21st Century road to expansion may have hurdles.

While analysts expect 21st Century Insurance Group's expansion strategy to succeed long term, the short term could get a little bumpy for the Woodland Hills-based auto insurance company.

The company's plan, to move into markets outside California, has been met with enthusiasm by The Street, but as it expands, so too will 21st Century experience higher loss ratios in these new markets. And an increasingly problematic legislative climate in California could mean weakening performance for the company in the home state where it still does the lion's share of its business.

"What investors have to keep in mind is we're probably looking at an earnings plateau (in California)," said John D. Gwynn, an analyst with Morgan, Keegan & Co. Inc. "Prices are not going up so there's less shopping going on. The result is less business for everyone."

Gwynn has an outperform rating on the stock, as do others, largely because of 21st Century's strategy to expand outside of California.

"It's absolutely the right strategy," said Meyer Shields, an analyst with Stifel, Nicolaus & Co. Inc. in Baltimore. "California is the worst or second worst regulatory environment."

The company declined to provide details on the new markets it will enter this year for competitive reasons, saying only that they will include "some of the larger states," based on population, said Rick Andre, senior vice president for human resources at 21st Century.

Analysts expect that the next wave of expansion will be centered on the East Coast and is likely to include Florida, Pennsylvania and Virginia. Speculation has also included Georgia.

21st Century has already expanded into Arizona, Texas, Illinois, Ohio, Nevada, Indiana, Washington and Oregon.

As the company moves into new markets where it does not have prior risk experience with the drivers it is insuring, its losses on policies written are increasing, analysts said.

In 2005 21st Century experienced net realized capital losses of $3.3 million, compared with net realized gains of $10.8 million in the prior year.

And while many of those new markets have shown significant growth, 94 percent of 21st Century's direct premiums were still written in California as of the end of 2005.

So far at least, 21st Century's performance has remained strong. Late in February, the company reported net income of $26.4 million or $0.31 per share for the fourth quarter ended Dec. 31, compared with earnings of $22.5 million or $0.26 per share for the fourth quarter of 2004.

But competition, coupled with further regulatory hassles, promise to slow the company's growth in the coming year.

Thomson's analyst consensus projects a nearly 4 percent decline in the company's earnings per share growth in 2006 to $0.98 compared with earnings per share of $1.02 for the 2005 year.

Already, 21st Century has seen some erosion in its California business. Direct premiums written in California for the fourth quarter of 2005 dropped by 5.7 percent to $294.5 million, versus $312.4 million for the comparable period a year ago.

"Our model continues to project top line degeneration," said Shields. "You can either write more business unprofitably or you can write less policies. You have two bad choices."

Besides the competition putting pressure on rates and increasing the advertising expenditures necessary, California regulators are proposing changes to Prop. 103 that. opponents say, will increase insurers' risk liabilities.

If the ballot measure is approved in November, auto insurers will no longer be allowed to consider zip codes as a significant factor in determining premiums. Opponents say that the measure ignores the statistical rate., of risk inherent in very congested or high crime areas.

Added to the specter of Prop. 103 revisions is the increased competition in California, where experts say, the auto insurance business is still highly profitable.

Average premiums rose nearly 25 percent in the state between 2000 and 2003, the last year for which data is available from the National Association of Insurance Commissioners.

21st Century officials say they have no intention of de-emphasizing the California market, but at the same time, they are bullish on the strategy to grow in new states.

"California is an extremely competitive market," said Andre. "So from a growth standpoint we see opportunities outside California, but certainly with a very large portion of our business in California, we're not decreasing the business there by any means."

Officials did not respond to requests to discuss the proposed changes in Prop. 103.

One of the things expected to work in 21st Century's favor is its highly scaleable computerized operating model that allows the company to move into new markets with minimal expense.

"Their model is very transportable, and there's not a lot of infrastructure," said Gwynn. "They've made a huge investment in Texas. They'll be able to handle volume that's foreseeable for five or 10 years."</p> <pre> 21st Century's Spread Direct Auto Insurance Premiums Written (in millions)

2005 California $1,262.3 Arizona

31.5 Texas 19.1 Illinois 11.4 Ohio

8.3 Nevada 5.3 Indiana 4.6 Washington

2.9 Oregon 1.0 Source: 21st Century Insurance Group </pre> <p>Please see 21ST page 15

SHELLY GARCIA

Senior Reporter