.4 million for the three months ended September 30, 2002 to $172.4 million for the three months ended September 30, 2003, an increase of $39.0 million, or 29.2%. FGI Insurance Subsidiaries Farmers Re Total Revenues. Total revenues increased $111.4 million, or 204.0%, from $54.6 million for the three months ended September 30, 2002 to $166.0 million for the three months ended September 30, 2003. 30 Non-life Reinsurance Premiums. Non-life reinsurance premiums increased $103.6 million, or 207.2%, from $50.0 million for the three months ended September 30, 2002 to $153.6 million for the three months ended September 30, 2003. Under the APD quota share reinsurance agreement, Farmers Re assumed $50.0 million of premiums in each of the three month periods ended September 30, 2003 and September 30, 2002. Under the 10% All Lines Quota Share treaty, which took effect December 31, 2002, Farmers Re assumed $52.4 million of premiums for the three month period ended September 30, 2003. In addition, under the 20% Personal Lines Auto Quota Share treaty which took effect December 31, 2002, Farmers Re assumed $51.2 million of premiums for the three month period ended September 30, 2003. Net Investment Income. Net investment income increased $0.8 million, or 7.7%, from $10.4 million for the three months ended September 30, 2002 to $11.2 million for the three months ended September 30, 2003. The increase was due primarily to higher average invested assets between periods resulting substantially from the increase in unearned premiums transferred from the P&C Group Companies to Farmers Re as a result of the two new quota share reinsurance agreements. Net Realized Gains/(Losses). Net realized gains/(losses) increased from a $1.8 million loss for the three months ended September 30, 2002 to a $1.2 million gain for the three months ended September 30, 2003, an increase of $3.0 million, or 166.7%. This increase was due mainly to an increase in gains realized from sales of fixed income securities. Impairment Losses on Investments. Impairment losses on investments were $4.0 million for the three months ended September 30, 2002. No impairment losses were recorded for the three months ended September 30, 2003. Total Operating Expenses. Total operating expenses increased $102.2 million, or 209.4%, from $48.8 million for the three months ended September 30, 2002 to $151.0 million for the three months ended September 30, 2003. Non-life Losses and Loss Adjustment Expenses. Non-life losses and loss adjustment expenses increased $62.3 million, or 215.6%, from $28.9 million for the three months ended September 30, 2002 to $91.2 million for the three months ended September 30, 2003 due primarily to the two quota share reinsurance treaties. Non-life Reinsurance Commissions. Non-life reinsurance commissions increased $17.9 million, or 90.4%, from $19.8 million for the three months ended September 30, 2002 to $37.7 million for the three months ended September 30, 2003 due primarily to the two quota share reinsurance treaties. Amortization of Non-life DAC. Amortization of non-life DAC resulting from the two quota share reinsurance treaties which became effective on December 31, 2002 was $21.8 million for the three months ended September 30, 2003. General and Administrative Expenses. General and administrative expenses increased $0.2 million, or 200.0%, from $0.1 million for the three months ended September 30, 2002 to $0.3 million for the three months ended September 30, 2003. Provision for Income Taxes. Provision for income taxes increased $3.0 million from $1.5 million for the three months ended September 30, 2002 to $4.5 million for the three months ended September 30, 2003 due primarily to an increase in pretax income between periods. Farmers Re Income. As a result of the foregoing, Farmers Re's income increased $6.2 million, or 144.2%, from $4.3 million for the three months ended September 30, 2002 to $10.5 million for the three months ended September 30, 2003. Farmers Re's underwriting gain increased $1.5 million from $1.2 million for the three months ended September 30, 2002 to $2.7 million for the three months ended September 30, 2003. 31 Farmers Life Total Revenues. Total revenues increased from $182.0 million for the three months ended September 30, 2002 to $188.7 million for the three months ended September 30, 2003 an increase of $6.7 million, or 3.7%. Life and Annuity Premiums. Life and annuity premiums decreased from $69.8 million for the three months ended September 30, 2002 to $47.4 million for the three months ended September 30, 2003, a decrease of $22.4 million, or 32.1%. This decrease was primarily due to a $23.1 million, or 99.8%, decrease in premiums for structured settlements involving life contingencies compared to the three months ended September 30, 2002. Farmers Life exited the business of writing structured settlements as of December 31, 2002 (see Note 1). Excluding structured settlements, life premiums increased from $46.6 million for the three months ended September 30, 2002 to $47.4 million for the three months ended September 30, 2003, an increase of $0.8 million, or 1.7%. Direct premium increased 8.2% between the three month periods ended September 30, 2002 and September 30, 2003, partially offset by an increase in reinsured term premium between the same periods. Life Policy Charges. Life policy charges increased from $56.1 million for the three months ended September 30, 2002 to $57.5 million for the three months ended September 30, 2003, an increase of $1.4 million, or 2.5%, reflecting growth in universal life-type insurance in-force. Net Investment Income. Net investment income decreased from $86.1 million for the three months ended September 30, 2002 to $85.1 million for the three months ended September 30, 2003, a decrease of $1.0 million, or 1.2%. This decrease was primarily due to a decline in fixed income yields partially offset by growth in invested assets, principally fixed income instruments. Net Realized Losses. Net realized losses decreased from $16.1 million for the three months ended September 30, 2002 to $1.1 million for the three months ended September 30, 2003, a decrease of $15.0 million, or 93.2%. This decrease was primarily due to a decrease between periods in net realized losses generated from the sale of corporate bonds. Impairment Losses on Investments. Impairment losses on investments decreased from $13.9 million for the three months ended September 30, 2002 to $0.2 million for the three months ended September 30, 2003, a decrease of $13.7 million, or 98.6%. No significant impairment losses were recorded for the three months ended September 30, 2003. Total Operating Expenses. Total operating expenses decreased from $150.7 million for the three months ended September 30, 2002 to $139.3 million for the three months ended September 30, 2003, a decrease of $11.4 million, or 7.6%. Life Policyholders' Benefits and Charges. Life policyholders' benefits expense and charges decreased from $118.5 million for the three months ended September 30, 2002 to $102.5 million for the three months ended September 30, 2003, a decrease of $16.0 million, or 13.5%. Policy Benefits. Policy benefits, which consist primarily of death and surrender benefits on life products, increased from $43.7 million for the three months ended September 30, 2002 to $49.3 million for the three months ended September 30, 2003, an increase of $5.6 million, or 12.8%, as Farmers Life experienced unfavorable claim volatility in the three months ended September 30, 2003. Increase in Liability for Future Benefits. Increase in liability for future benefits expense decreased from $31.0 million for the three months ended September 30, 2002 to $8.6 million for the three months ended September 30, 2003, a decrease of $22.4 million, or 72.3%. This decrease was primarily attributable to a $23.1 million, or 99.8%, decrease in deposits for structured settlements involving life contingencies compared to the three months ended September 30, 2002. Farmers Life exited the business of writing structured settlements as of December 31, 2002 (see Note 1). 32 Excluding structured settlements, the increase in liability for future benefits expense decreased from $8.2 million for the three months ended September 30, 2002 to $7.9 million for the three months ended September 30, 2003, a decrease of $0.3 million, or 3.7%. This decrease was attributed to changes in product mix, as Farmers Life now writes more term business, which carries lower overall reserves than whole life products. Interest Credited to Policyholders. Interest credited to policyholders, which represents the amount credited under universal life-type contracts, deferred annuities and structured settlements not involving life contingencies to policyholder funds on deposit, increased from $43.8 million for the three months ended September 30, 2002 to $44.6 million for the three months ended September 30, 2003, an increase of $0.8 million, or 1.8%. This increase was due primarily to growth in policyholder funds that credit interest partially offset by crediting rate reductions. General Operating Expenses. General operating expenses increased from $32.2 million for the three months ended September 30, 2002 to $36.8 million for the three months ended September 30, 2003, an increase of $4.6 million, or 14.3%. Amortization of DAC and VOLBA. Amortization expense increased from $19.9 million for the three months ended September 30, 2002 to $26.9 million for three months ended September 30, 2003, an increase of $7.0 million, or 35.2%. During 2002, there was a reduction in the rate at which DAC is amortized due to increases in expected long term future profit margins. This rate change was also applied to the calculation of the outstanding DAC back to product inception and created a one-time favorable impact in the year of change. In 2003, the slower amortization is reflected, however the one-time favorable impact in 2002 is not repeated, resulting in more amortization in the current period. The DAC amortization rate is determined using profit margin projections, which include current period realized gains and losses. Life Commissions. Life commissions expense decreased from ($2.5) million for the three months ended September 30, 2002 to ($5.3) million for the three months ended September 30, 2003, a change of $2.8 million, due primarily to a $2.5 million, or 34.3%, growth in the reinsurance expense allowance between periods, as Farmers Life is selling more reinsured term business. Commissions are reported net of expense reimbursements related to reinsured business. General and Administrative Expenses. General and administrative expenses increased from $14.8 million for the three months ended September 30, 2002 to $15.2 million for the three months ended September 30, 2003, an increase of $0.4 million, or 2.7%. This increase was due to higher employee benefits expenses. Provision for Income Taxes. Provision for income taxes increased from $11.0 million for the three months ended September 30, 2002 to $17.4 million for the three months ended September 30, 2003, an increase of $6.4 million, or 58.2%, as a result of an increase in pretax income between periods. The effective tax rate remained flat between periods. Farmers Life Income. As a result of the foregoing, Farmers Life income increased from $20.3 million for the three months ended September 30, 2002 to $32.0 million for the three months ended September 30, 2003, an increase of $11.7 million, or 57.6%. Consolidated Net Income Consolidated net income of the Company increased from $158.0 million for the three months ended September 30, 2002 to $214.9 million for the three months ended September 30, 2003, an increase of $56.9 million, or 36.0%. 33 Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002 Farmers Management Services Operating Revenues. Operating revenues increased $64.8 million, or 4.8%, from $1,344.4 million for the nine months ended September 30, 2002 to $1,409.2 million for the nine months ended September 30, 2003. This growth in operating revenues was primarily attributable to higher gross premiums earned by the P&C Group Companies, which benefited from a rising premium rate environment. Gross premiums earned increased $0.3 billion, or 3.0%, from $9.9 billion for the nine months ended September 30, 2002 to $10.2 billion for the nine months ended September 30, 2003. Operating Expenses. Operating expenses decreased from $672.9 million for the nine months ended September 30, 2002 to $636.3 million for the nine months ended September 30, 2003, a decrease of $36.6 million, or 5.4%. This decrease was due primarily to a $27.5 million write-down of internally developed software in the quarter ended September 30, 2002. Excluding the effects of the software write-down, operating expenses decreased $9.1 million, or 1.4%, between periods. Salaries and Employee Benefits. Salaries and employee benefits expenses increased $5.6 million, or 1.7%, from $332.1 million for the nine months ended September 30, 2002 to $337.7 million for the nine months ended September 30, 2003 due primarily to an increase in pension and medical insurance expenses, partially offset by a decrease in outside contractor expenses mainly in the information technology function. Buildings and Equipment Expenses. Buildings and equipment expenses decreased from $86.4 million for the nine months ended September 30, 2002 to $85.0 million for the nine months ended September 30, 2003, a decrease of $1.4 million, or 1.6%, due primarily to a decrease in software and hardware maintenance and rental expenses. This decrease was offset in part by an increase between periods in the amortization expense related to software. General and Administrative Expenses. General and administrative expenses decreased from $254.4 million for the nine months ended September 30, 2002 to $213.6 million for the nine months ended September 30, 2003, a decrease of $40.8 million, or 16.0%, due primarily to a $27.5 million write-down of internally developed software in the quarter ended September 30, 2002. Also contributing to the decrease between periods was a decrease in certain general and administrative expenses resulting from a lower number of policies in-force as well as a continued focus on cost controls and efficiencies. Net Investment Income. Net investment income increased from $48.0 million for the nine months ended September 30, 2002 to $61.2 million for the nine months ended September 30, 2003, an increase of $13.2 million, or 27.5%. This increase was due to improved equity markets and to growth in higher return invested assets, primarily fixed income securities including mortgage-backed securities. These increases were offset in part by lower interest income on the UKISA notes which were reissued in September 2002 at a lower interest rate as well as lost income resulting from partial redemption of the ZGAUS notes (see Note 7). Net Realized Gains. Net realized gains decreased from $4.2 million for the nine months ended September 30, 2002 to $2.8 million for the nine months ended September 30, 2003, a decrease of $1.4 million, or 33.3%, due mainly to $2.4 million of gains recognized on the sale of real estate in 2002, offset in part by favorable market conditions in the nine month period ended September 30, 2003. Impairment Losses on Investments. Impairment losses on investments decreased from $31.9 million for the nine months ended September 30, 2002 to $8.1 million for the nine months ended September 30, 2003, a decrease of $23.8 million, or 74.6%, due to a decrease in impairments related to common stock resulting from improved market conditions. Dividends on Preferred Securities of Subsidiary Trusts. Dividend expense was $31.6 million in each of the nine month periods ended September 30, 2003 and September 30, 2002. 34 Provision for Income Taxes. Provision for income taxes increased from $252.3 million for the nine months ended September 30, 2002 to $302.2 million for the nine months ended September 30, 2003, an increase of $49.9 million, or 19.8%, due mainly to an increase in pretax income between periods. Farmers Management Services Income. As a result of the foregoing, Farmers Management Services income increased from $407.9 million for the nine months ended September 30, 2002 to $495.0 million for the nine months ended September 30, 2003, an increase of $87.1 million, or 21.4%. Insurance Subsidiaries Farmers Re Total Revenues. Total revenues increased $328.0 million, or 196.3%, from $167.1 million for the nine months ended September 30, 2002 to $495.1 million for the nine months ended September 30, 2003. Non-life Reinsurance Premiums. Non-life reinsurance premiums increased $313.7 million, or 209.1%, from $150.0 million for the nine months ended September 30, 2002 to $463.7 million for the nine months ended September 30, 2003. Under the APD quota share reinsurance agreement, Farmers Re assumed $150.0 million of premiums in each of the nine month periods ended September 30, 2003 and September 30, 2002. Under the 10% All Lines Quota Share treaty which took effect December 31, 2002, Farmers Re assumed $158.0 million of premiums for the nine month period ended September 30, 2003. In addition, under the 20% Personal Lines Auto Quota Share treaty which took effect December 31, 2002, Farmers Re assumed $155.7 million of premiums for the nine month period ended September 30, 2003. Net Investment Income. Net investment income increased $2.5 million, or 8.2%, from $30.4 million for the nine months ended September 30, 2002 to $32.9 million for the nine months ended September 30, 2003. The increase was due primarily to higher average invested assets between periods resulting substantially from the increase in unearned premiums transferred from the P&C Group Companies to Farmers Re as a result of the two quota share reinsurance agreements. Net Realized Gains/(Losses). Net realized gains/(losses) increased from a $0.4 million loss for the nine months ended September 30, 2002 to a $1.9 million gain for the nine months ended September 30, 2003, an increase of $2.3 million, or 575.0%. This increase was due mainly to an increase in gains realized from sales of fixed income securities partially offset by a decrease in gains realized from common stock sales. Impairment Losses on Investments. Impairment losses on investments decreased $9.5 million, or 73.6%, from $12.9 million for the nine months ended September 30, 2002 to $3.4 million for the nine months ended September 30, 2003. The decrease was due to lower impairment losses recognized in the equity portfolio between periods. Total Operating Expenses. Total operating expenses increased $310.1 million, or 211.8%, from $146.4 million for the nine months ended September 30, 2002 to $456.5 million for the nine months ended September 30, 2003. Non-life Losses and Loss Adjustment Expenses. Non-life losses and loss adjustment expenses increased $188.5 million, or 195.7%, from $96.3 million for the nine months ended September 30, 2002 to $284.8 million for the nine months ended September 30, 2003 due primarily to the two quota share reinsurance treaties. Non-life Reinsurance Commissions. Non-life reinsurance commissions increased $55.5 million, or 111.2%, from $49.9 million for the nine months ended September 30, 2002 to $105.4 million for the nine months ended September 30, 2003 due primarily to the two quota share reinsurance treaties. 35 Amortization of Non-life DAC. Amortization of non-life DAC resulting from the two quota share reinsurance treaties which became effective on December 31, 2002 was $65.9 million for the nine months ended September 30, 2003. General and Administrative Expenses. General and administrative expenses increased $0.2 million, or 100.0%, from $0.2 million for the nine months ended September 30, 2002 to $0.4 million for the nine months ended September 30, 2003. Provision for Income Taxes. Provision for income taxes increased $5.7 million, or 96.6%, from $5.9 million for the nine months ended September 30, 2002 to $11.6 million for the nine months ended September 30, 2003 due primarily to an increase in pretax income between periods. Farmers Re Income. As a result of the foregoing, Farmers Re's income increased $12.2 million, or 82.4%, from $14.8 million for the nine months ended September 30, 2002 to $27.0 million for the nine months ended September 30, 2003. Farmers Re's underwriting gain increased $3.6 million from $3.6 million for the nine months ended September 30, 2002 to $7.2 million for the nine months ended September 30, 2003. Farmers Life Total Revenues. Total revenues increased from $555.8 million for the nine months ended September 30, 2002 to $556.9 million for the nine months ended September 30, 2003, an increase of $1.1 million, or 0.2%. Life and Annuity Premiums. Life and annuity premiums decreased from $195.5 million for the nine months ended September 30, 2002 to $143.7 million for the nine months ended September 30, 2003, a decrease of $51.8 million, or 26.5%. This decrease was primarily due to a $54.2 million, or 99.0%, decrease in premiums for structured settlements involving life contingencies compared to the nine months ended September 30, 2002 (see Note 1). Excluding structured settlements, life premiums increased from $140.7 million for the nine months ended September 30, 2002 to $143.2 million for the nine months ended September 30, 2003, and increase of $2.5 million, or 1.8%. Direct premium grew 9.4% between periods, partially offset by growth in reinsured term premiums. As such, Farmers Life's term business in-force grew $15.4 billion, or 33.5%, between periods. Life Policy Charges. Life policy charges increased from $167.3 million for the nine months ended September 30, 2002 to $171.0 million for the nine months ended September 30, 2003, an increase of $3.7 million, or 2.2%, reflecting a 2.0% growth in universal life-type insurance in-force. Net Investment Income. Net investment income increased from $254.8 million for the nine months ended September 30, 2002 to $256.4 million for the nine months ended September 30, 2003, an increase of $1.6 million, or 0.6%. This increase was primarily due to growth in invested assets, principally fixed income instruments, partially offset by a decline in fixed income yields. Net Realized Gains/(Losses). Net realized gains/(losses) increased from a $27.8 million loss for the nine months ended September 30, 2002 to a $14.3 million gain for the nine months ended September 30, 2003, an increase of $42.1 million, or 151.4%. This increase was due primarily to gains generated from fixed income sales during the nine months ended September 30, 2003. The most significant disposals were of collateralized mortgage obligations vulnerable to accelerated prepayment risk, previously impaired securities that have since appreciated in price and corporate bonds. Impairment Losses on Investments. Impairment losses on investments decreased from $34.0 million for the nine months ended September 30, 2002 to $28.5 million for the nine months ended September 30, 2003, a decrease of $5.5 million, or 16.2%. This decrease was primarily due to a $26.9 million decrease in equity impairments between periods offset in part by $21.2 million of fixed income impairments taken during the nine months ended September 30, 2003 on securities issued by major U.S. airlines. 36 Total Operating Expenses. Total operating expenses decreased from $448.8 million for the nine months ended September 30, 2002 to $413.2 million for the nine months ended September 30, 2003, a decrease of $35.6 million, or 7.9%. Life Policyholders' Benefits and Charges. Life policyholders' benefits expense and charges decreased from $342.6 million for the nine months ended September 30, 2002 to $295.9 million for the nine months ended September 30, 2003, a decrease of $46.7 million, or 13.6%. Policy Benefits. Policy benefits increased from $128.0 million for the nine months ended September 30, 2002 to $137.5 million for the nine months ended September 30, 2003, an increase of $9.5 million, or 7.4%, as life insurance in-force has grown 11.0% between periods, partially offset by an increase in reinsured term product mortality. Increase in Liability for Future Benefits. Increase in liability for future benefits expense decreased from $80.0 million for the nine months ended September 30, 2002 to $25.5 million for the nine months ended September 30, 2003, a decrease of $54.5 million, or 68.1%. This decrease was primarily attributable to a $54.2 million, or 99.0%, decrease in deposits for structured settlements involving life contingencies compared to the nine months ended September 30, 2002 (see Note 1). Excluding structured settlements, the increase in liability for future benefits expense decreased from $25.9 million for the nine months ended September 30, 2002 to $23.2 million for the nine months ended September 30, 2003, a decrease of $2.7 million, or 10.4%. This decrease was due to changes in product mix, as Farmers Life issued more term business, which carries a lower overall reserve than whole life products. Interest Credited to Policyholders. Interest credited to policyholders decreased from $134.6 million for the nine months ended September 30, 2002 to $132.9 million for the nine months ended September 30, 2003, a decrease of $1.7 million, or 1.3%. This decrease was due primarily to reductions in crediting rates related to the deferred annuity and universal life products. The effect of the reductions was offset by a 7.6% growth in policyholder funds that credit interest. General Operating Expenses. General operating expenses increased from $106.2 million for the nine months ended September 30, 2002 to $117.3 million for the nine months ended September 30, 2003, an increase of $11.1 million, or 10.5%. Amortization of DAC and VOLBA. Amortization expense increased from $66.6 million for the nine months ended September 30, 2002 to $85.6 million for the nine months ended September 30, 2003, an increase of $19.0 million, or 28.5%. During this period in 2002, there was a reduction in the rate at which DAC is amortized due to increases in expected long term future profit margins. This rate change was also applied to the calculation of the outstanding DAC back to product inception and created a one-time favorable impact in the year of change. In 2003, the slower amortization is reflected, however the one-time favorable impact in 2002 is not repeated, resulting in more amortization in the current period. The DAC amortization rate is determined using profit margin projections, which include current period realized gains and losses. Life Commissions. Life commissions decreased from ($5.5) million for the nine months ended September 30, 2002 to ($14.2) million for the nine months ended September 30, 2003, a change of $8.7 million, or 158.2%, due primarily to a $7.3 million, or 35.8%, growth in the reinsurance expense allowance between periods, as reinsured term premium has grown $19.5 million, or 18.0%, between periods. Commissions are reported net of expense reimbursements related to reinsured business. General and Administrative Expenses. General and administrative expenses increased from $45.1 million for the nine months ended September 30, 2002 to $45.9 million for the nine months ended 37 September 30, 2003, an increase of $0.8 million, or 1.8%. The increase was primarily due to higher employee benefits expense. Provision for Income Taxes. Provision for income taxes increased from $37.7 million for the nine months ended September 30, 2002 to $50.6 million for the nine months ended September 30, 2003, an increase of $12.9 million, or 34.2%, as a result of an increase in pretax income between periods. The effective tax rate remained flat between periods. Farmers Life Income. As a result of the foregoing, Farmers Life income increased from $69.3 million for the nine months ended September 30, 2002 to $93.1 million for the nine months ended September 30, 2003, an increase of $23.8 million, or 34.3%. Consolidated Net Income Consolidated net income of the Company increased from $492.0 million for the nine months ended September 30, 2002 to $615.1 million for the nine months ended September 30, 2003, an increase of $123.1 million, or 25.0%. Liquidity and Capital Resources As of September 30, 2003 and September 30, 2002, the Company held cash and cash equivalents of $248.1 million and $601.6 million, respectively. In addition, as of September 30, 2003, the Company had an aggregate borrowing facility of $250.0 million (see Note 12). As such, the Company believes that, combined with cash generated from operations, its total invested assets, including cash and short-term investments, are more than sufficient to satisfy the liquidity needs of the Company. The principal uses of funds by Farmers Management Services are: (i) operating expenses, (ii) dividends to the shareholders of the Company's QUIPS, (iii) capital expenditures and (iv) dividends to its stockholders. The principal uses of funds by Farmers Life are: (i) policy benefits and claims, (ii) loans to policyholders, (iii) capital expenditures, (iv) life commissions, (v) operating expenses and (vi) stockholder's dividends. The principal uses of funds by Farmers Re are: (i) the payment of non-life losses and loss adjustment expenses, (ii) the payment of reinsurance commissions and (iii) operating expenses. The principal sources of funds available to Farmers Management Services are: (i) the management fees that it receives for providing non-claims related management services to the P&C Group Companies, (ii) investment income and (iii) dividends from its subsidiaries. The principal sources of funds available to Farmers Life are premiums and amounts earned from the investment of premiums and deposits. The principal sources of funds available to Farmers Re are premiums assumed from the P&C Group Companies and investment income. In order to maintain the policyholders' surplus of the P&C Group Companies, the Company has, from time to time, purchased surplus notes or certificates of contribution of the P&C Group Companies, receiving certificates of contribution or surplus notes which bear interest at various rates. As of September 30, 2003, the Company held $949.8 million of certificates of contribution and an $87.5 million surplus note of the P&C Group Companies. The Company is under no obligation to purchase these certificates of contribution from the P&C Group Companies. However, the Company believes that these purchases of certificates of contribution and the surplus note have helped to support the historical growth in premiums earned by the P&C Group Companies and the related growth in management fees paid to the Company. The Company also believes that it is receiving a fair rate of return on its certificates of contribution and surplus note. On October 22, 2003, FGI announced that it will redeem all of its outstanding 8.45% Junior Subordinated Debentures, Series A and 8.25% Junior Subordinated Debentures, Series B. The proceeds will be applied by the Subsidiary Trusts, consolidated wholly owned subsidiaries of FGI, to simultaneously redeem all outstanding 8.45% QUIPS, Series A and all outstanding 8.25% QUIPS, Series B at a price of $25 per share plus accrued unpaid dividends. The redemption date will be November 25, 2003. 38 Net cash provided by operating activities increased from $963.0 million for the nine months ended September 30, 2002 to $1,042.5 million for the nine months ended September 30, 2003, an increase of $79.5 million, or 8.3%. The resulting increase in cash was due in part to a $116.5 million increase between periods in reserves for non-life losses and loss adjustment expenses resulting from the Farmers Re quota share reinsurance treaties that became effective December 31, 2002. In addition, the increase in cash was due in part to a $46.8 million decrease between periods in cash contributed to the Company's pension plan ($70.0 million vs. $23.2 million for the nine months ended September 30, 2002 and September 30, 2003, respectively). The Company also received $35.4 million in January 2003 from the P&C Group Companies related to a reimbursement of pension costs. Also contributing to the increase in cash was a $35.4 million increase in current income tax liability between periods and an increase in cash of $25.2 million due to a decrease between periods in cash used for software development. Furthermore, consolidated net income increased by $123.1 million between periods. This increase in consolidated net income was partially offset by the following non-cash items: a $41.5 million increase in gains on the sale of assets between periods and a $38.9 million decrease in impairment losses between periods. Partially offsetting the aforementioned increases in net cash provided by operating activities were: 1) a $119.0 million decrease in cash as a result of the January 2002 settlement of a $119.0 million surplus note of the P&C Group Companies that was redeemed in December 2001, 2) a $57.9 million decrease in cash between periods due to a decrease in the future policy benefits liability and 3) a $47.2 million decrease in cash resulting from higher premiums in collection. Net cash used in investing activities increased from $449.3 million of cash used for the nine months ended September 30, 2002 to $1,146.5 million of cash used for the nine months ended September 30, 2003, resulting in a decrease in cash of $697.2 million, or 155.2%. This decrease in cash was the result of a $1,133.6 million increase in purchases of investments available-for-sale in the nine month period ended September 30, 2003, compared to the same period in 2002 due in part to a decision to improve investment returns by investing a larger portion of the available cash in liquid and highly rated fixed income securities. Also contributing to the decrease in cash was the purchase of a $100.0 million note receivable - affiliate for the nine months ended September 30, 2003. Partially offsetting the aforementioned increase in net cash used in investing activities was a $398.0 million increase in cash provided by proceeds from sales and maturities of investments available-for-sale between the nine month periods ended September 30, 2003 and September 30, 2002 and a $230.0 million increase in proceeds from the redemption of notes receivable - affiliates (see Note 7). Net cash used in financing activities decreased from $309.5 million for the nine months ended September 30, 2002 to $264.6 million for the nine months ended September 30, 2003, resulting in an increase in cash of $44.9 million between periods. This increase was due primarily to a reduction in the net cash outflows associated with universal life and annuity contracts between periods. Recent Accounting Pronouncements. The following is a summary of recent FASB pronouncements. Please refer to Note 2 for further information related to these pronouncements. - In November 2002, the FASB issued Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This Interpretation identifies characteristics of certain guarantee contracts and requires that a liability be recognized at fair value at the inception of such guarantees for the obligations undertaken by the guarantor. The initial recognition and initial measurement provisions of this Interpretation are effective for these guarantees issued or modified after December 31, 2002. The disclosure requirements of this Interpretation are effective for the Company as of December 31, 2002. The adoption of this Interpretation did not have a material impact on the Company's consolidated financial statements. - In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities". This Interpretation provides guidance on the identification of entities for which control is achieved through means other than through voting rights, variable interest entities ("VIEs"), and how to determine when and which business enterprises should consolidate VIEs. This Interpretation applies immediately to VIEs created after 39 January 31, 2003. For a VIE created before February 1, 2003, the provisions of FIN 46 were to be applied at the beginning of the first interim or annual period beginning after June 15, 2003. However, the FASB, at its meeting on October 8, 2003, issued FASB staff position 46-6, "Effective Date of FASB Interpretation No. 46, Consolidation of VIEs" ("FSP 46-6"). FSP 46-6 delayed implementation of the provisions of FIN 46 for entities created before February 1, 2003 to the first interim or annual period ending after December 15, 2003. Based on the current Interpretation, the Company does not believe they have VIEs. - In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities". This Statement is effective for contracts entered into or modified after June 30, 2003. The adoption of this Statement did not have a material impact on the Company's consolidated financial statements. - In May 2003, the FASB issued SFAS No. 150, "Accounting of Certain Financial Instruments with Characteristics of both Liabilities and Equity". This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. Under this Statement, a financial instrument issued in the form of shares that are mandatorily redeemable that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date or upon an event that is certain to occur shall be classified as a liability at the amount of cash that would be paid under the conditions specified in the contract. The provisions of this Statement are effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement had an impact on presentation of the Company's consolidated balance sheet as the "Company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures" line on the balance sheet was reclassified to the liability section for the period ended September 30, 2003. Item 3. Quantitative and Qualitative Disclosures about Market Risks The market risks associated with the Company's investment portfolios have not changed materially from those disclosed at year-end 2002. ITEM 4. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures. The Company's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this quarterly report (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's reports filed or submitted under the Exchange Act. (b) Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in the Company's internal controls that could significantly affect such controls. 40 PART II. OTHER INFORMATION Item 1. Legal Proceedings. Due to its AIF relationships, the Company is a party to lawsuits in which the Exchanges are the primary defendants. The Company is also party to lawsuits arising from its other normal business activities. In addition, the Company is, from time to time, involved as a party to various governmental and administrative proceedings. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. Item 2. Changes in Securities. None. Item 3. Defaults upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. None. Item 5. Other Information. None. On October 19, 2003, the Company's Board of Directors (the "Board") increased the number of Directors on the Board to 14 and unanimously elected Peter Eckert, an officer of Zurich, to serve on the Board. On October 19, 2003 the Board also restructured its Audit and Compliance Committee into two separate committees, the Audit Committee and the Risk and Compliance Committee, in order to give greater focus and attention to each respective area. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. 31.1 Certification of Chief Executive Officer Pursuant to Rule 13a-15(e) or Rule 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer Pursuant to Rule 13a-15(e) or Rule 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K. None. 41 FARMERS GROUP, INC. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Farmers Group, Inc. (Registrant) November 5, 2003 /s/ Martin D. Feinstein --------------------------------------------- Date Martin D. Feinstein Chairman of the Board, President and Chief Executive Officer November 5, 2003 /s/ Pierre Wauthier --------------------------------------------- Date Pierre Wauthier Executive Vice President, Chief Financial Officer and Director

FARMERS GROUP INC 10-Q