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, 2007,

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 3, 2007

COMMON STOCK (No Par Value)		6,558,734

(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		33
	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
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.)

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
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

Forward-looking Statements

Mercer Insurance Group, Inc. (the “Group”) may from time to time make written or oral “forward-looking statements,” including statements contained in the Group’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 Group, which are made in good faith by the Group 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 Group’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 Group’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 Group’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 Group competes which are less favorable than expected;

the effects of weather-related and other catastrophic events;

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

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, 2007;

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 Company’s position within its agent’s offices relative to competitors, the stability of the Company’s independent agency force as agencies are sold or consolidated, and the volume of premium produced by the Company’s larger agents;

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;

inability to carry out marketing and sales plans, including, among others, development of new products or changes to existing products and acceptance of the new or revised products in the market;

unanticipated changes in industry trends and ratings assigned by nationally recognized rating organizations;

adverse litigation or arbitration results;

the ability to carry out our business plans; or

adverse changes in applicable laws, regulations or rules governing insurance holding companies and insurance companies, and environmental, tax or accounting matters including limitations on premium levels, increases in minimum capital and reserves, and other financial viability requirements, and changes that affect the cost of, or demand for our products.

The Group cautions that the foregoing list of important factors is not exclusive. Readers are also cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this report. The Group does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Group.

Part I — FINANCIAL INFORMATION

Item 1. Financial Statements

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET


	September 30,			December 31,
	2007			2006
	(Dollars in thousands)
	(Unaudited)
Assets
Investments, at fair value:
Fixed-income securities, available for sale, at fair value (cost $309,289 and $274,769, respectively)	$	308,204			273,454
Equity securities, at fair value (cost $11,115 and $10,940, respectively)		17,351			16,522
Short-term investments, at cost, which approximates fair value		5,743			7,692

Total investments		331,298			297,668

Cash and cash equivalents		14,963			17,618
Premiums receivable		43,702			38,030
Reinsurance receivables		93,217			87,987
Prepaid reinsurance premiums		9,935			16,383
Deferred policy acquisition costs		21,473			16,708
Accrued investment income		3,668			3,204
Property and equipment, net		12,152			11,936
Deferred income taxes		8,129			7,775
Goodwill		5,416			5,625
Other assets		3,998			4,033

Total assets	$	547,951			506,967


Liabilities and Equity
Liabilities:
Losses and loss adjustment expenses	$	271,006			250,455
Unearned premiums		92,232			81,930
Accounts payable and accrued expenses		15,576			13,442
Other reinsurance balances		18,504			24,588
Trust preferred securities		15,554			15,542
Advances under line of credit		3,000			3,000
Other liabilities		3,321			2,171

Total liabilities		419,193			391,128


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 shares and 7,064,233 shares, outstanding 6,688,146 and 6,582,232 shares		—			—
Additional paid-in capital		69,965			68,473
Accumulated other comprehensive income:
Unrealized gains in investments, net of deferred income taxes		3,400			2,815
Retained Earnings		65,042			54,629
Unearned ESOP shares		(3,288	)		(3,757	)
Treasury stock, 505,499 and 503,513 shares		(6,361	)		(6,321	)

Total stockholders’ equity		128,758			115,839

Total liabilities and stockholders’ equity	$	547,951			506,967

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2007 and 2006


	2007			2006
	(Dollars in thousands)
	(Unaudited)
Cash flows from operating activities:
Net income	$	11,355			7,739
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of fixed assets		1,605			1,834
Net amortization of premium		938			758
Amortization of restricted stock compensation		876			995
ESOP share commitment		892			904
Net realized investment gains		(267	)		(100	)
Deferred income tax		(655	)		(4,490	)
Change in assets and liabilities:
Premiums receivable		(5,672	)		(6,619	)
Reinsurance receivables		(5,230	)		(7,646	)
Prepaid reinsurance premiums		6,448			3,800
Deferred policy acquisition costs		(4,765	)		(6,971	)
Other assets		(424	)		1,079
Losses and loss adjustment expenses		20,551			30,676
Unearned premiums		10,302			9,766
Reinsurance balances payable		(6,084	)		5,933
Other		4,383			594

Net cash provided by operating activities		34,253			38,252


Cash flows from investing activities:
Purchase of fixed income securities, available for sale		(54,057	)		(163,045	)
Purchase of equity securities		(2,471	)		(4,468	)
Sale of short-term investments, net		1,949			2,490
Sale and maturity of fixed income securities, available for sale		17,505			116,848
Sale of equity securities		2,777			2,792
Purchase of property and equipment, net		(1,822	)		(1,922	)

Net cash used in investing activities		(36,119	)		(47,305	)


Cash flows from financing activities:
Purchase of treasury stock		(40	)		(37	)
Tax benefit from stock compensation plans		153			129
Proceeds from issuance of common stock		40			—
Dividends to stockholders		(942	)		(646	)

Net cash used in financing activities		(789	)		(554	)


Net decrease in cash and cash equivalents		(2,655	)		(9,607	)
Cash and cash equivalents at beginning of period		17,618			20,677

Cash and cash equivalents at end of period	$	14,963			11,070


Cash paid during the period for:
Interest	$	902			988
Income taxes	$	4,750			3,400

See accompanying notes to consolidated financial statements.

MERCER INSURANCE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(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.

Mercer Insurance Group, Inc. (MIG) and subsidiaries (collectively, the Group) includes Mercer Insurance Company (MIC), its subsidiaries Queenstown Holding Company, Inc. (QHC) and its subsidiary Mercer Insurance Company of New Jersey, Inc. (MICNJ), Franklin Holding Company, Inc. (FHC) and its subsidiary Franklin Insurance Company (FIC), and BICUS Services Corporation (BICUS). Effective October 1, 2005, MIG acquired Financial Pacific Insurance Group, Inc. (FPIG) and its subsidiaries, Financial Pacific Insurance Company (FPIC) and Financial Pacific Insurance Agency (FPIA), which is currently inactive after having sold the opportunity to solicit renewals to an unrelated agency for a fixed commission for one year, commencing in October, 2006. FPIG also holds an interest in three statutory business trusts that were formed for the purpose of issuing Floating Rate Capital Securities.

The Group, through its property and casualty insurance subsidiaries, provides a wide array of property and casualty insurance products designed to meet the insurance needs of individuals in New Jersey and Pennsylvania, and small and medium-sized businesses throughout Arizona, California, Nevada, New Jersey, New York, Oregon and Pennsylvania.

These financial statements should be read in conjunction with the financial statements and notes for the year ended December 31, 2006 included in the Group’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Share-Based Compensation

The Group makes grants of qualified (ISO’s) and non-qualified stock options (NQO’s), and non-vested shares (restricted stock) under its stock incentive 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 ten years for ISO’s and ten years and one month for NQO’s. Restricted stock grants vest over a period of three or five years.

Effective January 1, 2006, the Group adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment”, using the modified-prospective-transition method. There was no retroactive impact upon adoption. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for stock options (net of forfeitures) for the three months ended September 30, 2007 and 2006 was $54,000 and $130,000, respectively, and for the nine months ended September 30, 2007 and 2006 was $366,000 and $385,000, respectively. The compensation expense recorded (after tax benefit) in the consolidated statements of earnings for restricted stock (net of forfeitures) for the three months ended September 30, 2007 and 2006 was $47,000 and $112,000, respectively, and for the nine months ended September 30, 2007 and 2006 was $277,000 and $319,000, respectively.

As of September 30, 2007, the Group has $1.2 million of unrecognized total compensation cost related to non-vested stock options and restricted stock, based on the estimated grant date fair value. That cost will be recognized over the remaining weighted-average vesting period of 2.5 years.

For the nine months ended September 30, 2007, the Group made no grants of restricted stock and stock options. A total of 19,400 ISO’s and 3,000 shares of restricted stock were forfeited during the nine months ended September 30, 2007. A total of 3,000 ISO’s granted under the plan were exercised during the nine months ended September 30, 2007.

Recent Accounting Pronouncements

In February 2006, the 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, “Accounting

for Derivative Instruments and Hedging Activities”; 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, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, 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 adoption of SFAS No. 155 did not have a significant effect on operations, financial condition or liquidity.

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 Group is currently evaluating the impact that SFAS No. 157 will have, if any, on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value at specified election dates. Upon adoption, an entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Most of the provisions apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” applies to all entities with available for sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Group is currently evaluating the impact that SFAS No. 159 will have, if any, on its consolidated financial statements.

(2) Segment Information

The Group markets its products through independent insurance agents, which sell commercial lines of insurance to small to medium-sized businesses and personal lines of insurance to individuals.

The Group 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
	2007			2006
	(In thousands)
Revenues:
Net premiums earned:
Commercial lines	$	89,828		$	85,263
Personal lines		16,539			16,909

Total net premiums earned		106,367			102,172
Net investment income		9,592			7,057
Net realized investment gains		267			100
Other		1,494			1,605

Total revenues	$	117,720		$	110,934

Income before income taxes:
Underwriting income (loss):
Commercial lines	$	6,489		$	4,468
Personal lines		(879	)		(1,210	)

Total underwriting income		5,610			3,258
Net investment income		9,592			7,057
Net realized investment gains		267			100
Other		583			692

Income before income taxes	$	16,052		$	11,107


	Three Months Ended September 30
	2007			2006
	(In thousands)
Revenues:
Net premiums earned:
Commercial lines	$	31,867		$	29,336
Personal lines		5,436			5,668

Total net premiums earned		37,303			35,004
Net investment income		2,880			2,597
Net realized investment gains		(366	)		(505	)
Other		587			527

Total revenues	$	40,404		$	37,623

Income before income taxes:
Underwriting income (loss):
Commercial lines	$	983		$	1,254
Personal lines		367			(342	)

Total underwriting income		1,350			912
Net investment income		2,880			2,597
Net realized investment losses		(366	)		(505	)
Other		287			215

Income before income taxes	$	4,151		$	3,219

(3) Reinsurance

Premiums earned are net of amounts ceded of $24.9 million and $36.3 million for the nine months ended September 30, 2007 and 2006, respectively and $7.4 million and $11.4 million for the three months ended September 30, 2007 and 2006, respectively. Losses and loss adjustment expenses are net of amounts ceded of $16.2 million and $27.6 million for the nine months ended September 30, 2007 and 2006, respectively and $2.8 million and $12.1 million for the three months ended September 30, 2007 and 2006, respectively.

The reinsurance program renewed for 2007 with a number of changes focused on taking advantage of the Group’s capital position by reducing the level of ceded premium and retaining more of the business it writes. Effective January 1, 2007, the Group increased its retention to $750,000 (from a maximum retention of $500,000 in 2006) on the casualty, property and workers’ compensation lines of business. Additionally, the Group strengthened the credit quality of its reinsurers by replacing the various syndicates of reinsurers on its primary treaties (i.e., treaties covering risk limits less than $1.0 million on casualty lines, less than $5.0 million on property lines and less than $10 million on workers’ compensation) with a single reinsurer, General Reinsurance Corporation, rated A++ (Superior) by A.M. Best, their highest rating.

In conjunction with the renewal of the reinsurance program in 2007, the 2006 reinsurance treaties were terminated on a run-off basis, which requires that for policies in force as of December 31, 2006, these reinsurance agreements continue to cover losses occurring on these policies in the future. Therefore, the Group will continue to remit premiums to and collect reinsurance recoverables from these syndicates of reinsurers as the underlying business runs off.

Effective January 1, 2006, FPIC 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 at January 1, 2006 by FPIC 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 for the nine months ended September 30, 2006, and a $1.4 million increase in net earned premium for the three months ended September 30, 2006. There was no similar impact in 2007 relating to this restructuring.

(4) Comprehensive Income

The Group’s comprehensive income for the nine and three month periods ended September 30, 2007 and 2006 is as follows:


	Nine months ended
	September 30
	2007			2006
	(In thousands)
Net income	$	11,355		$	7,739
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period, net of related income tax expense (benefit) of $462 and ($39)		897			(76	)
Less reclassification adjustment for gains included in net income, net of related income tax expense of $161 and $5		(312	)		(11	)

		585			(87	)

Comprehensive income	$	11,940		$	7,652


	Three months ended
	September 30
	2007			2006
	(In thousands)
Net income	$	3,012		$	2,194
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax expense of $1,461 and $1,685		2,836			3,271
Less reclassification adjustment for gains included in net income, net of related income tax expense of $44 and $4		(85	)		(7	)

		2,751			3,264

Comprehensive income	$	5,763		$	5,458

(5) Share-based Compensation

The Group adopted the Mercer Insurance Group, Inc. 2004 Stock Incentive Plan (the Plan) on June 16, 2004. Awards under the Plan may be made in the form of incentive stock options, nonqualified stock options, restricted stock or any combination to employees and non-employee Directors. 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, 2007, the Plan’s authorization has been increased under this feature to 1,075,870 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 grants made under the plan 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. Upon exercise, it is anticipated that newly issued shares will be issued to the option holder.

For the nine months ended September 30, 2007, the Group made no grants of restricted stock and stock options. A total of 19,400 Incentive Stock Options and 3,000 shares of restricted stock were forfeited in the first nine months of 2007. A total of 3,000 incentive stock options granted under the plan were exercised during in the first nine months of 2007.

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


				Weighted Average
	Number of			Exercise Price
	Shares			per Share
Outstanding at December 31, 2006		636,700		$	13.21
Granted — 2007		—			—
Exercised — 2007		(3,000	)		13.25
Forfeited — 2007		(19,400	)		12.85

Outstanding at September 30, 2007		614,300		$	13.22


Exercisable at:
September 30, 2007		497,300		$	12.24
Weighted-average remaining contractual life				7.1 years
Compensation remaining to be recognized for unvested stock options at September 30, 2007 (millions)				$	0.6
Weighted-average remaining amortization period					2.5
Aggregate Intrinsic Value of outstanding options, September 30, 2007 (millions)				$	3.1
Aggregate Intrinsic Value of exercisable options, September 30, 2007 (millions)				$	2.7

In determining the expense to be recorded for stock options in the consolidated statements of earnings, the fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The significant assumptions utilized in applying the Black-Scholes-Merton option pricing model are the risk-free interest rate, expected term, dividend yield, and expected volatility. The risk-free interest rate is the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected term used as the assumption in the model. The expected term of an option award is based on expected experience of the awards. The dividend yield is determined by dividing the per share-dividend by the grant date stock price. The expected volatility is based on the volatility of the Group’s stock price over a historical period.

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


				Weighted
				Average
	Number of			Fair Value
	Shares			per Share
Unvested restricted stock at December 31, 2006		106,334		$	13.61
Granted — 2007		—			—
Vested — 2007		(56,084	)		12.22
Forfeited — 2007		(3,000	)		12.21

Unvested restricted stock at September 30, 2007		47,250		$	15.35

Compensation remaining to be recognized for unvested restricted stock at September 30, 2007 (millions)				$	0.6
Weighted-average remaining amortization period					2.1

(6) Earnings per Share

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


	Nine months ended
	September 30
	2007		2006
	(Dollars in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net income	$	11,355	$	7,739

Denominator for basic earnings per share — weighted-average shares		6,125,654		6,006,693
Effect of stock incentive plans		192,375		186,038

Denominator for diluted earnings per share		6,318,029		6,192,731

Basic earnings per share	$	1.85	$	1.29

Diluted earnings per share	$	1.80	$	1.25


	Three months ended
	September 30
	2007		2006
	(Dollars in thousands, except per share data)
Numerator for basic and diluted earnings per share:
Net income	$	3,012	$	2,194

Denominator for basic earnings per share — weighted-average shares		6,174,842		6,055,132
Effect of stock incentive plans		171,023		210,756

Denominator for diluted earnings per share		6,345,865		6,265,888

Basic earnings per share	$	0.49	$	0.36

Diluted earnings per share	$	0.47	$	0.35

The denominator for diluted earnings per share does not include the effect of outstanding stock options that have an anti-dilutive effect. As of September 30, 2007, 40,000 stock options were considered to be anti-dilutive and were excluded from the earnings per share calculation. As of September 30, 2006, there were no stock options considered to be anti-dilutive.

(7) Income Taxes

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. On January 1, 2007, the Group adopted FIN 48. As a result of adoption, the Group recognized a previously unrecognized tax benefit of approximately $0.2 million relating to merger-related expenses for the FPIG acquisition that took place October 1, 2005. The application of FIN 48 for this unrecognized tax benefit resulted in a corresponding reduction to goodwill relating to the FPIG acquisition of $0.2 million. The adoption of FIN 48 did not result in any adjustments to beginning retained earnings, nor have a significant effect on operations, financial condition or liquidity. As of January 1, 2007, the Group has no unrecognized tax benefits. Accordingly, the Group has no interest accrued relating to unrecognized tax benefits. The Group’s policy is to account for interest and penalties as a component of other expenses. The Group files income tax returns in the federal jurisdiction and various states.

(8) Retaliatory tax refund

As previously disclosed in the Group’s SEC filings, the Group paid an aggregate of $3.5 million, including accrued interest, to the New Jersey Division of Taxation (the “Division”) in retaliatory premium tax for the years 1999-2004. In conjunction with making such payments, the Group filed notices of protest with the Division with respect to the retaliatory tax imposed. The payments were made in response to notices of deficiency issued by the Division to the Group.

Pursuant to the protests, the Group has received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest, previously made by the Group for the periods 1999-2004. The refund has been recorded, after reduction for Federal income tax, in the amount of $2.8 million in the consolidated statement of earnings, with $2.5 million recorded in the quarter ending June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007. The allocation of the refund to pre-tax earnings included an increase to net investment income of $720,000, with $687,000 of that amount recognized in the quarter ended June 30, 2007, and $33,000 recognized in the quarter ended September 30, 2007, for the interest received on the refund, and $3.6 million as a reduction to Other Expense to recognize the recovery of amounts previously charged to Other Expense, with $3.1 million of that amount recognized in the quarter ended June 30, 2007, and $0.5 million recognized in the quarter ended September 30, 2007.

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 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. (MIG 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 (collectively, the Group). 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 (MIC), 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. (MICNJ), a New Jersey property and casualty stock insurance company offering insurance coverages to businesses and individuals located in New Jersey;

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

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

The Group’s insurance subsidiaries are licensed collectively in twenty two states, but are currently focused on doing business in six states; Arizona, California, Nevada, New Jersey, Pennsylvania and Oregon. MIC and MICNJ are licensed to write property and casualty insurance in New York, with a current focus on writing business there which supports existing accounts, and with possible future expansion in other programs. FPIC holds an additional fifteen state licenses outside of the Group’s current focus area. Currently, only direct marketed surety is being written in some of these states.

The Group is subject to regulation by the insurance regulators of each state in which it is licensed to transact business. The primary regulators are the Pennsylvania Insurance Department, the California Department of Insurance, and the New Jersey Department of Banking and Insurance, because these are the regulators for the states of domicile of the Group’s insurance subsidiaries, as follows: MIC (Pennsylvania-domiciled), FPIC (California-domiciled), MICNJ (New Jersey-domiciled), and FIC (Pennsylvania-domiciled).

The insurance affiliates within the Group participate in a reinsurance pooling arrangement (the “Pool”) whereby each insurance affiliate’s underwriting results are combined and then distributed proportionately to each participant. Each insurer’s share in the Pool is based on their respective statutory surplus from the most recently filed statutory annual statement as of the beginning of each year.

All insurance companies in the Group have been assigned a group rating of “A” (Excellent) by A.M. Best. The Group has been assigned that rating for the past 6 years, and the rating was affirmed in May, 2007. An “A” rating is the third highest rating of A.M. Best’s 16 possible rating categories.

We manage our business and report our operating results in three operating segments: commercial lines insurance (including surety), personal lines insurance and the investment function. 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 insurance coverages. Our personal lines insurance business consists primarily of homeowners (in New Jersey and Pennsylvania) and private passenger automobile (in Pennsylvania only) insurance coverages.

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.

Critical Accounting Policies

General. The Group’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, 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 FPIC’s business 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, 2007.

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 is not intended to illustrate what could be the potential best or worst case or likely scenarios:


	Adjusted Loss and					Adjusted Loss and
Change in Loss	Loss Adjustment		Percentage			Loss Adjustment		Percentage
and Loss	Reserves Net of		Change in			Reserves Net of		Change in
Adjustment	Reinsurance as of		Equity as of			Reinsurance as of		Equity as of
Reserves Net of	September 30,		September 30,			December 31,		December 31,
Reinsurance	2007		2007 (1)			2006		2006 (1)
(Dollars in thousands)
(10.0)%	$	164,591		9.4	%	$	148,070		9.4	%
(7.5)%		169,163		7.0	%		152,183		7.0	%
(5.0)%		173,735		4.7	%		156,296		4.7	%
(2.5)%		178,306		2.3	%		160,409		2.3	%
Base		182,878		—			164,522		—
2.5%		187,450		(2.3	%)		168,635		(2.3	)%
5.0%		192,022		(4.7	%)		172,748		(4.7	)%
7.5%		196,594		(7.0	%)		176,861		(7.0	)%
10.0%		201,166		(9.4	%)		180,974		(9.4	)%


(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, FPIC, 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,		December 31,
	2007		2006
	(In thousands)
Commercial lines:
Commercial multi-peril	$	194,440	$	181,523
Commercial automobile		41,107		36,647
Other liability		9,751		8,462
Workers’ compensation		8,375		8,107
Surety		6,040		5,104
Fire, allied, inland marine		202		222

		259,915		240,065

Personal lines:
Homeowners		7,500		6,724
Personal automobile		2,013		2,213
Other liability		1,166		1,079
Fire, allied, inland marine		368		333
Workers’ compensation		44		41

		11,091		10,390

Total	$	271,006	$	250,455

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 Group’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 $0.9 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, after giving 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.

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. The operating results of the United States property and casualty insurance industry are subject to significant variations due to competition, weather, catastrophic events, regulation, general economic conditions, judicial trends, fluctuations in interest rates and other changes in the investment environment.

Our premiums earned mix reflects the Group’s focus on growing the commercial lines book, while working within our underwriting standards.

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 current market is highly competitive, with pricing and coverage competition being seen in virtually all classes of commercial accounts, package policies, commercial automobile policies and in the Pennsylvania personal auto market and Pennsylvania and New Jersey homeowners markets, all of which impacts our ability to retain our accounts on renewal, or to renew a policy at expiring premium. We continue to work with our agents to target classes of business and accounts compatible with our underwriting appetite, which includes certain types of religious institution risks, contracting risks, small business risks and property risks. As a result of what management believes is a soft market, commercial lines direct written premium declined in the first nine months of 2007, as compared to the first nine months of 2006, due in part to increased competition, among other factors discussed more in detail below in the 2007 vs. 2006 Revenue discussion. Nevertheless, while commercial lines direct written premiums written declined in the nine months ended September 30, 2007, versus the same period in the prior year, commercial lines direct premiums written showed a 3.9% increase in the quarter ended September 30, 2007, as compared to the same quarter in the previous year. The current marketplace is also affording the Company the opportunity to bid on increased levels of new business opportunities.

The availability of reinsurance at reasonable pricing is an important part of our business. Effective, January 1, 2007, the Group increased its retention to $750,000 (from a maximum retention of $500,000 in 2006) on the casualty, property and workers’ compensation lines of business. As the Group increases the net retention of the business it writes, net premiums written and earned will increase and ceded losses will decrease. The impact of increased retentions under our reinsurance program in 2007 was offset in part by a decline in direct written premium due to the increasingly competitive marketplace. As older reinsurance treaties run off, the impact described above of the new reinsurance program will become more evident in net premiums written and net premiums earned.

The Group does not write homeowners insurance or other personal lines in California, nor does it have significant exposure to commercial risks in the areas affected by the recent wildfires in Southern California. Consequently, the Company expects to have very limited claim activity in connection with such wildfires.

Nine and three month periods ended September 30, 2007, compared to the same periods in 2006:

The components of income for 2007 and 2006, 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,
2007 vs. 2006 Income	2007			2006			Change			% Change
	(Dollars in thousands)
Commercial lines underwriting income	$	6,489		$	4,468		$	2,021			45.2	%
Personal lines underwriting loss		(879	)		(1,210	)		331			(27.4	)%
Total underwriting income		5,610			3,258			2,352			72.2	%
Net investment income		9,592			7,057			2,535			35.9	%
Net realized investment gains		267			100			167			167.0	%
Other		1,494			1,605			(111	)		(6.9	)%
Interest expense		(911	)		(913	)		2			(0.2	)%
Income before income taxes		16,052			11,107			4,945			44.5	%
Income taxes		4,697			3,368			1,329			39.5	%
Net Income	$	11,355		$	7,739		$	3,616			46.7	%
Loss/ LAE ratio (GAAP)		61.5	%		63.1	%		(1.6	)%
Underwriting expense ratio (GAAP)		33.2	%		33.7	%		(0.5	)%
Combined ratio (GAAP)		94.7	%		96.8	%		(2.1	)%
Loss/ LAE ratio (Statutory)		61.5	%		60.3	%		1.2	%
Underwriting expense ratio (Statutory)		31.5	%		34.0	%		(2.5	)%
Combined ratio (Statutory)		93.0	%		94.3	%		(1.3	)%


Three months ended September 30,
2007 vs. 2006 Income	2007			2006			Change			% Change
	(Dollars in thousands)
Commercial lines underwriting income	$	983		$	1,254		$	(271	)		(21.6	)%
Personal lines underwriting gain (loss)		367			(342	)		709			(207.3	)%
Total underwriting income		1,350			912			438			48.0	%
Net investment income		2,880			2,597			283			10.9	%
Net realized investment losses		(366	)		(505	)		139			(27.5	)%
Other		587			527			60			11.4	%
Interest expense		(300	)		(312	)		12			(3.8	)%
Income before income taxes		4,151			3,219			932			29.0	%
Income taxes		1,139			1,025			114			11.1	%
Net Income	$	3,012		$	2,194		$	818			37.3	%
Loss/ LAE ratio (GAAP)		61.0	%		63.8	%		(2.8	)%
Underwriting expense ratio (GAAP)		35.4	%		33.6	%		1.8	%
Combined ratio (GAAP)		96.4	%		97.4	%		(1.0	)%
Loss/ LAE ratio (Statutory)		61.1	%		62.8	%		(1.7	)%
Underwriting expense ratio (Statutory)		33.9	%		33.2	%		0.7	%
Combined ratio (Statutory)		94.9	%		96.0	%		(1.1	)%

The Group has received $4.3 million in 2007 as a reimbursement of protested payments of retaliatory tax, including accrued interest thereon, previously made by the Group for the periods 1999-2004. The refund has been recorded, after reduction for Federal income tax, in the amount of $2.8 million in the consolidated statement of earnings, with $2.5 million recorded in the quarter ending June 30, 2007, and $0.3 million recorded in the quarter ended September 30, 2007. The allocation of the refund to pre-tax earnings included an increase to net investment income of $720,000, with $687,000 of that amount recognized in the quarter ended June 30, 2007, and $33,000 recognized in the quarter ended September 30, 2007, for the interest received on the refund, and $3.6 million as a reduction to Other Expense to recognize the recovery of amounts previously charged to Other Expense, with $3.1 million of that amount recognized in the quarter ended June 30, 2007, and $0.5 million recognized in the quarter ended September 30, 2007. This is a non-recurring item which significantly affects the earnings of both the three and nine month periods ended September 30, 2007, and related performance metrics such as the combined ratio.

The Group’s GAAP combined ratio for the first nine months of 2007 was 94.7%, as compared to the combined ratio for the first nine months of 2006 of 96.8%. On a pro-forma basis, after removing the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for the first nine months of 2007 was 98.1%. The statutory combined ratio for the first nine months of 2007 and 2006 was 93.0% and 94.3%, respectively. See discussion below relating to commercial and personal lines performance.

The Group’s GAAP combined ratio for the third quarter of 2007 was 96.4%, as compared to the combined ratio for the same period in 2006 of 97.4%. On a pro-forma basis, after removing the effect of the non-recurring retaliatory tax refund described above, the GAAP combined ratio for the third quarter of 2007 was 97.7%. The statutory combined ratio for the third quarter of 2007 and 2006 was 94.9% and 96.0%, respectively.

Net investment income for the nine months ended September 30, 2007, increased $2.5 million to $9.6 million for the period. $720,000 of the increase is attributable to the non-recurring impact on investment income of the refund of retaliatory taxes described above. The balance of the increased investment income is due to increased cash and invested assets, resulting from operating cash flow and the reduced premium ceded to reinsurers in 2007, as well as a favorable interest rate environment. Net investment income for the third quarter of 2007 increased $0.3 million over the prior year to $2.9 million, with $33,000 of the increase being attributable to the non-recurring retaliatory tax refund described above.

Realized investment gains in the nine months ended September 30, 2007, amounted to $267,000, as compared to $100,000 in the same period in 2006, driven in part by changes in the fair value of the interest rate swaps for the floating rate trust preferred securities. Other revenue, which is primarily service charges recorded on installment payments of insurance premiums, totaled $1.5 million and $1.6 million for the first nine months of 2007 and 2006, respectively. Interest expense of $911,000 and $913,000 for the first nine months of 2007 and 2006, respectively, represents interest expense related to the trust preferred obligations.

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


Nine months ended September 30,
2007 vs. 2006 Revenue	2007		2006		Change			% Change
	(In thousands)
Direct premiums written	$	140,506	$	146,470	$	(5,964	)		(4.1	)%
Net premiums written		123,116		115,738		7,378			6.4	%
Net premiums earned		106,367		102,172		4,195			4.1	%
Net investment income		9,592		7,057		2,535			35.9	%
Net realized investment gains		267		100		167			167.0	%
Other revenue		1,494		1,605		(111	)		(6.9	)%
Total revenue	$	117,720	$	110,934	$	6,786			6.1	%


Three months ended September 30,
2007 vs. 2006 Revenue	2007			2006			Change		% Change
	(In thousands)
Direct premiums written	$	47,027		$	45,749		$	1,278		2.8	%
Net premiums written		41,110			34,809			6,301		18.1	%
Net premiums earned		37,303			35,004			2,299		6.6	%
Net investment income		2,880			2,597			283		10.9	%
Net realized investment losses		(366	)		(505	)		139		(27.5	)%
Other revenue		587			527			60		11.4	%
Total revenue	$	40,404		$	37,623		$	2,781		7.4	%

Total revenues for the first nine months of 2007 increased $6.8 million or 6.1% to $117.7 million, as compared to $110.9 million in the same period of 2006. This increase was due primarily to an increase in net premiums earned and net investment income. Net premiums earned totaled $106.4 million for the first nine months of 2007 as compared to $102.2 million for the same period in 2006, representing a 4.1%, or $4.2 million, increase. Net premiums written increased 6.4%, to $123.1 million, as compared to $115.7 million for the same period in 2006. Net premiums written and net premiums earned were impacted in the first nine months of 2007 by the volume of audit premium recorded, which is earned immediately upon recording, and by changes in reinsurance arrangements (see discussion below).

Net investment income totaled $9.6 million for the first nine months of 2007, as compared to $7.1 million for the same period in 2006, representing a 35.9% or $2.5 million increase. The increase in net investment income in the nine months of 2007 is primarily driven by an increase in average cash and invested assets and a favorable interest rate environment, as well as the $720,000 non-recurring impact of the retaliatory tax refund. Realized investment gains amounted to $267,000 in the first nine months of 2007, as compared to $100,000 in the same period in 2006. The gains in the nine months of 2007 and 2006 included mark-to-market fair value adjustments on the interest rate swaps related to the floating-rate trust preferred securities. See the investment income discussion below for further information.

Total revenues for the third quarter of 2007 increased $2.8 million or 7.4% to $40.4 million, as compared to $37.6 million in the same period of 2006. This increase was due primarily to an increase in net premiums earned. Net premiums earned totaled $37.3 million for the third quarter of 2007, as compared to $35.0 million for the same period in 2006, representing a 6.6% or $2.3 million increase.

Net investment income totaled $2.9 million for the third quarter of 2007 as compared to $2.6 million for the same period in 2006, representing a 10.9% or $283,000 increase. The increase in net investment income in the third quarter of 2007 is primarily driven by an increase in average cash and invested assets and a favorable interest rate environment, as well as a $33,000 non-recurring impact from the retaliatory tax refund. Realized investment losses amounted to $366,000 in the third quarter of 2007, as compared to a loss of $505,000 in the same period in 2006. The losses in the third quarter of 2007 and 2006 included mark-to-market fair value adjustments on the interest rate swaps related to the floating-rate trust preferred securities.

In the nine months and quarter ended September 30, 2007, direct premiums written decreased $6.0 million or 4.1% to $140.5 million, and increased $1.3 million or 2.8% to $47.0 million, respectively, as compared to the same periods in 2006. The year-to-date decline in direct premiums written is attributed to a more difficult economic environment and competitive market conditions, including a decline in construction related activity and related audit premium in California, increased competition on large accounts as well as the return of a number of competitors to the California contractor market and the East Coast habitational market. The increase in direct premiums written in the third quarter relates to greater production by existing agents, expansion of our agency force, and introduction of new and enhanced products.

The decline in year-to-date audit premium, as compared to the prior year, relates to a general decline in construction related activity, specifically in California, driven by a slowdown of the residential housing market. Approximately 50% of FPIC’s business (and approximately one-third of the Group’s business in total) is related to artisan contractor liability, primarily in the central valley of California.

Commercial multiple peril policies constitute a majority of the business written in FPIC’s contractor book of business. The premium on these policies is estimated at policy inception based on a prediction of the volume of the insured’s business operations during the policy period. In addition to endorsing the policy throughout the policy period based on known information, at policy expiration FPIC conducts an audit of the insured’s business operations in order to adjust the policy premium from an estimate to actual. Contractor liability policy premium tends to vary with local construction activity as well as changes in the nature of the contractor’s operations. The decline in construction related activity has impacted both the volume of premium for the contractor in-force book of business and the related audit premium on expiring policies. Audits for the first nine months of 2007, primarily of construction related policies, generated $2.2 million of premium, representing a decline of $7.4 million as compared to $9.6 million of premium that was generated in the first nine months of 2006. Similarly, in the third quarter of 2007, audits generated $600,000 in premium, a reduction of $1.6 million from the $2.2 million audit premium generated in the third quarter of 2006.

The decline in year-to-date direct premiums written also reflects an increasingly competitive marketplace and what management characterizes as a soft market. There has been increased competition on large accounts particularly in the East Coast habitational and California contractor programs, as competitors aggressively compete for these higher premium accounts. Management continues to maintain its policy of disciplined underwriting and pricing standards, declining business which is inadequately priced for its level of risk.

Effective, January 1, 2007, the Group consolidated the reinsurance program of all subsidiaries into a single program, and increased its reinsurance retention to $750,000 (from a maximum retention of $500,000 in 2006) on the working layer for all casualty, property and workers’ compensation lines of business. The effect of this change in reinsurance arrangements increased net premiums written for the first nine months of 2007.

Growth in Net Investment Income is discussed below.


Nine months ended September 30,
2007 vs. 2006 Investment Income and
Realized Gains	2007			2006			Change			% Change
	(In thousands)
Fixed income securities	$	9,627		$	7,961		$	1,666			20.9	%
Dividends		219			213			6			2.8	%
Cash, cash equivalents & other		1,458			710			748			105.4	%
Gross investment income		11,304			8,884			2,420			27.2	%
Investment expenses		(1,712	)		(1,827	)		115			6.3	%
Net investment income	$	9,592		$	7,057		$	2,535			35.9	%
Realized losses — fixed income securities	$	(8	)	$	(385	)	$	377			N/M
Realized gains — equity securities		481			401			80			N/M
Mark-to-market valuation for interest rate swaps		(206	)		84			(290	)		N/M
Net realized gains	$	267		$	100		$	167			167.0	%


Three months ended September 30,
2007 vs. 2006 Investment Income and
Realized Gains	2007			2006			Change			% Change
	(In thousands)
Fixed income securities	$	3,209		$	2,818		$	391			13.9	%
Dividends		72			68			4			5.9	%
Cash, cash equivalents & other		396			307			89			29.0	%
Gross investment income		3,677			3,193			484			15.2	%
Investment expenses		(797	)		(596	)		(201	)		(33.7	)%
Net investment income	$	2,880		$	2,597		$	283			10.9	%
Realized losses — fixed income securities	$	(8	)	$	—		$	(8	)		N/M
Realized gains — equity securities		138			11			127			N/M
Mark-to-market valuation for interest rate swaps		(496	)		(516	)		20			N/M
Net realized losses	$	(366	)	$	(505	)	$	139			(27.5	)%

(N/M means “not meaningful”)

In the first nine months of 2007, net investment income increased $2.5 million, or 35.9% to $9.6 million, as compared to $7.1 million in the first nine months of 2006. Our investment income benefited in 2007 from a favorable interest rate environment and an increase in average cash and invested assets. The increase in invested assets is driven primarily by operating cash flow, including the benefit of the 2007 reinsurance agreement, which results in less premium being ceded to reinsurers.

In the first nine months of 2007, investment income on fixed income securities increased $1.6 million, or 20.9% to $9.6 million, as compared to $8.0 million in the same period in 2006. This was driven by a favorable interest rate environment and an increase in the average investments held in fixed income securities caused by the reasons described above. The Group’s tax equivalent yield (yield adjusted for tax-benefit received on tax-exempt securities) on fixed income securities increased to 5.24% in the first nine months of 2007, as compared to 5.12% in the same period in 2006.

Dividend income in the nine months ended September 30, 2007, was comparable to that of the same period in 2006. Interest income on cash and cash equivalents increased $748,000 to $1.5 million, primarily as a result of the $720,000 of non-recurring interest received on the retaliatory tax refund. Investment expenses in the first nine months of 2007 decreased 6.3%, or $115,000, to $1.7 million in the first nine months of 2007 from $1.8 million in the nine months of 2006.

In the third quarter of 2007, net investment income increased $283,000, or 10.9% to $2.9 million, as compared to $2.6 million in the third quarter of 2006. In the third quarter of 2007, investment income on fixed income securities increased $391,000, or 13.9% to $3.2 million, as compared to $2.8 million in the same period in 2006.

Dividend income in the third quarter of 2007, was comparable to that of the same period in 2006. Interest income on cash and cash equivalents increased $89,000 to $396,000, including $33,000 of non-recurring interest received on the retaliatory tax refund. Investment expenses in the third quarter of 2007 increased 33.7%, or $201,000, to $797,000 from $596,000 in the same period in 2006.

Net realized gains for the nine months of 2007 were $267,000, as compared to $100,000 in the same period of 2006. In the first nine months of 2007, net realized gains of $267,000 included losses on securities sales of $94,000, a loss on the mark-to-market valuation on the interest rate swaps of $206,000, write-down of securities determined to be other than-temporarily impaired of $28,000, and gains of $595,000 on the sale of equity investments. In the first nine months of 2006, net realized gains of $100,000 included losses on securities sales of $552,000, a gain on the mark-to-market valuation on the interest rate swaps of $84,000, gains of $689,000 from the sale of securities, and a loss of $121,000 from the write-down of securities determined to be other-than-temporarily impaired. Securities determined to be other-than-temporarily impaired were written down to our estimate of fair market value at the time of the write-down. The Group has entered into five interest rate swap agreements to hedge against interest rate risk on its floating rate trust preferred securities. The estimated fair value of the interest rates swaps is obtained from the third-party financial institution counterparties. The Group marks the investments to market using these valuations and records the change in the economic value of the interest rate swaps as a realized gain or loss in the consolidated statement of earnings.

The fixed income portfolio is invested 100% in investment grade securities, with the exception of one fixed maturity investment held with a value of $0.5 million, as of September 30, 2007, with an average rating of AA, an average maturity of 5.3 years (excluding mortgage-backed securities), and an average tax equivalent yield of 5.24%. The Group holds no investments in sub-prime lenders and any exposure it has is limited to indirect exposure, through asset-backed securities. The asset-backed securities held by the Company which are invested in sub-prime home equity loans are carried at approximately $2.0 million, with approximately 75% and 25% having a credit rating of AAA and AA, respectively, are in the most secure tranche of the ABS’s, and with approximately half of the value insured against default as to principal and interest.

The estimated fair value and unrealized loss for securities in a temporary unrealized loss position as of September 30, 2007 are as follows:


	Less than 12 Months				12 Months or Longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
September 30, 2007	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
	(In Thousands)
U.S. Treasury securities and obligations of U.S. government corporations and agencies	$	15,223	$	46	$	36,264	$	507	$	51,487	$	553
Obligations of states and political subdivisions		41,386		284		39,600		326		80,986		610
Corporate securities		4,618		121		41,416		639		46,034		760
Mortgage-backed securities		8,666		42		9,113		112		17,779		154

Total fixed maturities		69,893		493		126,393		1,584		196,286		2,077

Total equity securities		1,791		115		—		—		1,791		115

Total securities in a temporary unrealized loss position	$	71,684	$	608	$	126,393	$	1,584	$	198,077	$	2,192

Fixed maturity investments with unrealized losses for less than twelve months are primarily due to changes in the interest rate environment. At September 30, 2007, the Group has 169 fixed maturity securities with unrealized losses for more than twelve months. Of the 169 securities with unrealized losses for more than twelve months, 166 of them have fair values of no less than 95% of cost, and the other 3 securities have a fair value greater than 92% of cost. The fixed income portfolio is invested 100% in investment grade securities, with the exception of one fixed maturity investment held with a value of $0.5 million, as of September 30, 2007, and these unrealized losses primarily reflect the current interest rate environment. The Group believes these declines are temporary.

There are 9 common stock securities that are in an unrealized loss position at September 30, 2007. All of these securities have been in an unrealized loss position for less than four months. The original cost of these securities is $1.1 million, and the unrealized loss is $76,000 at September 30, 2007. There are 2 preferred stock securities that are in an unrealized loss position at September 30, 2007. These securities have been in an unrealized loss position for less than ten months. The original cost of these securities is $0.8 million, and the unrealized loss is $39,000 at September 30, 2007. The Group believes these declines are temporary.

Results of our Commercial Lines segment were as follows:


Nine months ended September 30,
2007 vs. 2006 Commercial Lines (CL)	2007			2006			Change			% Change
	(Dollars in thousands)
CL Direct premiums written	$	123,245		$	128,170		$	(4,925	)		(3.8	)%
CL Net premiums written	$	107,353		$	98,842		$	8,511			8.6	%
CL Net premiums earned	$	89,828		$	85,263		$	4,565			5.4	%
CL Loss/ LAE expense ratio (GAAP)		59.6	%		62.2	%		(2.6)	%
CL Expense ratio (GAAP)		33.2	%		32.6	%		0.6	%
CL Combined ratio (GAAP)		92.8	%		94.8	%		(2.0)	%


Three months ended September 30,
2007 vs. 2006 Commercial Lines (CL)	2007			2006			Change			% Change
	(Dollars in thousands)
CL Direct premiums written	$	40,871		$	39,332		$	1,539			3.9	%
CL Net premiums written	$	35,490		$	28,879		$	6,611			22.9	%
CL Net premiums earned	$	31,867		$	29,336		$	2,531			8.6	%
CL Loss/ LAE expense ratio (GAAP)		62.0	%		63.1	%		(1.1	)%
CL Expense ratio (GAAP)		34.9	%		32.6	%		2.3	%
CL Combined ratio (GAAP)		96.9	%		95.7	%		1.2	%

In the first nine months of 2007, our commercial lines direct premiums written decreased by $4.9 million or 3.8% to $123.2 million as compared to direct written premium in the first nine months of 2006 of $128.2 million. In the third quarter of 2007, our commercial lines direct premiums written increased by $1.5 million or 3.9% to $40.8 million as compared to direct written premium in the third quarter of 2006 of $39.3 million. The decline in year-to-date direct premiums written is attributed to several factors including a decline in construction related activity and related audit premium in California, increased competition on large accounts, as well as the return of a number of competitors to the California contractor market and the East Coast habitational market. See additional discussion above in the 2007 vs. 2006 Revenue discussion.

In the first nine months of 2007, our commercial lines net premiums written increased by $8.5 million, or 8.6%, to $107.4 million as compared to net premiums written in the same period of 2006 of $98.8 million. Net premiums earned in the same period increased 5.4%, or $4.6 million, to $89.8 million from $85.3 million in the first nine months of 2006. See additional discussion above in the 2007 vs. 2006 Revenue discussion.

In the third quarter of 2007, our commercial lines net premiums written increased by $6.6 million, or 22.9%, to $35.5 million as compared to net premiums written in the same period of 2006 of $28.9 million. Net premiums earned in the same period increased 8.6%, or $2.5 million, to $31.9 million from $29.3 million in the third quarter of 2006. See additional discussion above in the 2007 vs. 2006 Revenue discussion.

In the commercial lines segment for the first nine months of 2007, we had underwriting income of $6.5 million, a GAAP combined ratio of 92.8%, a GAAP loss and loss adjustment expense ratio of 59.6% and a GAAP underwriting expense ratio of 33.2%, compared to 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% in the first nine months of 2006. Our commercial lines loss ratio for the first nine months of 2007 reflects a frequency of losses reported and severity within a normal range of our expectations. The performance of the commercial lines in the first nine months of 2007 was impacted favorably by the non-recurring retaliatory tax refund.

In the commercial lines segment for the third quarter of 2007, we had underwriting income of $1.0 million, a GAAP combined ratio of 96.9%, a GAAP loss and loss adjustment expense ratio of 62.0% and a GAAP underwriting expense ratio of 34.9%, compared to 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% in the third quarter of 2006. The performance of the commercial lines in the third quarter of 2007 was impacted favorably by the non-recurring retaliatory tax refund.

Results of our Personal Lines segment were as follows:


Nine months ended September 30,
2007 vs. 2006 Personal Lines (PL)	2007			2006			Change			% Change
	(Dollars in thousands)
PL Direct premiums written	$	17,261		$	18,300		$	(1,039	)		(5.7)	%
PL Net premiums written	$	15,763		$	16,896		$	(1,133	)		(6.7	)%
PL Net premiums earned	$	16,539		$	16,909		$	(370	)		(2.2	)%
PL Loss/ LAE expense ratio (GAAP)		71.5	%		68.1	%		3.4	%
PL Expense ratio (GAAP)		33.8	%		39.1	%		(5.3	)%
PL Combined ratio (GAAP)		105.3	%		107.2	%		(1.9	)%


Three months ended September 30,
2007 vs. 2006 Personal Lines (PL)	2007			2006			Change			% Change
	(Dollars in thousands)
PL Direct premiums written	$	6,156		$	6,417		$	(261	)		(4.1)	%
PL Net premiums written	$	5,620		$	5,930		$	(310	)		(5.2)	%
PL Net premiums earned	$	5,436		$	5,668		$	(232	)		(4.1)	%
PL Loss/ LAE expense ratio (GAAP)		55.5	%		67.1	%		(11.6	)%
PL Expense ratio (GAAP)		37.8	%		38.9	%		(1.1)	%
PL Combined ratio (GAAP)		93.3	%		106.0	%		(12.7	)%

In the first nine months of 2007, personal lines direct premiums written declined to $17.3 million, representing a decline of $1.0 million or 5.7% from $18.3 million in the first nine months of 2006. Our personal lines have been impacted by increased competition, similar to our commercial lines. Net premiums written in the period also declined to $15.8 million in the first nine months of 2007, as compared to $16.9 million in the first nine months of 2006, representing a decline of $1.1 million or 6.7%. Personal lines net premiums earned declined 2.2% to $16.5 million.

In the third quarter of 2007, personal lines direct premiums written declined to $6.2 million, representing a decline of $0.3 million or 4.1% from $6.4 million in the third quarter of 2006. Net premiums written in the period also declined to $5.6 million in the third quarter of 2007, as compared to $5.9 million in the third quarter of 2006, representing a decline of $0.3 million or 5.2%. Personal lines net premiums earned declined 4.1% to $5.4 million in the quarter.

In the personal lines segment for the first nine months of 2007, we had an underwriting loss of $879,000, a GAAP combined ratio of 105.3%, a GAAP loss and loss adjustment expense ratio of 71.5% and a GAAP underwriting expense ratio of 33.8%, compared to 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% in the first nine months of 2006. Our personal lines loss ratio for the nine months of 2007 reflects a frequency and severity of losses reported which falls generally within a normal range of our expectations.

In the personal lines segment for the third quarter of 2007, we had an underwriting gain of $367,000, a GAAP combined ratio of 93.3%, a GAAP loss and loss adjustment expense ratio of 55.5% and a GAAP underwriting expense ratio 37.8%, compared to 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% in the third quarter of 2006. Our Loss/LAE ratio of 55.5% for the third quarter of 2007 outperformed the comparable ratio of 67.1% for the third quarter of 2006, due to favorable claims loss frequency and severity in the quarter.

Underwriting Expenses and the Expense Ratio is discussed below.


Nine months ended September 30
2007 vs. 2006 Expenses and Expense Ratio	2007			2006			Change			% Change
	(Dollars in thousands)
Amortization of Deferred Acquisition Costs	$	27,829		$	24,187		$	3,642			15.1	%
As a % of net premiums earned		26.2	%		23.7	%		2.5	%
Other underwriting expenses	$	7,530		$	10,208			(2,678	)		(26.2	)%
Total expenses excluding losses/ LAE	$	35,359		$	34,395		$	964			2.8	%
Underwriting expense ratio		33.2	%		33.7	%		(0.5	)%

Underwriting expenses increased by $964,000, or 2.8%, to $35.4 million in the first nine months of 2007, as compared to $34.4 million in the first nine months of 2006. The increase in 2007 underwriting expenses reflects the inclusion of the non-recurring retaliatory tax refund, which reduced other underwriting expenses by $3.6 million in the first nine months of 2007. Offsetting that refund, other underwriting expenses increased due to an increase in salary expense from additions in staff Group-wide to support strategic initiatives, and other increased operating expenses. In addition, the amortization of deferred acquisition costs is lower in 2006 as compared to 2007 due to the fact that when FPIG was purchased on October 1, 2005, the accounting for the business combination required the Group to begin accruing deferred acquisition costs from the date of acquisition. Lastly, underwriting expenses are impacted by the previously discussed changes in the 2007 and 2006 reinsurance program whereby less ceded premium is being recorded and accordingly less ceding commission is received on treaties in runoff, and the treaties effective January 1, 2007 do not provide for ceding commission, which increases underwriting expenses and net acquisition costs.

Our Federal income tax was as follows:


2007 vs. 2006 Income Taxes	2007		2006			Change			% Change
	(Dollars in thousands)
Income before income taxes	$	16,052	$	11,107		$	4,945			44.5	%
Income taxes	$	4,697	$	3,368		$	1,329			39.5	%
Net income	$	11,355	$	7,739		$	3,616			46.7	%
Effective tax rate		29.3		30.3	%		(1.1	)%

Federal income tax expense was $4.7 million and $3.4 million for the first nine months of 2007 and 2006, respectively. The effective tax rate was 29.3% and 30.3% for the nine months of 2007 and 2006, respectively. The 2007 effective tax rate was impacted by an unusually high amount of taxable income in the period caused by the retaliatory tax refund, offset by higher tax-advantaged income (municipal bond interest and dividend income, which reduce the effective tax rate).

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.

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 the Holding Company (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 MIC and its quarterly dividend to shareholders) is dividend payments and other fees received from the insurance subsidiaries, and payments it receives on the 10-year note it received from the ESOP (see below) when the ESOP purchased shares at the time of the conversion from a mutual to a stock form of organization (the “Conversion”).

The Group’s insurance companies are required by law to maintain a certain minimum surplus on a statutory basis, and are subject to risk-based capital requirements and to regulations under which payment of a dividend from statutory surplus may be restricted and may require prior approval of regulatory authorities.

Additionally, there is a covenant in the Group’s line of credit agreement that requires the Group to maintain at least 50% of its insurance companies capacity to pay dividends without state regulation pre-approval.

Under Pennsylvania law, there is a maximum amount of dividends that may be paid by MIC to MIG 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 MIC’s statutory surplus as reported on its most recent annual statement filed with the Pennsylvania Insurance Department, or the net income of MIC for the period covered by such annual statement. As of December 31, 2006, the amounts available for payment of dividends from MIC in 2007, without the prior approval of the Pennsylvania Insurance Department is approximately $5.9 million.

All dividends from FPIC to FPIG require prior notice to the California Department of Insurance. All “extraordinary” dividends require advance approval, and the payment of ordinary dividends made for the purpose of servicing debt of the Group has been restricted and requires prior written consent. A dividend is deemed “extraordinary” if, when aggregated with all other dividends paid within the preceding 12 months, the dividend exceeds the greater of (a) statutory net income (excluding unrealized capital gains) for the preceding calendar year or (b) 10% of statutory surplus as of the preceding December 31. As of December 31, 2006, the amounts available for payment of dividends from FPIC in 2007, without the prior approval, in addition to those dividends required to service debt of the Group, for which pre-approval is required, is approximately $5.6 million.

As part of the funding of the acquisition of FPIG, MIC entered into a loan agreement with MIG, by which it advanced to MIG on September 30, 2005, a loan of $10 million with a 20-year note and a fixed interest rate of 4.75%, repayable in 20 equal annual installments. MIG has no special limitations on its ability to take periodic dividends from its insurance subsidiaries except for normal dividend restrictions administered by the respective domiciliary state regulators as described above. The Group believes that the resources available to MIG will be adequate for it to meet its obligation under the note to MIC, the line of credit and its other expenses.

On March 29, 2007, June 29, 2007, and September 28, 2007, MIG paid a quarterly shareholder dividend of $0.05 per common share. MIG began paying quarterly dividends in the second quarter of 2006. The amount of dividends paid for the nine months ending September 30, 2007 totaled $0.9 million, which amount was funded from the Group’s insurance companies, for which approval was sought and received (where necessary) from each of the insurance companies’ primary regulators.

The Group maintains an Employee Stock Ownership Plan (ESOP), which purchased 626,111 shares from the Group at the time of the Conversion in return for a note bearing interest at 4% on the principal amount of $6,261,110. MIC makes annual contributions to the ESOP sufficient for it to make its required annual payment under the terms of the loan to the Holding 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 Group’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. Shareholder dividends received on unallocated ESOP shares are used to pay-down principal and interest owed on the loan to the Holding Company.

The Group 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 September 30, 2007, the shares authorized under the plan has been increased under this provision to 1,075,870 shares. For the nine months ended September 30, 2007, the Group made no grants of restricted stock and stock options. A total of 19,400 incentive stock options and 3,000 shares of restricted stock were forfeited during the nine months ended September 30, 2007. A total of 3,000 incentive stock options granted under the plan were exercised during the nine months ended September 30, 2007.

Total assets increased 8%, or $41.0 million, to $548.0 million at September 30, 2007, from December 31, 2006. The Company’s total investments increased by $33.6 million, or 11%, primarily due to net cash provided by operations. Premiums receivable increased $5.7 million, or 15%, primarily reflecting timing of premiums written. Reinsurance receivables increased by $5.2 million, or 6%, from December 31, 2006, primarily due to increased receivables on paid claims. Prepaid reinsurance premiums decreased by $6.4 million, or 39%, principally due to a change to certain of the Company’s reinsurance contracts for 2007, whereby fewer unearned premium reserves are ceded. Deferred policy acquisition costs increased $4.8 million, or 29%, from December 31, 2006, reflecting the increase to net unearned premium reserves. Additionally, deferred income taxes increased by $0.4 million, or 5%, primarily due to profit commissions received on reinsurance contracts that are currently taxable and increases in loss and unearned premium reserves, offset by the timing difference resulting from the increase in deferred acquisition costs.

At September 30, 2007 total liabilities increased by $28.1 million, or 7%, from December 31, 2006, primarily as a result of the increase in losses and loss adjustment expense reserves of $20.6 million, or 8%, and the increase in unearned premiums of $10.3 million, or 13%. Other reinsurance balances decreased by $6.1 million, primarily due to changes to the Group’s reinsurance contracts in 2007.

Stockholders’ equity increased by $12.9 million or 11% to $128.8 million at September 30, 2007 from $115.8 million at December 31, 2006. The change for the period was primarily due to $11.4 million of net income. Additionally, the Group had $0.5 million in unrealized holding gains on securities. The change in stockholders’ equity for the period also included a $0.9 million increase to additional paid-in-capital from amortization of the stock compensation plans and $0.9 in ESOP shares committed, offset by stockholder dividends of $0.9 million.

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 Group was not a party to any unconsolidated arrangement or financial instrument with special purpose entities or other vehicles at September 30, 2007 which would give rise to previously undisclosed market, credit or financing risk.

The Group and its subsidiaries have no significant contractual obligations at September 30, 2007, other than its insurance obligations under its policies of insurance, trust preferred securities interest and principal, a line of credit obligation, and operating lease obligations. Projected cash disbursements pertaining to these obligations have not materially changed since December 31, 2006, and the Group 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, 2007, 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, 2006, 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, 2007 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, 2006.

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

None

Item 3. Defaults Upon Senior Securities

None


	MERCER INSURANCE GROUP, INC. (Registrant)
Dated: November 09, 2007	By:	/s/ Andrew R. Speaker
		Andrew R. Speaker,
		President and Chief Executive Officer


Dated: November 09, 2007	By:	/s/ David B. Merclean
		David B. Merclean,
		Senior Vice President and Chief Financial Officer

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	2007		2006
	(Dollars in thousands, except
	per share data)
	(Unaudited)
Revenue:
Net premiums earned	$	106,367		102,172
Investment income, net of expenses		9,592		7,057
Net realized investment gains		267		100
Other revenue		1,494		1,605

Total revenue		117,720		110,934


Expenses:
Losses and loss adjustment expenses		65,398		64,519
Amortization of deferred policy acquisition costs (related party amounts of $865 and $916, respectively)		27,829		24,187
Other expenses		7,530		10,208
Interest expense		911		913

Total expenses		101,668		99,827

Income before income taxes		16,052		11,107

Income taxes		4,697		3,368

Net income	$	11,355		7,739


Earnings per common share:
Basic	$	1.85		1.29
Diluted	$	1.80		1.25

Weighted average shares:
Basic		6,125,654		6,006,693
Diluted		6,318,029		6,192,731


							Accumulated
					Additional		other						Unearned
	Preferred		Common		paid-in		comprehensive			Retained			ESOP			Treasury
	stock		stock		capital		income			earnings			shares			stock			Total
Balance, December 31, 2006	$	—		—		68,473		2,815			54,629			(3,757	)		(6,321	)		115,839
Net income											11,355									11,355
Unrealized gains on securities:
Unrealized holding gains arising during period, net of related income tax of $462								897												897
Less reclassification adjustment for gains included in net income, net of related income tax expense of $161								(312	)											(312	)

Other comprehensive income																				585

Comprehensive income																				11,940

Stock compensation plan amortization						876														876
Tax benefit from stock compensation plan						153														153
ESOP shares committed						423								469						892
Issuance of common stock						40														40
Treasury stock																	(40	)		(40	)
Dividends to stockholders											(942	)								(942	)

Balance, September 30, 2007	$	—		—		69,965		3,400			65,042			(3,288	)		(6,361	)		128,758