Zenith National Insurance Corp. ("Zenith National") is a holding company engaged, through its wholly-owned subsidiaries (primarily Zenith Insurance Company ("Zenith Insurance")), in the workers' compensation insurance business, nationally. Unless otherwise indicated, all references to "Zenith," "we," "us," "our," the "Company" or similar terms refer to Zenith National together with its subsidiaries.

The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements if accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements include those related to the plans and objectives of management for future operations, future economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. Statements containing words such as expect, anticipate, believe, estimate, likely or similar words that are used in this Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations, in other parts of this report or in other written or oral information conveyed by or on behalf of Zenith are intended to identify forward-looking statements. The Company undertakes no obligation to update such forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, the following: 1) volatility in the financial markets, including the duration of the recent crisis and effectiveness of governmental solutions; 2) economic recession; 3) competition;
4) decreased payroll levels of our customers; 5) medical cost trends; 6) regulatory restrictions on investments; 7) changes in state and federal legislation and regulation; 8) changes in interest rates causing fluctuations of investment income and fair values of investments; 9) changes in the frequency and severity of claims and catastrophes; 10) adequacy of loss reserves; 11) changing environment for controlling medical, legal and rehabilitation costs, as well as fraud and abuse; 12) losses associated with any terrorist attacks that impact our workers' compensation business for amounts not covered by our reinsurance protection; 13) losses caused by nuclear, biological, chemical or radiological events whether or not there is any applicable reinsurance protection; and 14) other risks detailed herein and from time to time in our reports and filings with the Securities and Exchange Commission.

Overview

The economy significantly affects our business and over the past two years the recession has resulted in the following impacts:

1. Payrolls for our insureds have declined which has resulted in reduced premiums.

2. Claim counts have declined, but not necessarily at the same rate as payroll declines.

3. Premium increases in California have been moderated to assist our customers during a weak economy.

4. Selection of customers is more complex as certain businesses are facing unprecedented challenges in sustaining their operations.

As the economy recovers, the timing of which is uncertain, we expect that jobs will be restored, resulting in growth in payroll. We also expect an improved economy may be conducive to stronger premium rate levels and more opportunities to write business.

Revenues. Our revenues are comprised of the net premiums earned primarily from our workers' compensation segment, and net investment income and net realized gains (losses) from our investments segment.

Workers' compensation net premiums earned decreased in both the three and nine months ended September 30, 2009 compared to the corresponding periods of 2008 as a result of: 1) fewer policies in-force due to competition in relation to our risk management practices; 2) increased unemployment and declining payrolls for many insureds due to the recession; and 3) net reductions in Florida premium rates year over year, offset in part by California premium rate increases. Our risk-reward strategy emphasizes pricing and underwriting discipline to maintain profitability rather than focusing on revenue or market share.

Workers' compensation segment. Underwriting loss before tax from our workers' compensation segment in the three and nine months ended September 30, 2009 was $8.5 million and $49.4 million, respectively, compared to underwriting income before tax of $15.3 million and $81.8 million in the corresponding periods of 2008. The decrease in underwriting results in the three and nine months ended September 30, 2009 compared to 2008 principally reflects the decline in premium revenue and no prior period loss reserve development recognized in 2009 compared to favorable development of $23.6 million and $61.8 million recognized in the three and nine months ended September 30, 2008, respectively. Policyholders' dividends for the nine months ended September 30, 2009 reflect an $11.1 million reduction in our estimated Florida policyholders' dividends for prior accident years, partially offset by a $3.7 million increase in our current estimated California policyholders' dividends.

The 2009 accident year loss ratio estimate, excluding loss adjustment expenses, is 50.6% compared to 43.0% for the full year 2008, but continues to be an excellent result in comparison to historical industry trends. The higher expense ratio in 2009 compared to 2008 primarily reflects lower net premiums earned.

Investments segment. Net investment income and net realized gains (losses) on investments before tax were as follows:

                                        Three Months Ended         Nine Months Ended
                                          September 30,              September 30,
(Dollars in thousands)                  2009          2008         2009          2008
Net investment income                $    20,541   $   22,873   $    68,108   $   68,405
Net realized gains (losses) on
investments                               20,645       (8,883 )      26,162       (6,695 )
Income before tax from investments
segment                              $    41,186   $   13,990   $    94,270   $   61,710

The average annual yields on the investment portfolio in the three and nine months ended September 30, 2009 and 2008 were as follows:

                  Three Months Ended     Nine Months Ended
                    September 30,          September 30,
                   2009        2008       2009        2008
Before tax (1)        4.3 %       4.6 %      4.8 %       4.4 %
After tax             2.8 %       3.0 %      3.1 %       2.9 %

There were no other-than-temporary impairments recorded during the three months ended September 30, 2009. Net realized gains on investments before tax for the nine months ended

September 30, 2009 are net of other-than-temporary impairments of $19.1 million. Net realized losses on investments before tax for the three and nine months ended September 30, 2008 include other-than-temporary impairments of $15.3 million and $23.8 million, respectively.

The fair value of our available-for-sale investment portfolio improved from an unrealized loss before tax of $77.3 million at December 31, 2008 to an unrealized gain before tax of $55.6 million at September 30, 2009, an increase of $132.9 million, or $2.32 per share. Our investment portfolio reflects our philosophy of diversification and high quality assets with a focus on compounding interest over time. In the short-term, investment income and the value of our investment portfolio will be affected by historically low U.S. Government interest rates, as well as the recent narrowing of corporate spreads in relation to market expectations about the Federal Reserve Board withdrawing excess liquidity.

At September 30, 2009 and December 31, 2008, $808.7 million and $416.8 million, respectively, of the investment portfolio was in fixed maturity securities of two years or less. This represented 39% and 21%, respectively, of our investment portfolio.

Stockholders' equity. Stockholders' equity per share was $28.93, $28.11, $26.82 and $27.42 at September 30, 2009, June 30, 2009, March 31, 2009 and December 31, 2008, respectively. Stockholders' equity per share before stockholders' dividends increased by 11% from December 31, 2008 to September 30, 2009 primarily because of the increase in the fair value of our available-for-sale investment portfolio. Annualized return on average equity in the nine months ended September 30, 2009 was 3.0% compared to 8.9% in the year ended December 31, 2008.

Results of Operations

Summary Results by Segment

The comparative components of net income for the three and nine months ended September 30, 2009 and 2008 are set forth in the following table. These components of net income are consistent with the results of our business segments set forth in Note 8 to the Consolidated Financial Statements.

                                       Three Months Ended            Nine Months Ended
                                          September 30,                September 30,
(Dollars in thousands)                 2009           2008          2009           2008
Net investment income               $    20,541    $   22,873    $    68,108    $   68,405
Net realized gains (losses) on
investments                              20,645        (8,883 )       26,162        (6,695 )
Income from investments segment          41,186        13,990         94,270        61,710
(Loss) income from:
Workers' compensation segment            (8,526 )      15,268        (49,366 )      81,767
Reinsurance segment                          87           (94 )          (42 )        (107 )
Parent                                   (3,108 )      (3,086 )       (9,162 )      (9,145 )
Income before tax                        29,639        26,078         35,700       134,225
Income tax expense                       10,439         9,478         12,100        47,325
Net income                          $    19,200    $   16,600    $    23,600    $   86,900

Workers' Compensation Segment

Underwriting loss before tax from our workers' compensation segment was $8.5 million and $49.4 million for the three and nine months ended September 30, 2009, respectively, compared to underwriting income before tax of $15.3 million and $81.8 million for the corresponding periods of 2008.

The key operating goal for our workers' compensation segment is to achieve underwriting profitability and significantly out-perform the national workers' compensation industry ("industry"). Neither Zenith nor the industry is expected to achieve underwriting profitability in 2009. Underwriting profitability is comprised of the loss ratio, which is a measure of how we manage risk over the long term, and the expense ratio. In regards to our loss ratio, we expect to produce, and for a long period of time have produced, lower than average loss ratios compared to the industry. However, because of our service strategy as a workers' compensation specialist, our expense ratio may be higher compared to industry results. During periods of declining premiums and policy counts such as in 2009, this high expense ratio can result in underwriting losses. Although we are reducing costs as our business declines, we are maintaining and improving our ability to provide services to our customers and ensuring that we will be in a position to grow our business when the economy and market change.

Workers' compensation calendar year combined ratios, along with a reconciliation to the accident year combined ratios for the three and nine months ended September 30, 2009 and 2008, were as follows:

                                                                          Favorable
                                    Favorable                           (Unfavorable)
                        Calendar   Prior Period   Accident   Calendar   Prior Period    Accident
                          Year     Development      Year       Year      Development      Year
                                       2009                                 2008
Three Months Ended
September 30,
Losses and loss
adjustment expenses         69.5 %                    69.5 %     49.1 %          15.5 %     64.6 %
Underwriting and
other operating
expenses                    42.5                      42.5       37.2                       37.2
Policyholders'
dividends                   (4.6 )          9.6 %      5.0        3.7            (1.6 )      2.1
Combined ratio             107.4 %          9.6 %    117.0 %     90.0 %          13.9 %    103.9 %

Nine Months Ended
September 30,
Losses and loss
adjustment expenses         71.3 %                    71.3 %     41.9 %          13.3 %     55.2 %
Underwriting and
other operating
expenses                    43.2                      43.2       36.7                       36.7
Policyholders'
dividends                   (0.4 )          3.2 %      2.8        3.8            (1.6 )      2.2
Combined ratio             114.1 %          3.2 %    117.3 %     82.4 %          11.7 %     94.1 %

The combined ratio, expressed as a percentage, is a key measurement of profitability traditionally used in the property-casualty insurance business. The combined ratio, also referred to as the "calendar year combined ratio," is the sum of the losses and loss adjustment expense ratio and the underwriting and other operating expense ratio. The losses and loss adjustment expense ratio is the percentage of net losses and loss adjustment expenses incurred to net premiums earned. The underwriting and other operating expense ratio is the percentage of underwriting and other operating expenses to net premiums earned. When the calendar year combined ratio is adjusted to exclude prior period items, such as loss reserve development and policyholders' dividends, it becomes the "accident year combined ratio," a non-GAAP financial measure.

The following provides additional information related to the decrease in underwriting results and the increase in combined ratios in the three and nine months ended September 30, 2009 compared to the corresponding periods of 2008:

† Net premiums earned for the workers' compensation segment were as follows:

                              Three Months Ended       Nine Months Ended
                                September 30,            September 30,
(Dollars in thousands)         2009        2008        2009        2008
California                  $   68,616   $  85,990   $ 200,977   $ 254,508
Outside California              47,050      66,741     149,403     210,816
Total net premiums earned   $  115,666   $ 152,731   $ 350,380   $ 465,324

Workers' compensation net premiums earned decreased approximately 25% in both the three and nine months ended September 30, 2009 compared to the corresponding periods of 2008 as a result of: 1) our risk-reward strategy, which emphasizes pricing and underwriting discipline to maintain profitability in a highly competitive environment, resulting in approximately 15% fewer policies in-force compared to September 30, 2008; 2) increased unemployment as well as declining payrolls for many of our insureds due to the recession; and 3) net reductions in Florida premium rates year over year, offset in part by California premium rate increases.

† Our actuaries perform a comprehensive review of our loss reserve estimates every quarter. For the three and nine months ended September 30, 2009, we did not recognize any development of prior accident years' loss reserve estimates compared to $23.6 million and $61.8 million of favorable development recognized in the corresponding periods of 2008.

† Our accident year estimated loss ratio, excluding loss adjustment expenses, recorded in the nine months ended September 30, 2009 increased to 50.6% compared to 38.9% estimated for the 2008 accident year in the corresponding period of 2008. Our 2008 accident year loss ratio was increased in the third and fourth quarters 2008 to 43.0% for the full year as a result of premiums declining more than claim frequency combined with increasing medical costs in California. Our 2009 accident year loss ratio is an excellent result in comparison to historical industry trends and current industry estimates, but is higher than 2008 primarily because of reduced premiums and increasing average cost of claims.

† Loss adjustment expenses consist of both costs directly related to individual claims (allocated) as well as primarily our internal costs associated with servicing and settling claims (unallocated). Allocated loss adjustment expenses generally vary in proportion to losses. Unallocated loss adjustment expenses are more fixed in nature and become a larger percentage of net premiums earned as premiums trend lower. The overall trend of loss adjustment expenses, however, is toward lower expenses.

† Policy acquisition costs are generally variable to net premiums earned. However, underwriting and other costs are also more fixed in nature and become a larger percentage of net premiums earned as premiums trend lower.

† We recognized a charge of $5.0 million before tax in the first quarter 2009 related to workforce and other operating cost reductions, offset by expense savings from these actions recognized in the second and third quarters 2009. We anticipate annualized expense savings of approximately $10.0 million, or $6.5 million after tax.

† At September 30, 2009, we reduced our estimated Florida policyholders' dividends for prior accident years by $11.1 million based on our actual filing with the Florida Department of Insurance ("Florida DOI"), which was partially offset by an increase of $3.7 million in our current estimated California policyholders' dividends.

Workers' compensation premiums in-force, number of policies in-force and insured payrolls in California and outside of California are shown in the following table. Premiums in-force is a measure of the amount of premiums billed, or to be billed, on all unexpired policies at the date shown; and insured payroll is an indicator of exposure.

                           California                      Outside California                         Total
(Dollars in      Premiums    Policies    Insured     Premiums    Policies    Insured     Premiums    Policies    Insured
millions)        In-force    In-force   Payrolls     In-force    In-force   Payrolls     In-force    In-force    Payrolls
September 30,
2009            $    273.0     16,600   $ 6,388.5   $    200.4     14,000   $ 9,933.1   $    473.4     30,600   $ 16,321.6
December 31,
2008                 304.5     19,600     7,133.2        251.7     14,900    10,838.9        556.2     34,500     17,972.1
September 30,
2008                 325.7     20,600     7,538.8        267.3     15,200    11,302.4        593.0     35,800     18,841.2
December 31,
2007                 359.3     22,100     8,108.8        310.8     16,200    11,875.7        670.1     38,300     19,984.5

The table above reflects the following trends in our workers' compensation business:

1) The reduction in premiums in-force reflects the impact of competition in relation to our risk management practices; increased unemployment and declining payrolls due to the recession; as well as net premium rate reductions in Florida year over year, offset in part by California premium rate increases;

2) The reduction in policies in-force also reflects the impact of competition in relation to our risk management practices; and

3) The reduction in insured payrolls is caused by the reduction in policies in-force (competition), as well as the impact of increased unemployment and declining payroll levels of our insureds.

To the extent that payroll levels on in-force policies continue to decline as a result of the recession, our actual premiums earned will be less than the amount implied by premiums in-force.

In California, the state in which the largest volume of our workers' compensation premiums is earned, the Workers' Compensation Insurance Rating Bureau ("WCIRB") recommends claims cost benchmarks (previously called advisory pure premium rates) to be used by companies in determining their premium rates. The California Department of Insurance ("California DOI") also adopts and publishes its own claims cost benchmark. The benchmark rates cover expected loss costs, but do not contain an element to cover operating expenses or profit. In September 2008, the WCIRB proposed a 16% increase in the January 1, 2009 claims cost benchmark and the California DOI adopted and published a claims cost benchmark increase of 5% for January 1, 2009. In April 2009, the WCIRB proposed a 23.7% increase in the July 1, 2009 claims cost benchmark consisting of 16.9% for increased medical inflation and 5.8% for its estimates of the potential cost impacts of the two recent en banc decisions from the Workers' Compensation Appeals Board discussed on page 35. On July 8, 2009, the California DOI rejected the WCIRB's recommendations and did not make any changes to its claims cost benchmark for July 1, 2009. In August 2009, the WCIRB recommended a 22.8% increase in the January 1, 2010 claims cost benchmark. The California DOI has not yet indicated what changes, if any, will be made to the advisory rate levels for January 1, 2010.

Notwithstanding the foregoing, we set our own California premium rates based upon our actuarial analysis of current and anticipated cost trends, including any modification to the workers' compensation system, while maintaining our goal of achieving underwriting profits and out-performing the industry. We reduced our premium rates from 2004 through 2007 as a result of favorable loss costs trends originating from the 2003 and 2004 legislative reforms. Due to increasing claim costs in

California, we increased our manual premium rates 4% effective January 1, 2009 and increased premium rates another 4% effective July 1, 2009. We have not yet determined the amount of the change in our California manual premium rates for January 1, 2010, but we expect it will be in the vicinity of the most recent changes.

These manual premium rates do not necessarily indicate the rates charged to our policyholders because employers' experience modification factors are subject to revision annually and our underwriters are given authority to increase (debit) or decrease (credit) rates based upon individual risk characteristics. The following table sets forth the manual premium rate change percentages in California, as well as the change in the average rates charged in California on renewal business for each period. The change in the average renewal rate takes into consideration changes in manual premium rates, as well as the changes in experience modification factors and net credits or debits applied by our underwriters (decreases are shown in parentheses):

                                                Average Renewal
                               Manual Premium    Charged Rate
Policy Renewal Date             Rate Change         Change
July 1, 2003 - June 30, 2004              0.0 %            (3.0 )%
July 1, 2004 - June 30, 2005            (11.0 )           (14.0 )
July 1, 2005 - June 30, 2006            (24.0 )           (31.0 )
July 1, 2006 - June 30, 2007             (9.0 )           (16.0 )
July 1, 2007 - June 30, 2008              0.0              (9.0 )
July 1, 2008 - June 30, 2009              4.0               0.0
July 1, 2009                              4.0                NA

In Florida, the state in which the second largest volume of our workers' compensation premiums is earned, premium rates for workers' compensation insurance are set by the Florida DOI. Manual premium rate change percentages in Florida are as follows:

                           Manual Premium
Effective date of change    Rate Change
January 1, 2004                       0.0 %
January 1, 2005                      (4.0 )
January 1, 2006                     (13.4 )
January 1, 2007                     (12.5 )
January 1, 2008                     (18.4 )
January 1, 2009                     (18.6 )
April 1, 2009                         6.4
July 1, 2009                         (6.4 )
January 1, 2010                      (6.8 )

The April 1, 2009 Florida premium rate increase related to the fourth quarter 2008 Florida Supreme Court decision in the Emma Murray vs. Mariner Health case, which was expected to increase claimants' attorneys' fees on open claims. In the second quarter 2009, the Florida Legislature restored the limits on claimants' attorneys' fees going forward and as a result, the Florida DOI reversed the April 1, 2009 6.4% rate increase effective July 1, 2009, including rates on in-force policies issued on or after April 1, 2009.

Reinsurance Segment

In September 2005, we exited the assumed reinsurance business and ceased writing and renewing assumed reinsurance contracts with all contracts fully expired at the end of 2006; however, we will be making payments on assumed reinsurance claims for several years. For further information, refer to "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2008.

Investments Segment

Investment income and realized gains and losses are discussed in the "Investments" section below.

Parent



The parent loss reflects the holding company activities of Zenith National as
follows:



                           Three Months Ended       Nine Months Ended
                             September 30,            September 30,
. . .