e10vq

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


		Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the Quarterly Period Ended September 30, 2006,


		Transition report pursuant to Section 13 or 15(d) Of the Exchange Act

for the Transition Period from to

No. 000-25425

(Commission File Number)

MERCER INSURANCE GROUP, INC.

(Exact name of Registrant as specified in its charter)


PENNSYLVANIA		23-2934601

(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

10 North Highway 31, P.O. Box 278, Pennington, NJ		08534

(Address of principal executive offices)		(Zip Code)

(609) 737-0426

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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 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 þ No o

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

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

Indicate by check mark if the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


		Number of Shares Outstanding as of November 8, 2006

COMMON STOCK (No Par Value)		6,550,720

(Title of Class)		(Outstanding Shares)

TABLE OF CONTENTS


	Page
PART I. FINANCIAL INFORMATION		5
Item 1. Financial Statements		5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3. Quantitative and Qualitative Disclosures About Market Risk		34
Item 4. Controls and Procedures		34
PART II. OTHER INFORMATION		34
Item 1. Legal Proceedings		34
Item 1A. Risk Factors		34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3. Defaults Upon Senior Securities		34
Item 4. Submission of Matters to a Vote of Security Holders		35
Item 5. Other Information		35
Item 6. Exhibits		35
SIGNATURES		36
EMPLOYMENT AGREEMENT
Certification of Chief Executive Officer
Certification of Chief Financial Officer
Certification of Chief Executive Officer in accordance with Section 906
Certification of Chief Financial Officer in accordance with Section 906

Exhibits:


Exhibit No.		Title
3.1		Articles of Incorporation of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Pre-effective Amendment No. 3 on Form S-1, SEC File No. 333-104897.)

3.2		Bylaws of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.

10.2		Employment Agreement, dated as of October 1, 2006, among BICUS Services Corporation, Mercer Insurance Group, Inc., Mercer Insurance Company and Paul R. Corkery (filed herewith.)

31.1		Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002

Forward-looking Statements

Mercer Insurance Group, Inc. (the “Company”) may from time to time make written or oral “forward-looking statements,” including statements contained in the Company’s filings with the Securities and Exchange Commission (including this Quarterly Report on Form 10-Q and the exhibits hereto and thereto), in its reports to shareholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements include statements with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors (some of which are beyond the Company’s control). The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:

future economic conditions in the regional and national markets in which the Company competes which are less favorable than expected;

the effects of weather-related and other catastrophic events;

the concentration of insured accounts in New Jersey, Pennsylvania and California;

the effect of legislative, judicial, economic, demographic and regulatory events in the six states in which we do the majority of our business as of September 30, 2006;

the continuation of an A.M. Best rating in the Excellent category;

the ability to enter new markets successfully and capitalize on growth opportunities either through acquisitions or the expansion of our producer network;

the ability to obtain regulatory approval for an acquisition, to close the transaction, and to successfully integrate an acquisition and its operations.

financial market conditions, including, but not limited to, changes in interest rates and the stock markets causing a reduction of investment income or investment gains, an acceleration of the amortization of deferred policy acquisition costs, reduction in the value of our investment portfolio or a reduction in the demand for our products;

the impact of acts of terrorism and acts of war;

the effects of terrorist related insurance legislation and laws;

inflation;

the cost, availability and collectibility of reinsurance;

estimates and adequacy of loss reserves and trends in losses and loss adjustment expenses;

heightened competition, including specifically the intensification of price competition, the entry of new competitors and the development of new products by new and existing competitors;

changes in the coverage terms selected by insurance customers, including higher deductibles and lower limits;

our inability to obtain regulatory approval of, or to implement, premium rate increases;

the potential impact on our reported net income that could result from the adoption of future accounting standards issued by the Financial Accounting Standards Board or other standard-setting bodies;

Part I — FINANCIAL INFORMATION

Item 1. Financial Statements

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET


	September 30,			December 31,
	2006			2005
	(Dollars in thousands)
	(Unaudited)
ASSETS
Investments:
Fixed income securities, available-for-sale, at fair value (amortized cost of $276,245 and $231,191, respectively)	$	274,966		$	229,129
Equity securities, at fair value (cost of $10,679 and $8,599, respectively)		16,145			14,981
Short-term investments, at cost, which approximates fair value		1,799			4,289

Total investments		292,910			248,399
Cash and cash equivalents		11,070			20,677
Premiums receivable		44,116			37,497
Reinsurance receivables		86,860			79,214
Prepaid reinsurance premiums		17,754			21,554
Deferred policy acquisition costs		17,760			10,789
Accrued investment income		2,784			2,625
Property and equipment, net		11,808			11,720
Deferred income taxes		8,122			3,588
Goodwill		5,625			5,633
Other assets		3,867			5,002

Total assets	$	502,676		$	446,698

LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Losses and loss adjustment expenses	$	242,355		$	211,679
Unearned premiums		88,748			78,982
Accounts payable and accrued expenses		14,342			13,761
Other reinsurance balances		24,507			18,574
Trust preferred securities		15,538			15,525
Advances under line of credit		3,000			3,000
Other liabilities		1,790			1,778

Total liabilities		390,280			343,299

Stockholders’ Equity:
Preferred stock, no par value, authorized 5,000,000 shares, no shares issued and outstanding		—			—
Common stock, no par value, authorized 15,000,000 shares, issued 7,064,233 and 7,068,233 shares, outstanding 6,566,451 and 6,463,538 shares		—			—
Additional paid-in capital		67,878			67,973
Accumulated other comprehensive income:
Unrealized gains in investments, net of deferred income taxes		2,764			2,851
Retained earnings		51,989			44,896
Unearned restricted stock compensation		—			(1,654	)
Unearned ESOP shares		(3,914	)		(4,383	)
Treasury stock, at cost, 503,513 and 501,563 shares		(6,321	)		(6,284	)

Total stockholders’equity		112,396			103,399

Total liabilities and stockholders’ equity	$	502,676		$	446,698

See accompanying notes to condensed consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Nine months ended September 30, 2006
(Unaudited, dollars in thousands)


								Accumulated						Unearned
					Additional			other						restricted			Unearned
	Preferred		Common		paid-in			comprehensive			Retained			stock			ESOP			Treasury
	stock		stock		capital			income			Earnings			compensation			shares			stock			Total
Balance, December 31, 2005	$	—		—		67,973			2,851			44,896			(1,654	)		(4,383	)		(6,284	)	$	103,399
Net income												7,739												7,739
Unrealized losses on securities:
Unrealized holding losses arising during period, net of related income tax benefit of $39									(76	)														(76	)
Less reclassification adjustment for gains included in net income, net of related income tax expense of $5									(11	)														(11	)

Other comprehensive loss																								(87	)

Comprehensive income																								7,652

Reclassification of unearned restricted stock compensation						(1,654	)								1,654									—
Stock compensation plan amortization						995																		995
Tax benefit from stock compensation plan						129																		129
ESOP shares committed						435												469						904
Treasury stock purchased																					(37	)		(37	)
Dividends to shareholders												(646	)											(646	)

Balance, September 30, 2006	$	—		—		67,878			2,764			51,989			—			(3,914	)		(6,321	)	$	112,396

See accompanying notes to condensed consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2006 and 2005


	2006			2005
	(Dollars in thousands)
	(Unaudited)
Cash flows from operating activities:
Net income	$	7,739		$	4,119
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of fixed assets		1,834			1,325
Net amortization of premium		758			402
Amortization of stock compensation		995			517
ESOP share commitment		904			610
Net realized investment gains		(100	)		(1,273	)
Deferred income tax		(4,490	)		(120	)
Change in assets and liabilities:
Premiums receivable		(6,619	)		1,535
Reinsurance receivables		(7,646	)		(1,189	)
Prepaid reinsurance premiums		3,800			155
Deferred policy acquisition costs		(6,971	)		2
Other assets		1,079			(1,098	)
Losses and loss adjustment expenses		30,676			(246	)
Unearned premiums		9,766			(1,422	)
Other		6,527			(422	)

Net cash provided by operating activities		38,252			2,895

Cash flows from investing activities:
Purchase of fixed income securities, available-for-sale		(163,045	)		(17,814	)
Purchase of equity securities		(4,468	)		(1,020	)
Sale and maturity of fixed income securities, available-for-sale		116,848			44,718
Sale of equity securities		2,792			9,701
Sale (purchase) of short-term investments, net		2,490			(2,496	)
Purchase of property and equipment, net		(1,922	)		(1,194	)

Net cash (used) provided by investing activities		(47,305	)		31,895

Cash flows from financing activities:
Purchase of treasury stock		(37	)		(3,230	)
Tax benefit from stock compensation plans		129			—
Dividends to shareholders		(646	)		—

Net cash used by financing activities		(554	)		(3,230	)

Net (decrease) increase in cash and cash equivalents		(9,607	)		31,560
Cash and cash equivalents at beginning of period		20,677			16,289

Cash and cash equivalents at end of period	$	11,070		$	47,849

Cash paid during the period for:
Interest	$	988		$	28
Income taxes	$	3,400		$	1,650

See accompanying notes to condensed consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)
(Unaudited)

(1) Basis of Presentation

The financial information for the interim periods included herein is unaudited; however, such information reflects all adjustments which are, in the opinion of management, necessary to a fair presentation of the financial position, results of operations, and cash flows for the interim periods. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year.

Certain amounts in the Company’s earlier 2006 interim consolidated financial statements have been presented in these financial statements using a different classification. This change has had no effect on the Company’s net income or stockholders’ equity.

All of the outstanding stock of Financial Pacific Insurance Group, Inc. (FPIG), and its subsidiaries Financial Pacific Insurance Company (“Financial Pacific” or FPIC) and Financial Pacific Insurance Agency (FPIA) was acquired on October 1, 2005, for approximately $41 million in cash. FPIG also holds an interest in three business trusts that were formed for the purpose of issuing Floating Rate Capital Securities. The results of its operations are included in the 2006 Consolidated Statement of Earnings, but not in the corresponding statement for 2005, and this should be taken into account in making any observations based on comparisons of these statements.

FPIC provides property and casualty insurance to small and medium sized businesses in California, Arizona, Nevada and Oregon, as well as direct mail surety products to commercial businesses in various other states.

These financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Share-based compensation

The Company makes grants of qualified (ISO’s) and non-qualified stock options (NQO’s), and non-vested shares (restricted stock) under its plan. Stock options are granted at prices that are not less than market price at the date of grant, and are exercisable over a period of 10 years.

Prior to January 1, 2006, the Company accounted for this plan under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, as permitted by Statement of Financial Accounting Standards (“SFAS”) 123, “Accounting for Stock-Based Compensation”. Under the principles of APB 25, as permitted by SFAS 123, stock-based compensation was recognized for grants of restricted stock in the Statements of Earnings for the years ended December 31, 2005 and 2004, but not for grants of stock options because options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, “Share-Based Payment,” using the modified-prospective-transition method. Statements of Earnings for prior periods have not been retrospectively adjusted for SFAS 123R. As of September 30, 2006, the Company has $2.2 million of unrecognized total compensation cost related to non-vested stock options and restricted stock. That cost will be recognized over the remaining weighted-average vesting period of 2.1 years, based on the estimated grant date fair value.

As a result of adopting SFAS 123R on January 1, 2006, the Company’s income before income taxes and net income for the three months ended September 30, 2006, were reduced by $170,000 and $127,000, respectively, and for the nine months ended September 30, 2006, $499,000 and $377,000, respectively, to recognize the compensation cost of unvested stock options granted under the Company’s plan and the impact of SFAS 123R on the computation of expense relating to grants of restricted stock. There would have been no charge to earnings for stock option grants if we had continued to account for stock-based compensation under APB 25 for unvested stock options. SFAS 123R also eliminated the presentation of the contra-equity account “Unearned restricted stock compensation,” resulting in a reclass of $1.7 million to Additional paid-in capital.

The Company has made grants of 10,000 shares of restricted stock and no grants of stock options during the nine month period ended September 30, 2006.

The following tables show the pro-forma effect on the Statement of Earnings and earnings per share as if the Company had applied SFAS 123 to stock options granted under its plan prior to the adoption of SFAS 123R on January 1, 2006.


	Nine months
	ended
	September 30, 2005
	(In thousands,
	except per
	share data)

Net income, as reported	$	4,119
Plus: Share-based compensation expense included in reported net income, net of related tax effects		334
Less: Total share-based compensation expense determined under fair value based method for all awards, net of related tax effects		(708	)

Pro forma net income	$	3,745

Basic earnings per share:
As reported	$	0.69
Pro forma	$	0.63
Diluted earnings per share:
As reported	$	0.67
Pro forma	$	0.61


	Three months
	ended
	September 30, 2005
	(In thousands,
	except per
	share data)

Net income, as reported	$	2,061
Plus: Share-based compensation expense included in reported net income, net of related tax effects		116
Less: Total share-based compensation expense determined under fair value based method for all awards, net of related tax effects		(247	)

Pro forma net income	$	1,930

Basic earnings per share:
As reported	$	0.35
Pro forma	$	0.33
Diluted earnings per share:
As reported	$	0.34
Pro forma	$	0.32

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes” which clarifies the accounting for income tax reserves and contingencies recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact, if any, that FIN 48 will have on its Consolidated Financial Statements.

In February 2006, FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. The Company is currently evaluating the impact that SFAS No. 155, if any, will have on its Consolidated Financial Statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact that SFAS No. 157 will have, if any, on its Consolidated Financial Statements.

In September 2006, FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This statement requires an employer to recognize the overfunded or underfunded status of a single-employer defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 will become effective for years ending after December 15, 2006. The Company is currently evaluating the impact, if any, that SFAS No. 158 will have on its Consolidated Financial Statements.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 108 to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that registrants quantify the impact on the current year’s financial statements of correcting all misstatements, including the carryover and reversing effects of prior years’ misstatements, as well as the effects of errors arising in the current year. SAB 108 is effective as of the first fiscal year ending after November 15, 2006, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The Company is currently evaluating the impact of adopting SAB No. 108, if any, on its Consolidated Financial Statements.

(2) Segment Information

The Company manages its business in three segments: commercial lines insurance, personal lines insurance, and investments. The commercial lines insurance and personal lines insurance segments are managed based on underwriting results determined in accordance with U.S. generally accepted accounting principles, and the investment segment is managed based on after-tax investment returns.

Underwriting results for commercial lines and personal lines take into account premiums earned, incurred losses and loss adjustment expenses, and underwriting expenses. The investments segment is evaluated by consideration of net investment income (investment income less investment expenses), and realized gains and losses.

In determining the results of each segment, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes.

Financial data by segment is as follows:


	Nine Months Ended September 30
	2006			2005
	(In thousands)
Revenue:
Net premiums earned:
Commercial lines	$	85,263		$	28,517
Personal lines		16,909			16,861

Total net premiums earned		102,172			45,378

Net investment income		7,057			2,254
Realized investment gains		100			1,273
Other		1,605			256

Total revenue		110,934			49,161

Income before income taxes:
Underwriting income (loss):
Commercial lines		4,468			3,242
Personal lines		(1,210	)		(1,121	)

Total underwriting income		3,258			2,121
Net investment income		7,057			2,254
Realized investment gains		100			1,273
Other		692			256

Income before income taxes	$	11,107		$	5,904


	Three Months Ended September 30
	2006			2005
	(In thousands)
Revenue:
Net premiums earned:
Commercial lines	$	29,336		$	9,860
Personal lines		5,668			5,544

Total net premiums earned		35,004			15,404

Net investment income		2,597			770
Realized investment (losses) gains		(505	)		1,175

(3) Reinsurance

Premiums earned are net of amounts ceded of $36,286 and $6,140 for the nine months ended September 30, 2006 and 2005, respectively, and $11,386 and $2,037 for the three months ended September 30, 2006 and 2005, respectively. Losses and loss adjustment expenses are net of amounts ceded of $27,633 and $1,862 for the nine months ended September 30, 2006 and 2005, respectively, and $12,127 and $957 for the three months ended September 30, 2006 and 2005, respectively.

Effective for 2006, Financial Pacific restructured its property reinsurance agreement covering the first $2.0 million of loss from an 80% quota share to an $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s combined capital. The restructuring also included the assumption of ceded unearned premium by Financial Pacific from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written premium and a $5.2 million increase in net earned premium in the nine months of 2006.

During the third quarter, the Company commuted all reinsurance agreements with Alea North America Insurance Company (“Alea”). These reinsurance agreements included participation in the property quota share and casualty excess of loss treaties. As a result of the commutation the Company received a cash payment of $4.5 million, and recorded a pre-tax net loss on commutation of $160,000.

(4) Comprehensive Income

The Company’s comprehensive income for the nine and three month periods ended September 30, 2006 and 2005 is as follows:


	Nine Months ended
	September 30
	2006			2005
	(In thousands)
Net income	$	7,739		$	4,119
Other comprehensive loss, net of tax:
Unrealized losses on securities:
Unrealized holding losses arising during period, net of related income tax benefit of $39 and $503		(76	)		(975	)
Less reclassification adjustment for gains included in net income, net of related income tax expense of $5 and $433		(11	)		(840	)

		(87	)		(1,815	)

Comprehensive income	$	7,652		$	2,304


	Three Months ended
	September 30
	2006			2005
	(In thousands)
Net income	$	2,194		$	2,061
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains and (losses) arising during period, net of related income tax (expense) benefit of $(1,685) and $22		3,271			(41	)
Less reclassification adjustment for gains included in net income, net of related income tax expense of $4 and $400		(7	)		(776	)

		3,264			(817	)

Comprehensive income	$	5,855		$	1,244

(5) Share-based Compensation

The Company adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards may be made in the form of Incentive Stock Options (ISO’s), nonqualified stock options, restricted stock or any combination to employees and non-employee directors, except that non-employee directors are not eligible for grants of ISOs. At adoption, the Plan initially limited to 250,000 the number of shares that may be awarded as restricted stock, and to 500,000 the number of shares for which incentive stock options may be granted.

The total number of shares initially authorized in the Plan was 876,555 shares, with an annual increase equal to 1% of the shares outstanding at the end of each year. As of September 30, 2006, the Plan’s authorization has been increased under this feature to 1,010,263 shares. The Plan provides that stock options and restricted stock awards may include vesting restrictions and performance criteria at the discretion of the Compensation Committee of the Board of Directors. The term of options may not exceed ten years for incentive stock options, and ten years and one month for nonqualified stock options, and the option price may not be less than fair market value on the date of grant. The 2004, 2005 and 2006 grants employ graded vesting over vesting periods of 3 or 5 years for restricted stock, incentive stock options, and nonqualified stock option grants, and include only service conditions. As of September 30, 2006, no stock options granted under the Plan have been exercised. Upon exercise, it is anticipated that new shares will be issued to the option holder. Grants of 10,000 shares of restricted stock have been made under the Plan in 2006.

Information regarding stock option activity in Mercer Insurance Group’s Plan is presented below:


				Weighted Average
	Number			Exercise Price
	of shares			Per Share
Options outstanding at December 31, 2005		659,200		$	12.42
Granted — 2006		0			—
Exercised — 2006		0			—
Forfeited — 2006		(62,500	)		13.04

Options outstanding at September 30, 2006		596,700		$	12.36

Exercisable at:
September 30, 2006		322,533		$	12.22
Weighted-average remaining contractual life				7.9 years
Compensation remaining to be recognized for unvested stock options at September 30, 2006				$	917,000
Weighted-average remaining amortization period				2.0 years
Aggregate Intrinsic Value of outstanding options, September 30, 2006 (millions)				$	8.1
Aggregate Intrinsic Value of exercisable options, September 30, 2006 (millions)				$	4.4

The per share weighted-average fair value of options granted during 2004 was $4.19, and for 2005 was $4.27. The fair value of each option grant was estimated on the date of grant using the Black-Scholes-Merton option-pricing model with the following weighted-average assumptions used for grants in 2004: dividend yield of 0%; expected volatility of 20.91%; risk-free interest rate of 4.73%, and an expected life of 6.5 years, and in 2005: dividend yield of 0%; expected volatility of 18.44%; risk-free interest rate of 4.04%, and an expected life of 7.5 years.

Information regarding unvested restricted stock activity in Mercer Insurance Group’s Plan is below:


				Weighted Average
	Number			Fair value
	of shares			Per Share
Unvested restricted stock at December 31, 2005		166,417		$	12.29
Granted — 2006		10,000			26.87
Vested — 2006		(56,083	)		12.22
Forfeited — 2006		(14,000	)		13.08

Unvested restricted stock at September 30, 2006		106,334		$	13.61

Compensation remaining to be recognized for unvested restricted stock at September 30, 2006 (millions):				$	1.2
Weighted-average remaining amortization period				2.2 years

(6) Earnings per Share

The computation of basic and diluted earnings per share is as follows:


	Nine months ended
	September 30,
	2006		2005
	(Dollars in thousands,
	except per share data)
Numerator for basic and diluted earnings per share:
Net income	$	7,739	$	4,119

Denominator for basic earnings per share — weighted-average shares outstanding		6,006,693		5,939,436
Effect of stock incentive plans		186,038		215,892

Denominator for diluted earnings per share		6,192,731		6,155,328

Basic earnings per share	$	1.29	$	0.69

Diluted earnings per share	$	1.25	$	0.67


	Three months ended
	September 30,
	2006		2005
	(Dollars in thousands,
	except per share data)
Numerator for basic and diluted earnings per share:
Net income	$	2,194	$	2,061

Denominator for basic earnings per share — weighted-average shares outstanding		6,055,132		5,938,388
Effect of stock incentive plans		210,756		182,386

Denominator for diluted earnings per share		6,265,888		6,120,774

Basic earnings per share	$	0.36	$	0.35

Diluted earnings per share	$	0.35	$	0.34

(7) Contingency

As previously disclosed in the Company’s SEC filings, during 2003 and 2004 the Company paid an aggregate of $3.2 million, plus interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory tax. The retaliatory tax generally is imposed on foreign insurers when the foreign company’s home state (i.e., its state of incorporation or domicile) has a higher rate of premium tax than the state imposing the tax, in this case New Jersey. The payments were made in response to notices of deficiency issued by the Division to the Company.

In conjunction with making such payments, the Company filed notices of protest with the Division with respect to the retaliatory tax imposed. The basis for the protests was that the Division’s imposition of the retaliatory tax was unconstitutional and based on an incorrect interpretation of the law which denied the Company the ability to take advantage of New Jersey’s premium tax cap, which limits the premiums tax to the lesser of the Company’s New Jersey premiums or 12.5 percent of the Company’s total premiums received from both New Jersey and out-of-state policyholders. The protests currently are pending with the Division’s Conferences and Appeals branch.

Concurrent with the processing of the Company’s protests of the retaliatory tax, other foreign insurers have litigated virtually identical issues in New Jersey courts. On March 9, 2005, the Appellate Division of the New Jersey Superior Court reversed a decision of the New Jersey Tax Court that had sustained the Division’s imposition of the retaliatory tax against a foreign insurer. The Division appealed that decision of the Appellate Division to the New Jersey Supreme Court, which on October 19, 2006 ruled in favor of the other foreign carriers’ appeal. The Company expects that the Division’s ruling on the Company’s protest will be based on the opinion issued by the New Jersey Supreme Court, although the Company was not a party to the litigation giving rise to the Supreme Court decision. The Company is unable to determine whether all, or any portion, of the retaliatory tax will be refunded. Any such refund would be reduced by related Federal Income Tax. Due to the contingencies involved, the Company has not accrued any refund of the retaliatory tax.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following presents management’s discussion and analysis of our financial condition and results of operations as of the dates and for the periods indicated. You should read this discussion in conjunction with the condensed consolidated financial statements and notes thereto included in this report. This discussion contains forward-looking information that involves risks and uncertainties. Actual results could differ significantly from these forward-looking statements. See “Forward-Looking Statements”.

Overview

Mercer Insurance Group, Inc. (the “Company” or the “Holding Company”) is a holding company owning, directly and indirectly, all of the outstanding shares of our four insurance companies and our non-insurance subsidiaries. Mercer Insurance Company, our oldest insurance company, has been engaged in the sale of property and casualty insurance since 1844. Our insurance companies underwrite property and casualty insurance principally in Arizona, California, New Jersey, Nevada, Oregon, and Pennsylvania and are as follows:

	•		Mercer Insurance Company, a Pennsylvania property and casualty stock insurance company offering insurance coverages to businesses and individuals in New Jersey and Pennsylvania,

	•		Mercer Insurance Company of New Jersey, Inc., a New Jersey property and casualty stock insurance company offering insurance coverages to businesses and individuals located in New Jersey,

	•		Franklin Insurance Company, a Pennsylvania property and casualty stock insurance company offering private passenger automobile and homeowners insurances to individuals located in Pennsylvania, and

	•		Financial Pacific Insurance Company, a California property and casualty stock insurance company offering insurance and surety products to small and medium sized commercial businesses in California, Arizona, Nevada and Oregon, and direct mail surety products to commercial businesses in various other states.

All insurance companies in the Group, including Financial Pacific Insurance Company, participate in an insurance pooling agreement and have been assigned a group rating of “A” (Excellent) by A.M. Best. The Group has been assigned that rating for the past 5 years. An “A” rating is the third highest rating of A.M. Best’s 16 possible rating categories.

The Company is subject to regulation by the Pennsylvania Insurance Department, the New Jersey Department of Banking and Insurance, and the California Department of Insurance as its primary regulators.

Mercer Insurance Company and Mercer Insurance Company of New Jersey have recently been licensed to write property and casualty insurance in New York. It is intended that these companies will initially write business which supports existing accounts, and may introduce in that state specialty programs for select religious institutions and habitational risks.

We manage our business and report our operating results in three operating segments: commercial lines insurance, personal lines insurance and the investment function. See Note 2 of the notes to our condensed consolidated financial statements included in this report. However, assets are not allocated to segments and are reviewed in the aggregate for decision-making purposes. Our commercial lines insurance business consists primarily of multi-peril, general liability, commercial auto, and related coverages. Our personal lines insurance business consists primarily of homeowners (in New Jersey and Pennsylvania) and private passenger automobile (in Pennsylvania only) insurance coverages. We market both the commercial and personal insurance lines through independent producers.

Our income is principally derived from written premiums received from insureds in the commercial lines (businesses insured) and personal lines (individuals insured) segments, less the costs of underwriting the insurance policies, the costs of settling and paying claims reported on the policies, and from investment income reduced by investment expenses and gains or losses on holdings in our investment portfolio. Written premiums are the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a policy period. Written premiums become premiums earned as the policy ages. In the absence of premium rate changes, if an insurance company writes the same number and mix of policies each year, written premiums and premiums earned will be equal, and the unearned premium reserve will remain constant. During periods of growth, the unearned premium reserve will increase, causing premiums earned to be less than written premiums. Conversely, during periods of decline, the unearned premium reserve will decrease, causing premiums earned to be greater than written premiums.

Variability in our income is caused by a variety of circumstances, some within the control of our companies and some not within our control. Premium volume is affected by, among other things, the availability and regular flow to our insurance companies of quality, properly-priced risks being produced by our agents, the ability to retain on renewal existing good-performing accounts, competition from other insurance companies, regulatory rate approvals, our reputation, and other limitations created by the marketplace or regulators. Our underwriting costs are affected by, among other things, the amount of commission and profit-sharing commission we pay our agents to produce the underwriting risks for which we receive premiums, the cost of issuing insurance policies and maintaining our customer and agent relationships, marketing costs, taxes we pay to the states in which we operate on the amount of premium we collect, and other assessments and charges imposed on our companies by the regulators in the states in which we do business. Our claim and claim settlement costs are affected by, among other things, the quality of our accounts, severe or extreme weather in our operating region, the nature of the claim, the regulatory and legal environment in our territories, inflation in underlying medical and property repair costs, and the availability and cost of reinsurance. Our investment income and realized gains and losses are determined by, among other things, market forces, the rates of interest and dividends paid on our investment portfolio holdings, the credit or investment quality of the issuers and the success of their underlying businesses, the market perception of the issuers, and other factors such as ratings by rating agencies and analysts.

Effective January 1, 2006, Financial Pacific Insurance Company joined the pooling agreement among the Company’s insurance subsidiaries, whereby each company cedes all business to Mercer Insurance Company and then shares in the pooled business in proportion to their statutory surplus. In connection with its participation in the pool, Financial Pacific Insurance Company transferred approximately $54 million in assets to the other companies in the pooling agreement to recognize their assumption of a portion of its loss and loss adjustment expense and unearned premium reserves.

Critical Accounting Policies

General. The Company’s financial statements are prepared in conformity with U.S. generally accepted accounting principles (GAAP). We are required to make estimates and assumptions in certain circumstances that affect amounts reported in our consolidated financial statements and related footnotes. We evaluate these estimates and assumptions on an on-going basis based on historical developments, market conditions, industry trends and other information that we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, and that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. We believe the following policies are the most sensitive to estimates and judgments.

Liabilities for Loss and Loss Adjustment Expenses. The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all losses incurred, including losses for claims that have not yet been reported to our insurance companies. The amount of loss reserves for reported claims is based primarily upon a case-by-case evaluation of the type of risk involved, knowledge of the circumstances surrounding each claim and the insurance policy provisions relating to the type of loss. The amounts of loss reserves for unreported claims and loss adjustment expenses are determined using historical information by line of insurance as adjusted to current conditions. Inflation is ordinarily implicitly provided for in the reserving function through analysis of costs, trends and reviews of historical reserving results over multiple years.

Reserves are closely monitored and are recomputed periodically using the most recent information on reported claims and a variety of statistical techniques. Specifically, on a quarterly basis, we review, by line of business, existing reserves, new claims, changes to existing case reserves, and paid losses with respect to the current and prior accident years. We use historical paid and incurred losses and accident year data to derive expected ultimate loss and loss adjustment expense ratios by line of business. We then apply these expected loss and loss adjustment expense ratios to earned premium to derive a reserve level for each line of business. In connection with the determination of the reserves, we also consider other specific factors such as recent weather-related losses, trends in historical paid losses, and legal and judicial trends with respect to theories of liability. Some of our business relates to coverage for short-term risks, and for these risks loss development is comparatively rapid and historical paid losses, adjusted for known variables, have been a reliable predictive measure of future losses for purposes of our reserving. Some of our business relates to longer-term risks, where the claims are slower to emerge and the estimate of damage is more difficult to predict. For these lines of business, more sophisticated actuarial methods must be employed to project an ultimate loss expectation, and then the related loss history must be regularly evaluated and loss expectations updated, with the possibility of variability from the initial estimate of ultimate losses. A substantial portion of the business of our recent acquisition, Financial Pacific Insurance Company, is this type of longer-tailed casualty business.

Reserves are estimates because there are uncertainties inherent in the determination of ultimate losses. Court decisions, regulatory changes and economic conditions can affect the ultimate cost of claims that occurred in the past as well as create uncertainties regarding future loss cost trends. Accordingly, the ultimate liability for unpaid losses and loss settlement expenses will likely differ from the amount recorded at September 30, 2006.

The table below summarizes the effect on net loss reserves and equity in the event of reasonably likely changes in the variables considered in establishing loss and loss adjustment expense reserves. The range of reasonably likely changes was established based on a review of changes in accident year development by line of business and applied to loss reserves as a whole. The selected range of changes does not indicate what could be the potential best or worst case or likely scenarios:


Adjustment
Change in Loss and	Adjusted Loss and					Adjusted Loss and Loss		Percentage Change
Loss Adjustment	Loss Reserves Net of		Percentage Change in			Adjustment Reserves Net		in Stockholders’
Reserves Net of	Reinsurance as of		Stockholders’ Equity as			of Reinsurance as of		Equity as of
Reinsurance	September 30, 2006		of September 30, 2006 (1)			December 31, 2005		December 31, 2005 (1)
(Dollars in thousands)
(10.0)%	$	142,250		9.3	%	$	119,640		8.5	%
(7.5)%		146,202		7.0	%		122,964		6.4	%
(5.0)%		150,153		4.6	%		126,287		4.2	%
(2.5)%		154,105		2.3	%		129,610		2.1	%
Base		158,056		—			132,934		—
2.5%		162,007		-2.3	%		136,257		-2.1	%
5.0%		165,959		-4.6	%		139,581		-4.2	%
7.5%		169,910		-7.0	%		142,904		-6.4	%
10.0%	$	173,862		-9.3	%	$	146,227		-8.5	%


(1)		Net of tax

The property and casualty industry has incurred substantial aggregate losses from claims related to asbestos-related illnesses, environmental remediation, product liability, mold, and other uncertain exposures. We have not experienced significant losses from these types of claims. Our subsidiary Financial Pacific Insurance Company insures contractors for liability for construction defect risks, among other risks.

The table below summarizes loss and loss adjustment reserves by major line of business:


	September 30, 2006		December 31, 2005
	(Dollars in thousands)
Commercial lines:
Commercial multi-peril	$	173,462	$	147,041
Commercial automobile		35,198		32,581
Other liability		10,000		9,632
Workers’ compensation		7,300		6,058
Surety		5,387		5,304
Fire, allied, inland marine		334		318

		231,681		200,934

Personal lines:
Homeowners		7,223		7,595
Personal automobile		2,046		1,840
Other liability		1,022		900
Fire, allied, inland marine		343		344
Workers’ compensation		40		66

		10,674		10,745

Total	$	242,355	$	211,679

Investments. Unrealized investment gains or losses on investments carried at fair value, net of applicable income taxes, are reflected directly in stockholders’ equity as a component of comprehensive income and, accordingly, have no effect on net income. A decline in fair value of an investment below its cost that is deemed other than temporary is charged to earnings as a realized loss. We monitor our investment portfolio and review investments that have experienced a decline in fair value below cost to evaluate whether the decline is other than temporary. These evaluations involve judgment and consider the magnitude and reasons for a decline and the prospects for the fair value to recover in the near term. Adverse investment market conditions, or poor operating results of underlying investments, could result in impairment charges in the future.

The Company’s policy on impairment of value of investments is as follows: if a security has a market value below cost it is considered impaired. For any such security a review of the financial condition and prospects of the issuing company will be performed by the Investment Committee to determine if the decline in market value is other than temporary. If it is determined that the decline in market value is “other than temporary”, the carrying value of the security will be written down to “realizable value” and the amount of the write-down accounted for as a realized loss. “Realizable value” is defined for this purpose as the market price of the security. Write-down to a value other than the market price requires objective evidence in support of that value.

In evaluating the potential impairment of fixed income securities, the Investment Committee will evaluate relevant factors, including but not limited to the following: the issuer’s current financial condition and ability to make future scheduled principal and interest payments, relevant rating history, analysis and guidance provided by rating agencies and analysts, the degree to which an issuer is current or in arrears in making principal and interest payments, and changes in price relative to the market.

In evaluating the potential impairment of equity securities, the Investment Committee will evaluate certain factors, including but not limited to the following: the relationship of market price per share versus carrying value per share at the date of acquisition and the date of evaluation, the price-to-earnings ratio at the date of acquisition and the date of evaluation, any rating agency announcements, the issuer’s financial condition and near-term prospects, including any specific events that may influence the issuer’s operations, the independent auditor’s report on the issuer’s financial statements; and any buy/sell/hold recommendations or price projections by outside investment advisors.

We have one significant non-traded equity security, a non-voting common stock in Excess Reinsurance Company, which is carried at $1.1 million. Its fair value is estimated at the statutory book value as reported to the National Association of Insurance Commissioners (NAIC). Other non-traded securities, which are not material in the aggregate, are carried at cost.

Policy Acquisition Costs. We defer policy acquisition costs, such as commissions, premium taxes and certain other underwriting expenses that vary with and are primarily related to the production of business. These costs are amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, loss and loss adjustment expenses, and certain other costs expected to be incurred as the premium is earned. Future changes in estimates, the most significant of which is expected loss and loss adjustment expenses, may require acceleration of the amortization of deferred policy acquisition costs.

Reinsurance. Amounts recoverable from property and casualty reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for reinsurance contracts are expensed over the contract period during which insured events are covered by the reinsurance contracts.

Effective for 2006, Financial Pacific Insurance Company restructured its property reinsurance agreement covering the first $2.0 million of loss from an 80% quota share to an $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s combined capital. The restructuring also included the assumption by Financial Pacific Insurance Company of ceded unearned premium from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written premium and a $5.2 million increase in net earned premium in the nine months of 2006.

Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid loss and loss adjustment expenses are reported separately as assets, instead of being netted with the appropriate liabilities, because reinsurance does not relieve us of our legal liability to our policyholders. Reinsurance balances recoverable are subject to credit risk associated with the particular reinsurer. Additionally, the same uncertainties associated with estimating unpaid loss and loss adjustment expenses affect the estimates for the ceded portion of these liabilities. We continually monitor the financial condition of our reinsurers.

Income Taxes. We use the asset and liability method of accounting for income taxes. Deferred income taxes are provided and arise from the recognition of temporary differences between financial statement carrying amounts and the tax bases of our assets and liabilities. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period of the enactment date.

Results of Operations

Our results of operations are influenced by factors affecting the property and casualty insurance industry in general, which include potentially significant variations due to competition, weather, catastrophic events, regulation, the state of the reinsurance market, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

Our growth in premiums, underwriting results and investment income have been, and continue to be, influenced by market conditions, as well as the acquisition of Financial Pacific on October 1, 2005. Pricing in the property and casualty insurance industry historically has been and remains cyclical. During a soft market cycle, price competition is prevalent, which makes it difficult to write and retain properly priced personal and commercial lines business. Our policy is to maintain disciplined underwriting and pricing standards during soft markets, declining business which is inadequately priced for its level of risk. The market has become much more competitive recently, with increasing competition recently being seen particularly in certain classes of commercial accounts, package policies and in the Pennsylvania personal auto market. This has resulted in slowing premium growth for the Company.

The availability of reinsurance at reasonable pricing is an important part of our business. The surge in catastrophic activity in 2005 has placed reinsurers under greater financial pressures, and this has been reflected in their underwriting appetite, reinsurance terms, and their rates for catastrophe coverage. Our operating territories and the Group’s claim activity experienced only a minor impact from the residual effects of the hurricanes in 2005 that ravaged the Gulf coast, and this was helpful in keeping our 2006 reinsurance program in place without significant rate change on renewal.

On October 1, 2005, the Group acquired Financial Pacific Insurance Group, Inc., including its insurance subsidiary, Financial Pacific Insurance Company. Financial Pacific underwrites commercial lines of business, principally in the states of California, Arizona, Nevada and Oregon. The results of its operations are included in the 2006 Consolidated Statement of Earnings, but not in the corresponding statement for 2005, and this should be taken into account in making any observations based on comparisons of these statements.

Nine and three month periods ended September 30, 2006 compared to nine and three month periods ended September 30, 2005

The components of income for 2006 and 2005, and the change and percentage change from year to year, are shown in the charts below. The accompanying narrative refers to the statistical information displayed in the chart immediately above the narrative.


Nine months ended September 30,
2006 vs. 2005 Income
(Dollars in thousands)	2006			2005			Change			% Change
Commercial lines underwriting income	$	4,468		$	3,242		$	1,226			37.8	%
Personal lines underwriting loss		(1,210	)		(1,121	)		(89	)		(7.9	%)
Total underwriting income		3,258			2,121			1,137			53.6	%
Net investment income		7,057			2,254			4,803			213.1	%
Net realized investment gains		100			1,273			(1,173	)		(92.1	%)
Other revenue		1,605			256			1,349			527.0	%
Interest expense		(913	)		—			(913	)		N/M
Income before income taxes		11,107			5,904			5,203			88.1	%
Income taxes		3,368			1,785			1,583			88.7	%
Net income	$	7,739		$	4,119		$	3,620			87.9	%

Loss / LAE ratio (GAAP)		63.1	%		47.6	%		15.5	%
Underwriting expense ratio (GAAP)		33.7	%		47.7	%		(14.0	)%
Combined ratio (GAAP)		96.8	%		95.3	%		1.5	%

Loss / LAE ratio (Statutory)		60.3	%		47.6	%		12.7	%
Underwriting expense ratio (Statutory)		34.0	%		47.1	%		(13.1	)%
Combined ratio (Statutory)		94.3	%		94.7	%		(0.4	)%

Charts and discussion relating to each of our segments (commercial lines underwriting, personal lines underwriting, and the investments segment) follow with further discussion below.

The Company’s GAAP combined ratio for the first nine months of 2006 was 96.8%, as compared to a combined ratio for the prior year of 95.3%. For the quarter ended September 30, 2006, the combined ratio was 97.4%, up from a combined ratio of 93.5% in 2005. The statutory combined ratios for the nine and three months ended September 30, 2006 were 94.3% and 96.0%, respectively, as compared to 94.7% for both the quarterly and year to date periods in 2005. Our commercial lines underwriting income in both the nine months and quarter ended September 30, 2006 benefited by the contribution of Financial Pacific Insurance Company, which was acquired on October 1, 2005. The personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed the prior year in the nine months ended September 30, 2006. Frequency and severity of claims across both commercial lines and personal lines were within the normal range of expectations in the first nine months of 2006, while a small number of large fire losses in the third quarter of 2006 adversely affected the quarter’s results.

Net investment income increased 213.1% in the first nine months of 2006 to $7.1 million, primarily as a result of the acquisition of Financial Pacific and inclusion of its net investment income. Realized investment gains amounted to $100,000 in the nine months of 2006, compared to a gain of $1.3 million in 2005. Other revenue, which is primarily service charges recorded on insurance premiums paid over the term of the policy instead of when the policy is first issued, increased 527.0% in the nine months of 2006, to $1.6 million, reflecting the inclusion of service charges recognized by Financial Pacific. Interest expense of $913,000 was included in the nine months of 2006, resulting from inclusion of the trust preferred securities obligations of Financial Pacific and their related interest charges.


Nine months ended September 30,
2006 vs. 2005 Revenue
(Dollars in thousands)	2006		2005		Change		% Change
Direct premiums written	$	146,470	$	48,004	$	98,466		205.1	%
Net premiums written		115,738		44,112		71,626		162.4	%
Net premiums earned		102,172		45,378		56,794		125.2	%
Net investment income		7,057		2,254		4,803		213.1	%
Realized investment gains		100		1,273		(1,173)		(92.1	)%
Other revenue		1,605		256		1,349		527.0	%
Total Revenue	$	110,934	$	49,161	$	61,773		125.7	%


Three months ended September 30,
2006 vs. 2005 Revenue
(Dollars in thousands)	2006			2005		Change		% Change
Direct premiums written	$	45,749		$	15,270	$	30,479		199.6	%
Net premiums written		34,809			14,171		20,638		145.6	%
Net premiums earned		35,004			15,404		19,600		127.2	%
Net investment income		2,597			770		1,827		237.3	%
Realized investment (losses) gains		(505	)		1,175		(1,680)		(143.0	)%
Other revenue		527			84		443		527.4	%
Total Revenue	$	37,623		$	17,433	$	20,190		115.8	%


N/M		means “Not Meaningful”

Total revenues for the first nine months of 2006 were up 125.7%, or $61.8 million, over 2005 revenues to $110.9 million. This increase was due primarily to inclusion of the revenue of Financial Pacific, which was not included in the Company’s operations in the first nine months of 2005. Net premiums earned increased in the first nine months of 2006 over the prior year by 125.2%, or $56.8 million, to $102.2 million, with $57.0 million of the increase relating to the inclusion of Financial Pacific in the Group’s results. In the first nine months of 2006, net investment income increased 213.1% over the prior year to $7.1 million, driven by higher interest rates and the inclusion of Financial Pacific’s net investment income. Realized gains in the first nine months of 2006 related primarily to the mark-to-market fair value adjustment on interest rate swaps related to the floating-rate trust preferred securities, whereas in 2005 the realized gains in the nine months ended September 30 were primarily gains taken on equities holdings liquidated to generate cash proceeds to be used in the acquisition of Financial Pacific Insurance Group, Inc.

Total revenues for the third quarter of 2006 were up 115.8%, or $20.2 million, over 2005 revenues to $37.6 million. This increase was due primarily to inclusion of the revenue of Financial Pacific, which was not included in the Company’s operations in the third quarter of 2005. Net premiums earned increased in the third quarter of 2006 over the prior year by 127.2%, or $19.6 million, to $35.0 million, with $19.6 million of the increase relating to the inclusion of Financial Pacific in the Group’s results. In the third quarter of 2006, net investment income increased 237.3% over the prior year to $2.6 million, driven by higher interest rates and the inclusion of Financial Pacific’s net investment income. Realized losses in the third quarter of 2006 related primarily to the mark-to-market fair value adjustment on interest rate swaps related to the floating-rate trust preferred securities, whereas in 2005 the realized gains in the quarter ended September 30 were primarily gains taken on equities holdings liquidated to generate cash proceeds to be used in the acquisition of Financial Pacific Insurance Group, Inc.

In the first nine months of 2006, direct premiums written increased 205.1% over the same period in the prior year to $146.5 million from $48.0 million. Inclusion of Financial Pacific added $95.7 million in direct written premium.

In the third quarter of 2006, direct premiums written increased 199.6% over the same quarter in the prior year to $45.7 million from $15.3 million. Inclusion of Financial Pacific added $30.2 million in direct written premium.

Effective January 1, 2006, Financial Pacific restructured its property reinsurance agreement covering the first $2.0 million of loss from an 80% quota share to an $1,650,000 excess of $350,000 excess of loss contract to take advantage of the Group’s combined capital. The restructuring also included the assumption by Financial Pacific of ceded unearned premium from the 2005 property quota share and casualty excess of loss agreements. These assumed premiums were then ceded into the respective 2006 treaties, which due to the reduced ceding rates, resulted in a $5.6 million increase in net written premium and a $5.2 million increase in net earned premium in the first nine months of 2006.

Net Investment Income is discussed below.


Nine months ended September 30,
2006 vs. 2005 Investment income and
realized gains
(Dollars in thousands)	2006			2005			Change			% Change
Fixed income securities	$	7,961		$	2,651		$	5,310			200.3	%
Dividends		213			303			(90	)		(29.7	)%
Cash, cash equivalents & other		710			582			128			22.0	%
Gross investment income		8,884			3,536			5,348			151.2	%
Investment expenses		(1,827	)		(1,282	)		(545	)		42.5	%
Net investment income	$	7,057		$	2,254		$	4,803			213.1	%
Realized losses on fixed income	$	(385	)	$	(498	)	$	113			N/M
Realized gains on equities		401			1,771			(1,370	)		N/M
Realized gains — other		84			—			84			N/M
Net realized gains	$	100		$	1,273		$	(1,173	)		N/M


Three months ended September 30,
2006 vs. 2005 Investment income and
realized gains (losses)
(Dollars in thousands)	2006			2005			Change			% Change
Fixed income securities	$	2,818		$	806		$	2,012			249.6	%
Dividends		68			94			(26	)		(27.7	)%
Cash, cash equivalents & other		307			322			(15	)		(4.7	)%
Gross investment income		3,193			1,222			1,971			161.3	%
Investment expenses		(596	)		(452	)		(144	)		31.9	%
Net investment income	$	2,597		$	770		$	1,827			237.3	%
Realized losses on fixed income	$	—		$	(89	)	$	89			N/M
Realized gains on equities		11			1,264			(1,253	)		N/M
Realized losses — other		(516	)		—			(516	)		N/M
Net realized (losses) gains	$	(505	)	$	1,175		$	(1,680	)		N/M


(N/M means “not meaningful”)

In the nine months and quarter ended September 30, 2006, net investment income increased $4.8 million, or 213.1%, and $1.8 million, or 237.3%, respectively, from the same periods in 2005. The increases were driven primarily by the acquisition of Financial Pacific, and increases to invested assets resulting from cash flow from operations. In the third quarter of 2006, the Company recorded $130,000 in non-recurring interest income relating to the settlement of a balance in connection with a reinsurance agreement.

In the first nine months of 2006, investment income on fixed income securities was up $5.3 million, or 200.3%, over the same period in 2005. A much larger proportion, as compared to the Group’s business before the acquisition, of Financial Pacific’s premiums written relate to casualty, or longer-tail, business. By its nature, longer-tail business requires more time for losses to manifest themselves, with the result that claims tend to be paid later on casualty claims than on other types of claims. The later payment of claims associated with casualty reserves provides a company with the opportunity to use the funds which will ultimately be paid out as claims for a longer period of time, thus generating a larger relative portfolio of fixed income securities and higher investment income. Accordingly, the inclusion of Financial Pacific’s investment income on fixed income securities had a significant impact on the Group’s gross investment income in 2006.

Dividend income in the nine months of 2006 was down $90,000 or 29.7% from the same period in 2005. The decrease was caused by the sale of some equity securities during 2005 in order to fund the Financial Pacific acquisition.

Interest on cash and cash equivalents in the first nine months of 2006 increased $128,000, or 22.0%, to $710,000, over the same period in 2005. This increase is due to increased short term interest rates as compared to 2005, and in part to the fact that short term investments were being accumulated by Financial Pacific Insurance Company in anticipation of its portfolio transfer settlement obligation resulting from it joining in the pooling agreement with the other insurance subsidiaries of the Group effective January 1, 2006.

Investment expenses increased 42.5% in 2006, or $545,000, to $1.8 million when compared to the first nine months of 2005. This increase is largely attributable to the inclusion of Financial Pacific’s net investment income.

Net realized gains for the first nine months of 2006 were $100,000, as compared to a gain of $1.3 million in the similar period in 2005. In 2006, net realized gains of $100,000 included $773,000 of gains on securities sales and mark-to-market fair value adjustments on interest rate swaps related to the floating-rate trust preferred securities, offset by losses on securities of $673,000. The losses from securities were comprised of $271,000 from the sale of fixed income securities, $281,000 from the sale of equities securities, and $121,000 from the writedown of securities determined to be other-than-temporarily impaired. These securities were written down to our estimate of fair market value at the time of the writedown.

The Company has entered into five interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. For the nine months ended September 30, 2006, the Company’s net realized gain on the interest rate swap agreements was $80,000.

The following table summarizes the length of time equity securities with unrealized losses at September 30, 2006 have been in an unrealized loss position:


							Length of Unrealized Loss
September 30, 2006	Fair		Unrealized		Less than		6 to 12		Over 12
(in thousands)	Value		Losses		6 months		Months		Months
Equity securities:
Preferred stocks	$	463		12		—		12	$	—
Common stocks		1,758		179		179		—		—

Total equities	$	2,221		191		179		12	$	—

The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of September 30, 2006 are as follows :


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
September 30, 2006	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	4,446	$	33	$	50,527	$	869	$	54,973	$	902
Obligations of states and political subdivisions		4,722		22		47,911		463		52,633		485
Corporate securities		7,234		45		42,768		778		50,002		823
Mortgage-backed securities		1,991		9		13,707		161		15,698		170

Total fixed maturities		18,393		109		154,913		2,271		173,306		2,380

Total equity securities		2,221		191		—		—		2,221		191

Total securities in a temporary unrealized loss position	$	20,614	$	300	$	154,913	$	2,271	$	175,527	$	2,571

The unrealized losses on fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At September 30, 2006, the Group has 187 fixed maturity securities with unrealized losses for more than twelve months. Of the 187 securities with unrealized losses for more than twelve months, 181 of them have fair values of no less than 96% of cost, and the other 6 securities have a fair value greater than 92% of cost. The Company believes these declines are temporary.

There are 16 equity securities that are in an unrealized loss position at September 30, 2006. Of these equities, 15 have been in an unrealized loss position for less than 6 months. The remaining equity security has been in an unrealized loss position for less than twelve months. The Group believes these declines are temporary.

Results of our Commercial Lines segment were as follows:


Nine months ended September 30,
2006 vs. 2005 Commercial lines (CL)
(Dollars in thousands)	2006			2005			Change			% Change
CL Direct premiums written	$	128,170		$	30,832		$	97,338			315.7	%
CL Net premiums written	$	98,842		$	28,005		$	70,837			252.9	%
CL Net premiums earned	$	85,263		$	28,517		$	56,746			199.0	%

CL Loss / LAE expense ratio (GAAP)		62.2	%		39.1	%		23.1	%
CL Expense ratio (GAAP)		32.6	%		49.5	%		(16.9	)%
CL Combined ratio (GAAP)		94.8	%		88.6	%		6.2	%


Three months ended September 30,
2006 vs. 2005 Commercial lines (CL)
(Dollars in thousands)	2006			2005			Change			% Change
CL Direct premiums written	$	39,332		$	9,104		$	30,228			332.0	%
CL Net premiums written	$	28,879		$	8,393		$	20,486			244.1	%
CL Net premiums earned	$	29,336		$	9,860		$	19,476			197.5	%

CL Loss / LAE expense ratio (GAAP)		63.1	%		33.0	%		30.1	%
CL Expense ratio (GAAP)		32.6	%		50.8	%		(18.2	)%
CL Combined ratio (GAAP)		95.7	%		83.8	%		11.9	%

In the first nine months of 2006, our commercial lines direct premiums written increased by $97.3 million to $128.2 million when compared to the same period in 2005. The acquisition of Financial Pacific added $95.7 million of the total. Commercial lines net premium written increased $70.8 million to $98.8 million in the same period, of which $69.9 million is attributable to the Financial Pacific acquisition. Net premiums earned increased $56.7 million to $85.3 million, of which Financial Pacific contributed $57.0 million.

In the third quarter of 2006, our commercial lines direct premiums written increased by $30.2 million to $39.3 million when compared to the same period in 2005. The acquisition of Financial Pacific added $30.2 million of the total. Commercial lines net premium written increased $20.5 million to $28.9 million in the same period, of which $20.5 million is attributable to the Financial Pacific acquisition. Net premiums earned increased $19.5 million to $29.3 million, of which Financial Pacific contributed $19.6 million.

Our premiums earned growth reflects the Company’s focus on growing the commercial lines book, while working within our underwriting standards. Growth in our commercial lines direct premiums written has declined recently as compared to previous years, due to an increasingly competitive marketplace. Some of our classes of business, consisting generally of the larger accounts, are more sensitive to competition than others. Competitive pressures tend to be more moderate for some of our smaller accounts, with a higher retention rate and less pressure on the renewal premium. We continually work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, small business risks and property risks.

In the commercial lines segment for the first nine months of 2006, we had underwriting income of $4.5 million, a GAAP combined ratio of 94.8%, a GAAP loss and loss adjustment expense ratio of 62.2% and a GAAP underwriting expense ratio of 32.6%, compared to an underwriting gain of $3.2 million, a GAAP combined ratio of 88.6%, a GAAP loss and loss adjustment expense ratio of 39.1% and an underwriting expense ratio of 49.5% for the same period in 2005.

In the commercial lines segment for the third quarter of 2006, we had underwriting income of $1.3 million, a GAAP combined ratio of 95.7%, a GAAP loss and loss adjustment expense ratio of 63.1% and a GAAP underwriting expense ratio of 32.6%, compared to an underwriting gain of $1.6 million, a GAAP combined ratio of 83.8%, a GAAP loss and loss adjustment expense ratio of 33.0% and an underwriting expense ratio of 50.8% for the same period in 2005.

Our commercial lines loss ratio for the nine months and the third quarter of 2006 reflects a frequency and severity of losses within a normal range of our expectations, but includes a small number of large fire losses in the third quarter of 2006 which adversely affected the quarter’s results.

In addition, Financial Pacific’s commercial lines tend to operate with higher loss ratios and lower expense ratios than the Group’s commercial lines business prior to the acquisition of Financial Pacific, and so in quarterly comparisons for the current quarter and nine months it is expected that the loss ratio will grow to reflect the inclusion of Financial Pacific, and that the expense ratio will show a corresponding decrease.

The Financial Pacific book focuses on targeted classes of business. One of the targeted classes, Contractors Commercial Liability, generates premium currently representing approximately 50% of Financial Pacific’s book of business. While this class remains an important component, the Company is actively working to diversify its book of business by increasing production in other target programs, as well as leveraging our existing contractors liability book to add additional coverages such as commercial auto and commercial property.

Results of our Personal Lines segment were as follows:


Nine months ended September 30,
2006 vs. 2005 Personal lines (PL)
(Dollars in thousands)	2006			2005			Change			% Change
PL Direct premiums written	$	18,300		$	17,172		$	1,128			6.6	%
PL Net premiums written	$	16,896		$	16,107		$	789			4.9	%
PL Net premiums earned	$	16,909		$	16,861		$	48			0.3	%

PL Loss / LAE expense ratio (GAAP)		68.1	%		61.9	%		6.2	%
PL Expense ratio (GAAP)		39.1	%		44.7	%		(5.6	)%
PL Combined ratio (GAAP)		107.2	%		106.6	%		0.6	%


Three months ended September 30,
2006 vs. 2005 Personal lines (PL)
(Dollars in thousands)	2006			2005			Change			% Change
PL Direct premiums written	$	6,417		$	6,166		$	251			4.1	%
PL Net premiums written	$	5,930		$	5,778		$	152			2.6	%
PL Net premiums earned	$	5,668		$	5,544		$	124			2.2	%

PL Loss / LAE expense ratio (GAAP)		67.1	%		59.7	%		7.4	%
PL Expense ratio (GAAP)		38.9	%		51.0	%		(12.1	)%
PL Combined ratio (GAAP)		106.0	%		110.7	%		(4.7	)%

Personal lines direct premiums written increased in the nine months of 2006 by 6.6% to $18.3 million. Net premiums written increased $789,000 over the same period in the prior year to $16.9 million, and net premiums earned increased by 0.3%, or $48,000, to $16.9 million.

Personal lines direct premiums written increased in the third quarter of 2006 by 4.1% to $6.4 million. Net premiums written was up 2.6%, or $152,000, to $5.9 million when compared with the prior year’s quarter, and net premiums earned increased by 2.2%, or $124,000, to $5.7 million.

In the personal lines segment for the first nine months of 2006, we had an underwriting loss of $1.2 million, a GAAP combined ratio of 107.2%, a GAAP loss and loss adjustment expense ratio of 68.1% and a GAAP underwriting expense ratio of 39.1%, compared to an underwriting loss of $1.1 million, a GAAP combined ratio of 106.6%, a GAAP loss and loss adjustment expense ratio of 61.9% and an underwriting expense ratio of 44.7% for the same period in 2005. Our personal lines business is unaffected by the acquisition of Financial Pacific, which does not write any personal lines business.

In the personal lines segment for the third quarter of 2006, we had an underwriting loss of $342,000, a GAAP combined ratio of 106.0%, a GAAP loss and loss adjustment expense ratio of 67.1% and a GAAP underwriting expense ratio of 38.9%, compared to an underwriting loss of $596,000, a GAAP combined ratio of 110.7%, a GAAP loss and loss adjustment expense ratio of 59.7% and an underwriting expense ratio of 51.0% for the same period in 2005.

Our personal lines performance, while benefiting from rate increases initiated in 2005 on our homeowners line of business and a redirection of our Pennsylvania personal auto book to better performing tiers of business, underperformed the prior year in the nine months ended September 30, 2006. The frequency and severity of losses in the personal lines book in the first nine months of 2006 is within the range of our normal expectations.

Although the Company expects to continue growing its personal lines book, it will continue to devote greater focus to growth in the commercial lines book.

Our underwriting expenses were as follows:


2006 vs. 2005 Expenses and expense ratio	2006			2005			Change			% Change
Amortization of DAC	$	24,187		$	11,936		$	12,251			102.6	%
As a % of net premiums earned		23.7	%		26.3	%		(2.6	)%
Other underwriting expenses		10,208			9,725			483			5.0	%
Total expenses excluding losses/LAE and interest expense	$	34,395		$	21,661		$	12,734			58.8	%
Underwriting expense ratio		33.7	%		47.7	%		(14.0	)%

Underwriting expenses increased in the first nine months of 2006 over the prior year by $12.7 million, or 58.8%, to $34.4 million. This increase was driven primarily by the inclusion of Financial Pacific, and, to a lesser extent, to an increase in other underwriting expenses, growth in commissions resulting from higher earned premium volume, and increased charges relating to corporate expenses and compensation expenses, including bonuses and agents profit-sharing.

The Company maintains various Agency Profit Sharing plans, which, in addition to base commissions, annually reward agents for the growth and profitability of the business they produce while representing the Company. The additional commission is computed only on the aggregate growth and profitability of the book of business the agent produces each year. The Company does not have any marketing services agreements, placement services agreements, or similar arrangements.

We are currently in the process of converting our information system, which is targeted for completion in 2007. When completed, we expect some costs to moderate as implementation costs and costs associated with operating dual systems end. These reduced costs will be offset by some higher staffing costs, but we also should be positioned to expand premium volume in the near term without material incremental expense because of increased processing capacity.

Our Federal income tax was as follows:


2006 vs. 2005 Income taxes	2006			2005			Change			% Change
Income before income taxes	$	11,107		$	5,904		$	5,203			88.1	%
Income taxes		3,368			1,785			1,583			88.7	%
Net income	$	7,739		$	4,119		$	3,620			87.9	%
Effective tax rate		30.3	%		30.2	%		0.1	%

Federal income tax expense was $3.4 million for 2006, an effective rate of 30.3%, compared to $1.8 million, an effective rate of 30.2%, in 2005. The increase in the effective tax rate in the first nine months of 2006 is due to an increase in the tax rate on current taxable income of 1% (due to the graduated tax rate structure), offset by higher tax-advantaged income (municipal bond interest and dividend income, which reduce the effective tax rate) than in the same period in 2005.

LIQUIDITY AND CAPITAL RESOURCES

Our insurance companies generate sufficient funds from their operations and maintain a high degree of liquidity in their investment portfolios. The primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments.

We are in the process of building an information system platform that will allow our producers to conduct their business through the Internet or through the method they have historically used. As of September 30, 2006, we have spent $4.2 million on the development of this platform, which includes license fees for software used in the platform. It is anticipated to be completed in 2007, at an additional cost of $500,000. Mercer Insurance Company possesses sufficient resources for these future expenditures without incurring any debt.

Our insurance companies maintain investment and reinsurance programs that are intended to provide sufficient funds to meet their obligations without forced sales of investments. This requires them to ladder the maturity of their portfolios and thereby maintain a portion of their investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds.

The principal source of liquidity for Mercer Insurance Group, Inc. (which has modest expenses and does not currently, or for the foreseeable future, need a significant regular source of cash flow to cover these expenses, other than its debt service on its indebtedness to Mercer Insurance Company) is dividend payments and other fees received from Mercer Insurance Company or other subsidiaries and payments it receives on the 10-year note it received from the ESOP (see below).

Until December 15, 2006, as one of the conditions of approval of its conversion from a mutual form of organization, Mercer Insurance Company may not declare or pay any dividend to Mercer Insurance Group without the approval of the Pennsylvania Insurance Department. After this three-year period, Mercer Insurance Company will be limited by the insurance laws of Pennsylvania as to the amount of dividends or other distributions it may pay to its holding company. Under Pennsylvania law, there is a maximum amount that may be paid by Mercer Insurance Company during any twelve-month period after notice to, but without prior approval of, the Pennsylvania Insurance Department. This limit is the greater of 10% of Mercer Insurance Company’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of Mercer Insurance Company for the period covered by such annual statement. Similarly, Financial Pacific is limited by the insurance laws of California as to how much it may issue as dividends to Mercer Insurance Group, using a formula similar to that described for Pennsylvania.

If the dividend restrictions imposed on Mercer Insurance Company related to the Conversion were not in effect, then as of December 31, 2005, the amounts available for payment of dividends from Mercer Insurance Company in 2006, without the prior approval of the Pennsylvania Insurance Department would have been approximately $5.6 million.

Prior to its payment of any dividends, Mercer Insurance Company of New Jersey, Inc. is required to provide notice of the intended dividends to the New Jersey Department of Banking and Insurance. New Jersey law sets the maximum amount of dividends that may be paid, which cannot exceed the greater of 10% of Mercer Insurance Company of New Jersey, Inc.’s statutory surplus as reported on the most recent annual statement filed with New Jersey, or the net income, not including realized capital gains, for the period covered by the annual statement. The New Jersey Department has the power to limit or prohibit dividend payments if certain conditions exist. These restrictions or any subsequently imposed restrictions may affect our future liquidity. As of December 31, 2005, the amount available for payment of dividends by Mercer Insurance Company of New Jersey, Inc. to Mercer Insurance Company in 2006 without the prior approval of the New Jersey Department of Banking and Insurance is approximately $1.7 million.

As a California domiciled insurance company, dividends payable by Financial Pacific Insurance Company are subject to a restriction similar to that described above. As of December 31, 2005, the amount available for payment of dividends from Financial Pacific Insurance Company in 2006, without the prior approval of the California Insurance Department, is approximately $3.9 million.

As part of the funding of the Financial Pacific acquisition, Mercer Insurance Company, with the approval of the Pennsylvania Department of Insurance, paid an extraordinary dividend of $10 million on September 30, 2005, to Mercer Insurance Group, Inc. Mercer Insurance Company also entered into a loan agreement with Mercer Insurance Group, Inc., by which it advanced on September 30, 2005 to Mercer Insurance Group, Inc., a loan of $10 million with a 20-year note and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. After the acquisition, Mercer Insurance Group has no special limitations on its ability to take periodic dividends from Financial Pacific Insurance Group, but Financial Pacific Insurance Group will be subject to normal dividend restrictions administered by the California Department of Insurance similar to those described above for Mercer Insurance Company, and by a covenant in Financial Pacific’s line of credit that prohibits dividends while that facility is in use, unless a waiver of this restriction is obtained. The Company believes that the resources available to Mercer Insurance Group, Inc., will be adequate for it to meet its obligation under the note to Mercer Insurance Company and its other expenses.

On both July 6, 2006, and on September 29, 2006, Mercer Insurance Group, Inc. paid a dividend of $0.05 per common share. The amount of dividends paid out on both dates totaled $646,000, which amount was funded by dividends from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators, and waivers were received pursuant to the requirements of the covenants under the Financial Pacific line of credit.

Total assets increased 12.5%, or $56.0 million, to $502.7 million at September 30, 2006, from December 31, 2005. The Company’s total investments increased by $44.5 million, or 17.9%, primarily due to net cash provided by operations. Premiums receivable increased $6.6 million, or 17.7% reflecting the increase in written premiums. Reinsurance receivables increased by $7.6 million, or 9.7%, primarily due to an increase in ceded loss and loss adjustment expense reserves. Prepaid reinsurance premiums decreased by $3.8 million, or 17.6%, due to a change to certain of the Company’s reinsurance contracts for 2006, whereby fewer unearned premium reserves are ceded. Deferred policy acquisition costs increased $7.0 million from December 31, 2005, reflecting the increase to net unearned premium reserves for the period, and the effects of the purchase of Financial Pacific Insurance Company on October 1, 2005. Additionally, deferred income taxes increased by $4.5 million, primarily due to profit commissions received on reinsurance contracts that are currently taxable and increased loss and loss adjustment expense reserves.

At September 30, 2006 total liabilities increased by $47.0 million, or 13.7%, from December 31, 2005, primarily a result of the increase in losses and loss adjustment expense reserves of $30.7 million, or 14.5%, and the increase in unearned premiums of $9.8 million, or 12.4%. Other reinsurance balances increased by $5.9 million, primarily due to reinsurance commissions payable. Additionally, accounts payable and accrued expenses increased by $581,000 primarily due to increased current federal income taxes payable included therein.

Stockholders’ equity increased by $9.0 million or 8.7% to $112.4 million at September 30, 2006 from $103.4 million at December 31, 2005. The change for the period was primarily due to $7.7 million of net income, offset by $0.6 million in dividends paid to stockholders.

The Company maintains an ESOP, which purchased 626,111 shares from the Company in return for a note bearing interest at 4% on the principal amount of $6,261,110. Mercer Insurance Company makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Company. It is anticipated that approximately 10% of the original ESOP shares will be allocated annually to employee participants of the ESOP. An expense charge is booked ratably during each year for the shares committed to be allocated to participants that year, determined with reference to the fair market value of the Company’s stock at the time the commitment to allocate the shares is accrued and recognized. The issuance of the shares to the ESOP was fully recognized in the Additional Paid-in Capital account at Conversion, with a contra account entitled Unearned ESOP Shares established in the Stockholders’ Equity section of the balance sheet for the unallocated shares at an amount equal to their original per-share purchase price.

Mercer Insurance Group, Inc. adopted a stock-based incentive plan at its 2004 annual meeting of shareholders. Pursuant to that plan, Mercer Insurance Group may issue a total of 876,555 shares, which amount will increase automatically each year by 1% of the number of shares outstanding at the end of the preceding year. At January 1, 2006, the shares authorized under the Plan has been increased under this provision to 1,010,263 shares. The Company has made grants, net of forfeitures, of 218,500 shares of restricted

stock, net grants of 232,000 Incentive Stock Options, and net grants of 364,700 non-qualified stock options. No options granted under the plan have been exercised as of September 30, 2006.

On October 20, 2004, the Company’s Board of Directors authorized the repurchase of up to 250,000 additional shares of its common stock (in addition to the 250,000 share repurchase authorized June 16, 2004 and previously completed). The repurchase of the additional 250,000 shares was completed on March 2, 2005. The repurchased shares will be held as treasury shares available for issuance in connection with Mercer Insurance Group’s 2004 Stock Incentive Plan. In the aggregate, 500,000 shares have been repurchased since the Conversion, at an aggregate cost of $6.3 million, or $12.53 per share, with 2005 purchases totaling $3.2 million, or $13.18 per share. In addition, 1,563 and 1,950 shares of stock were repurchased from employees in 2005 and 2006, respectively, in order to pay the required tax withholdings on the vesting of restricted stock under the stock incentive plan.

In connection with a continuing retaliatory tax controversy, in 2003 and 2004 the Company paid an aggregate of $3.2 million, plus interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory tax. The retaliatory tax generally is imposed on foreign insurers when the foreign company’s home state (i.e., its state of incorporation or domicile) has a higher rate of premium tax than the state imposing the tax, in this case New Jersey. The payments were made in response to notices of deficiency issued by the Division to the Company.

IMPACT OF INFLATION

Inflation increases an insured’s need for property and casualty insurance coverage. Inflation also increases the cost of claims incurred by property and casualty insurers as property repairs, replacements and medical expenses increase. These cost increases reduce profit margins to the extent that rate increases are not implemented on an adequate and timely basis. We establish property and casualty insurance premiums levels before the amount of losses and loss expenses, or the extent to which inflation may affect these expenses, are known. Therefore, our insurance companies attempt to anticipate the potential impact of inflation when establishing rates, and if inflation is not adequately factored into rates, the rate increases will lag behind increases in loss costs resulting from inflation. Because inflation has remained relatively low in recent years, financial results have not been significantly affected by inflation.

Inflation also often results in increases in the general level of interest rates, and, consequently, generally results in increased levels of investment income derived from our investments portfolio, although increases in investment income will generally lag behind increases in loss costs caused by inflation.

OFF BALANCE SHEET COMMITMENTS AND CONTRACTUAL OBLIGATIONS

The Company was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at September 30, 2006 which would give rise to previously undisclosed market, credit or financing risk.

The Company and its subsidiaries have no significant contractual obligations at September 30, 2006, other than its insurance obligations under its policies of insurance, Trust preferred securities, a line of credit obligation, and operating lease obligations.

Projected cash disbursements pertaining to these obligations have not materially changed since December 31, 2005, and the Company expects to have the resources to pay these obligations as they come due.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

General. Market risk is the risk that we will incur losses due to adverse changes in market rates and prices. We have exposure to three principal types of market risk through our investment activities: interest rate risk, credit risk and equity risk. Our primary market risk exposure is to changes in interest rates. We have not entered, and do not plan to enter, into any derivative financial instruments for hedging, trading or speculative purposes, other than the interest rate swap agreements that hedge the floating rate trust preferred securities which were assumed as part of the Financial Pacific Insurance Group, Inc. acquisition.

Interest Rate Risk. Interest rate risk is the risk that we will incur economic losses due to adverse changes in interest rates. Our exposure to interest rate changes primarily results from our significant holdings of fixed rate investments. Fluctuations in interest rates have a direct impact on the market valuation of these securities. Our available-for-sale portfolio of fixed-income securities is carried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities would result in losses reflected in the balance sheet.

Credit Risk. The quality of our interest-bearing investments is generally good. Our fixed maturity securities at September 30, 2006, have an average rating of AA or better.

Equity Risk. Equity price risk is the risk that we will incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices primarily results from our holdings of common stocks, mutual funds and other equities. Our portfolio of equity securities is carried on the balance sheet at fair value. Therefore, an adverse change in market prices of these securities would result in losses reflected in the balance sheet.

There have been no material changes in market risk from the end of the most recent fiscal year ended December 31, 2005, and the information disclosed in connection therewith.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including the President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the President and Chief Executive Officer and the Senior Vice President and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II — OTHER INFORMATION

Item 1. Legal Proceedings.

None

Item 1A. Risk Factors.

No material changes from risk factors previously disclosed in the registrant’s Form 10-K for the year ended December 31, 2005.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to Vote of Security Holders

None

Item 5. Other Information

None

Item 6. Exhibits

Exhibits


Exhibit No.		Title
3.1		Articles of Incorporation of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Pre-effective Amendment No. 3 on Form S-1, SEC File No. 333-104897.)

3.2		Bylaws of Mercer Insurance Group, Inc. (incorporated by reference herein to the Company’s Annual Report on Form 10-K, SEC File No. 000-25425, for the fiscal year ended December 31, 2003.)

10.2		Employment Agreement, dated as of October 1, 2006, among Bicus Services Corporation, Mercer Insurance Group, Inc., Mercer Insurance Company and Paul R. Corkery (filed herewith)

31.1		Certification of Chief Executive Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)

31.2		Certification of Chief Financial Officer in accordance with Section 302 of the Sarbanes-Oxley Act of 2002, (filed herewith)

32.1		Certification of Chief Executive Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)

32.2		Certification of Chief Financial Officer in accordance with Section 906 of the Sarbanes-Oxley Act of 2002, (filed herewith)


	MERCER	INSURANCE GROUP, INC. (Registrant)

Dated: November 9, 2006	By:	/s/ Andrew R. Speaker

		Andrew R. Speaker,
		President and Chief Executive Officer

Dated: November 9, 2006	By:	/s/ David B. Merclean

		David B. Merclean,
		Senior Vice President and Chief Financial Officer

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	2006		2005
	(Dollars in thousands, except per
	share data)
	(Unaudited)
Revenue:
Net premiums earned	$	102,172	$	45,378
Investment income, net of expenses		7,057		2,254
Net realized investment gains		100		1,273
Other revenue		1,605		256

Total revenue		110,934		49,161

Expenses:
Losses and loss adjustment expenses		64,519		21,596
Amortization of deferred policy acquisition costs (related party amounts of $916 and $947, respectively)		24,187		11,936
Other expense		10,208		9,725
Interest expense		913		—

Total expenses		99,827		43,257

Income before income taxes		11,107		5,904
Income taxes		3,368		1,785

Net income	$	7,739	$	4,119

Earnings per common share:
Basic	$	1.29	$	0.69
Diluted	$	1.25	$	0.67
Weighted average shares:
Basic		6,006,693		5,939,436
Diluted		6,192,731		6,155,328